Dec 6, 2023

The Startup Founder’s Guide to Raising a Term Loan in 2024

Arc Team

Go-To-Market

Term loans are one of the more traditional forms of financing for businesses. Typically asset-lite startups do not pursue this form of financing, instead, they opt for venture debt or mezzanine financing which have more flexible repayment structures. Given you’re reading this guide, we’re going to assume you’re either in the market for a term loan or trying to determine if a term loan is right for your startup. As such, we’ve taken a stab at breaking down the key factors to consider when evaluating term loans. Ready? Let’s dive in!

Term loans - the basics

What a term loan is (and isn’t)

A term loan is a form of debt financing in which a borrower receives a lump sum of capital from a lender and agrees to repay the loan amount over a specified period, typically with predetermined fixed or variable interest rates. Unlike revolving credit facilities, such as business lines of credit or credit cards, term loans have a fixed term, ranging from one to several years, and a structured repayment schedule. Unlike equity financing, there is no dilutive component to term loans.

The key features of a term loan

Fixed Term: Term loans come with a set repayment period, distinguishing them from open-ended credit facilities. This fixed-term allows borrowers to plan and budget for repayments over a defined period.
Fixed Interest Rates: While some term loans may have variable interest rates, most offer fixed rates, providing borrowers with predictability in monthly repayment amounts.
Purpose-Specific: Term loans are often earmarked for specific purposes within a startup, such as equipment financing, expansion, working capital, or other capital-intensive needs.
Repayment Schedule: Unlike bullet loans, borrowers repay term loans through regular installments, usually monthly, over the loan's duration. Each installment covers both the principal amount borrowed and the accrued interest.
Secured or Unsecured: Term loans can be secured or unsecured. Secured loans require collateral, which serves as security for the lender in case of default. Unsecured loans, on the other hand, do not require collateral but come with higher interest rates.

The common use cases for term loans

Startups can use term loans for a variety of things, outlined below are some of the most common use cases.

Equipment Financing: Acquiring or upgrading business equipment, machinery, or technology.
Working Capital: Covering day-to-day operational expenses, managing inventory, or addressing short-term cash flow gaps.
Debt Refinancing: Consolidating existing debts, securing more favorable terms, or lowering overall interest costs.
Real Estate Acquisition: Purchasing or upgrading commercial real estate for business operations.
Technology Investment: Financing the implementation of new technologies or software systems that enhance business operations.
Seasonal Financing: Covering increased expenses or capitalizing on opportunities during peak seasons.

The common types of term loans

Traditional Term Loans: These are the standard term loans offered by traditional banks and financial institutions, which can be used for general business needs, equipment purchases, and expansion projects. They come with fixed or variable interest rates, regular monthly payments, and a predetermined repayment period.
Short-Term Term Loans: These are term loans with a shorter repayment period, typically one year or less. They can be used for immediate working capital needs, seasonal fluctuations, and bridge financing. They come with a quick approval time, and faster repayment schedules, and are often unsecured.
Intermediate-Term Term Loans: These are loans with a moderate repayment period, usually between one and five years. They’re typically used for equipment financing, technology upgrades, and moderate expansion projects. They come with competitive interest rates and structured repayment plans.
Long-Term Term Loans: These are loans with an extended repayment period, often beyond five years. They’re most frequently used for large-scale expansions, real estate purchases, and significant business investments. They come with lower monthly payments and are suitable for projects with extended payback periods.

