Equity Financing (Part 1)

Financing – A black Box

Financing activities is often a black box for the CEO of a Small and Medium company (SME). The main activity of the Manager is not to make financial management but to manage the business, to create products and sell them. In order to demystify the thing, this article is the first of a series of several articles devoted to corporate finance.

SMEs contribute significantly to the Quebec and Canadian economy. Their launch or expansion requires a lot of efforts and especially funds. Each SME is unique and has specific financing needs which must be tailored. We hope that our articles will provide answers to your questions about this topic less often, without flooding you too much with complex information.

Equity financing (part 1)

Equity financing is an important source of money for companies at all stages of their development. This type of financing allows an SME to remain debt-free, but on the other hand, a percentage of the company or profits shall be transferred to the investor. In contrast, some entrepreneurs borrow money to finance their business; in doing so, they will go into debt, and must repay their loans with interest. This approach allows keeping the entire possession of the company; however the entrepreneur absorbs all the risk. Remember that all debt financings require a sharing of risk between the lender and the entrepreneur, either by down payment (in equity or in the form of cash advance) or by generating surpluses with operations.

Equity financing comes mostly from the entrepreneur or by reinjection of the retained earnings and surplus. Access to external financing, in the form of venture capital, is very restricted in Quebec according to some observations and studies. If the business plan is sufficiently rigorous to convince an investor, and that the entrepreneur is surrounded by an outstanding management team, accessing equity becomes possible.

Equity financing has certain peculiarities. Unlike commercial loans, equity financing does not provide a guarantee to investors. The only guarantee is that the company is profitable so that the investor can realize a return based on the future value of its shares. The return on investment sought (by the investor) is higher for than commercial loans because warranties are non-existent. It is also not surprising that the access to this type of financing is difficult for a start-up company, moreover, if it operates in a certain industry with less margins, such as, restaurants, retails, etc.

Sources of capital

• Personal investment (personal savings, pension funds, RRSP, personal loans, etc.)
• Retained earnings (re-injection to contribute to growth)
• Friendly capital (family, suppliers, partners)
• Participatory financing (crowd funding)
• Angel Investors (experienced entrepreneurs and professionals)
• Development Capital Funds (Desjardins Business Capital régional et coopératif, Fondation, Fonds FTQ, Investissement Québec and BDC)
• Formal Venture Capital (public or private companies)
• Initial public offering (IPO) (massive need for capital, monitoring by the financial markets authority) 

Major uses of funds

• Early stage / Start-Up
• Growth
• Green economy
• Information technology company
• Export and new markets
• Acquisition of the company by managers (MBO)
• Business transfer
• Development and R & D
• Bridge loan 

Advantages

• No financial charge (excluding dividends)
• Formal risk and development capital (access to strategic partners and their advice)
• Increases the cash liquidity in a great way compared to other forms of corporate finance
• Increases the borrowing capacity for the company but reduces the level of control exercised by the owner 

Disadvantages

• Dividends are not tax-deductible (for the company)
• Strict laws on securities
• Administrative burden (creation of formal committees and a Board of Directors in some cases)

 

Sources of information

We invite you to consult the directory of Réseau Capital in order to find the ideal partner for your company if you are looking for equity financing.

Réseau Capital, the Québec Venture Capital and Private Equity Association, is the only private equity association that brings together all stakeholders involved in the Quebec investment chain. Réseau Capital as more than 425 members representing private equity, tax-advantaged and public investment companies as well as banks and insurance companies, accounting and law firms, along with many professionals working in the field.

Canadian Venture Capital and Private Equity Association (CVCA) is the Canadian penchant of Réseau Capital. This association has nearly 1500 members.

If you want to share your thoughts on this blog and its contents, simply write to us at info@stage1success.com. We look forward to reading your comments and feedback.

References: Journal Les Affaires, Réseau Capital, CVCA.

10 steps to your stage 1 project

We are often asked “what are the top 10 best advices” you could share with us for starting up a new enterprise or launching a new project or product.

1. Get your winning business plan in motion and prepare a realistic financial forecast
2. Hire the best talents
3. Be a financial savvy with investors
4. Learn or get help navigating and negotiate with financial institutions
5. Your first clients are your best marketing tool
6. Put your stamps on everything you sell and have memorable products and services
7. Always follow through your customers and clients and build lasting relationships
8. Identify project risk and mitigate
9. Review your business stages and don’t hesitate to pivot your model
10. Identify and get the best business experts for your stage 1 enterprise or project. Do not hesitate to share with your mentor or your advisor any issues with your company.

Hard work and get the best to help and advice to enable you achieve your goals

The 5 Criteria for Analysis in the Granting of Commerical Loans

You’ve tweaked your business plan and prepared your financial projections with care. Your start-up phase is a thing of the past and you have shown that your business model works. You are now ready to move on in second gear and would like to meet a lender to obtain a commercial loan. STOP! Above all else, it is important to know the 5 most important criteria of analysis of commercial loans by a financial institution, what are called in the garden of the lender, the 5 “C’s” of credit.

The assessment of the 5 ‘C’ is a method used by lenders to determine the creditworthiness of companies. This method weighs 5 company criteria and attempts to assess the risk of default of a potential borrower.