The common components of a term loan agreement

A term loan agreement is a legally binding document that outlines the terms and conditions of a term loan. While the specific details can vary based on the lender, borrower, and the nature of the loan, here are some of the common components found in a typical term loan agreement:

Loan Amount and Purpose: This clearly states the total amount of the loan granted to the borrower and specifies the purpose for which the loan proceeds can be used.
Interest Rate: This defines the interest rate structure, whether fixed or variable, and details how the interest is calculated, accrued, and when it is due.
Repayment Terms: These outline the schedule of repayments, including the frequency (monthly, quarterly, etc.) and the due dates, and specify the method of repayment, such as direct debit, wire transfer, or other approved methods.
Collateral (if applicable): This identifies any collateral or security interests required to secure the loan, and specifies the type, value, and location of the collateral.
Covenants: These outline any financial or operational covenants the borrower must adhere to during the term of the loan, and specify the reporting requirements and timelines for providing financial statements and other requested documents.
Representations and Warranties: These list the statements made by the borrower regarding its financial condition, business operations, and legal compliance to ensure the accuracy of the information provided by the borrower.
Events of Default: This defines the conditions or events that, if they occur, would be considered a default under the agreement, as well as the consequences of default, which may include acceleration of the loan or other remedies available to the lender.
Prepayment Terms: This outlines any terms or conditions related to the prepayment of the loan, including whether prepayment penalties or fees apply.
Fees and Expenses: This section outlines any upfront fees, closing costs, or ongoing fees associated with the loan and specifies who is responsible for covering legal, administrative, and other expenses.
Conditions Precedent: This lists the conditions that must be satisfied by the borrower before the loan is disbursed. Examples include providing certain documents, obtaining necessary approvals, or meeting specific financial benchmarks.
Amendment and Waiver Provisions: These outline the process for making amendments or modifications to the agreement and address whether waivers of certain provisions can be granted and under what circumstances.
Confidentiality and Non-Disclosure: This one is pretty standard across most agreements, it includes the provisions regarding the confidentiality of information exchanged between the borrower and lender.
Miscellaneous Provisions: These can include miscellaneous clauses covering matters such as notices, force majeure, and the parties' rights and obligations.

Assessing whether a term loan is right for your startup

Advantages of term loans

Predictable Repayment Schedule: Term loans come with a fixed repayment schedule, typically monthly, allowing businesses to plan and budget with certainty.
Fixed Interest Rate: Most term loans come with a fixed interest rate, which provides stability over the loan term.
Flexibility in Use of Funds: Term loans can be used for various business purposes, from working capital and equipment financing to expansion projects.
Structured Repayments: Repayments are structured into regular installments, making it easier for startups to manage their cash flow and allocate resources efficiently.
Secured and Unsecured Options: Term loans can be either secured or unsecured. Secured loans, requiring collateral, may offer lower interest rates, while unsecured loans provide an option for startups without specific assets to pledge.

Disadvantages of term loans

Rigidity in Repayment: The same thing that is advantageous for some startups that take a term loan can be a disadvantage to another startup. Monthly installments must be paid regardless of fluctuations in cash flow, potentially straining the startup’s finances.
Collateral Requirements: Many term loans require collateral to secure the debt, which can be seized in a default.
Early Repayment Penalties: Some term loans impose penalties for early repayment.
Impact on Cash Flow: The structured repayment schedule, while predictable, impacts startups' cash flow.
Not Ideal for Short-Term Needs: Term loans might not be the best solution for short-term financing needs or immediate cash injections.

Qualification criteria for term loans

The specific criteria used to determine whether a startup qualifies for term loan financing varies by lender. Generally speaking, term loans are only provided to startups that have raised equity financing and have an adequate cash balance or those that have positive cash flow. Outlined below are some of the common factors that lenders may consider.

Current Cash Balance: Typically lenders extend 30-50% of a startup's current cash balance for the sizing of a term loan.
Burn: Lenders consider a startup's current and forecasted burn when determining how much debt they can afford to take on.
Runway: If a startup has <12mo of runway, generally speaking, they will not be qualified for a term loan. In 2023, most startups received a term length of <50% of their runway.
Collateral: For secured term loans, startups need to provide collateral, to mitigate the lender's risk in case of default.
Debt-to-Equity Ratio: Lenders analyze a startup's debt-to-equity ratio to assess its financial structure. Generally speaking, lenders look for a debt-to-equity ratio of less than 2.

Evaluating a term loan offer

Admittedly, this section is pretty basic, if you’ve already raised equity or debt in the past, you can skip it. The main thing to consider is whether or not term loans align with your business needs and financial objectives.

Interest Rate Type: Fixed interest rates are great for businesses that want a predictable monthly payment. Variable interest rates can be beneficial for startups that intend to pay back the loan before maturity as they typically come with a lower introductory interest rate.
Fees: Factor in all associated costs to calculate the true cost of the loan. Choose a lender with transparent fee structures and minimal extra charges.
Loan Amount: It can be tempting to go with the term loan option with the greatest sizing, proceed with caution as this can result in overburdening your business with excess debt.
Repayment Length: Generally speaking, the longer the term length the higher the cost of capital and vice versa. The repayment length you settle on should align with your intended use of the funds.
Collateral Requirements: As mentioned a few times throughout this article there are collateralized and uncollateralized term loans. Collateralized loans have a lower cost of capital, but can result in the seizure of your assets in a default event.
Loan Restrictions: Some lenders may restrict the use of funds for specific purposes. Ensure that the loan allows you to achieve your intended business goals.
Lender Reputation: This factor is crucial. If you’re a first-time founder and have never raised debt before, make sure that you research the reputation of the lenders you’re considering working with. Read reviews, seek recommendations from other founders, and choose a lender with a positive track record and a history of supporting businesses similar to yours.

Frequently asked questions (FAQs) about term loans

How do interest rates work in term loans?

Interest rates in term loans can be either fixed or variable. Fixed rates remain constant throughout the loan term, providing stability and predictability in monthly payments. Variable rates, on the other hand, can change based on market conditions, potentially affecting the overall cost of the loan.

What are the typical repayment terms for term loans?

Repayment terms for term loans vary but commonly range from one to five years for short-term loans and up to 25 years for long-term loans. The repayment schedule involves regular installments, often monthly, covering both the principal amount borrowed and accrued interest.

Can startups qualify for term loans?

Yes, startups can qualify for term loans, but the process may be more challenging compared to established businesses. Lenders typically assess the startup's financial health, creditworthiness, and the founder's experience. Startups may need to provide detailed documentation and demonstrate a clear plan for using the loan funds and repaying the debt.

What is the difference between secured and unsecured term loans?

Secured term loans require collateral, such as business assets or personal assets, which can be seized in a default. Unsecured term loans, on the other hand, do not require specific collateral but may have higher interest rates to compensate for the increased risk to the lender.

How does the loan application process for a term loan work?

The loan application process involves several steps. It begins with gathering necessary documentation, including a comprehensive business plan, financial statements, and legal documents. Once the documentation is prepared, the borrower completes the loan application, specifying the loan amount, purpose, repayment terms, and other details. Meetings with lenders may follow to present the case, discuss the application, and address any questions or concerns.

How can startups manage their debt effectively?

Startups can manage their debt effectively by:

Creating a Realistic Budget: Develop a budget that accounts for all business expenses, including loan repayments.
Monitoring Cash Flow: Regularly track and manage cash flow to ensure the availability of funds for debt obligations.
Communicating with Lenders: Maintain open communication with lenders, especially if facing financial challenges. Discussing potential modifications or solutions before issues escalate is crucial.
Exploring Repayment Options: Some term loans offer repayment flexibility. Explore options such as early repayment or restructuring if needed.

Wrap up - raising a term loan in 2024

Term loans offer startups a stable financing option due to their predictable repayment schedules, making them the perfect fit for strategic initiatives such as expansion plans and equipment purchases. However, this rigid structure can become problematic for startups with lumpy revenues as the monthly payment is due regardless of whether the startup has a “bad month”. They also aren’t ideal for short-term financing needs because most come with early repayment penalties.

If you’re interested in a term loan, get in touch with us.