This blog will help you demystify the analysis of your business plan, of your predictions and of yourself by a typical lender. The 5 “C” are presented in order of importance.

1. CARACTER

The first criterion is of course an analysis which focuses on you (honesty, transparency, experience, training, past success, your strengths, etc.). The lender looks at the character of the leader and the company first and foremost. The lender will ask himself/herself, do I have enough confidence in the person before me to grant a loan? Will he/she repay the loan as agreed? In addition, the lender will look at the quality of managers in place. Even in difficult times, a highly competent management team will take the necessary decisions in order to maintain profitability.

2. CAPACITY

The second criterion is the ability to make your repayments (the ability to meet debt service). Often, we think that if we offer enough guarantees, we will get the loan. However, a commercial loan is offered on the basis of positive cash-flows and not on the guarantees you offer. Therefore, it becomes important to demonstrate the profitability of your business. You will need to justify how you are going to produce income as well on how you can control your costs. You will need to demonstrate how you will generate profits in order to repay the debt when it comes due.

The lender will also analyze your past results and compare them with your financial forecasts. Do not exaggerate. There is no need to demonstrate a “Hockey Stick” growth if not evidently assured, because you will lose your credibility. It is important to demonstrate to the lender a prudent and realistic repayment capacity. He/she must believe in your financial projections, which should demonstrate conservative estimations. In addition to your financial forecasts, bring your pipeline of clients, and your list of recurring clients. Further, demonstrate that you fully understand the management of your gross margin and your fixed costs.

3. CAPITAL^[1]

The third analysis criterion is capital structure. More specifically, the lender is looking for a company with a solid capital structure (equity). It is important for the lender for two reasons:

• Firstly, the company must have sufficient equity as a cushion to withstand any anomaly in the ability to generate expected cash flows. For example, if the business became unprofitable for some reason, it will start burning cash to finance its operations. Financial institutions are never interested in lending money to finance business losses. A solid capital structure allows the lender to make sure that there is enough equity to weather a temporary storm.
• Secondly, when it comes to capital, the financial institution is looking for business owners who have invested enough of their personal assets in their business, so that if a storm is underway, the owner will be motivated to work with the financial institution during a recovery phase.

Generally, financial institutions prefer companies whose total debt to equity ratio is less than 3. Depending on the type of business, this ratio can vary.

4. COLLATERAL

The collateral consists of guarantees (accounts receivable, inventories, equipment, building, etc.) that you offer to your lender and are elements of mitigating risk for the latter. The lender will rarely finance assets at 100%[2]  of cost or their fair value market. A sharing of risk between the lender and the company is therefore necessary.

The financial institution is interested in the guarantee as a secondary source of repayment of the loan in the event of the need to exercise a guarantee. In addition, the financial institution may require an assessment of some of your assets, normally for real estate financing. Keep in mind that you will be responsible for the cost of third parties in the valuation of the assets. Don’t forget to take into account the time required to conduct the required assessment.

Finally, the type of guarantees is of importance, because in a liquidation scenario, intangible assets (the amounts paid in advance, investments, etc.), will not be regarded as significant, because they generate little or no liquidity.

5. CONDITIONS

The last criterion of analysis relates to the Market Conditions and the Loan Conditions.

Market conditions

The lender will assess the market conditions surrounding your business and its industry to determine key risks and how the company operates to mitigate them. Even if the historical financial performance is strong, the lender wants to ensure the future viability of your business. Here are some elements of risk that the lender may take into account in his analysis:

• The competitive landscape: Who are your competitors? How do you differentiate yourself from the competition? How does your business have access to capital compared to your competitors? How are identified risks to be mitigated? What are the risks of losing your customers to the competition?
• The nature of your relationship with your customer: Does one of your customers represent more than 10 % of your total recurrent revenues? If yes, how do you protect your relationship with this client? What is the company doing to diversify its sources of income? What is the longevity of the relationship with your customer? Are some clients subject to financial stress? Is the company sufficiently capitalized to withstand any significant impairment of bad debt caused by a defaulting customer?
• The risk of supply: Is the company subject to ruptures in supply with a key supplier? How the company is able to mitigate this risk. What is the nature of the relationship with its key suppliers?
• The problems of the industry: Is there any macroeconomic factor or policy that could affect the company? Could the passage of pending legislation harm the industry or the economy?

The lender will need your help to identify and understand these key risks and how you are able to mitigate them. Be prepared to speak on the main threats and demonstrate that you are comfortable to manage these risks and how you protect your business.

Loan conditions

Now that your loan is authorized, make sure you understand all of the credit conditions listed in the loan contract. For example, the lender may restrict your salary, your dividend payments, and the purchase of equipment, or will accept any changes or increases without its agreement. The lender may also require adherence to certain financial ratios, including debt, the debt service coverage and so on. If certain conditions or requirements are not satisfactory to you and to your business, it is best to discuss these issues with your lender, and/or seek to renegotiate the clauses that do not meet your capacity or expectations.  It is important to keep your freedom of action.

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We hope that this article has helped you understand how your lender analyzes your loan applications.  With a better understanding of the way in which your lender evaluates your application, you will be better prepared. Do not hesitate to use these 5 ‘C’ as a strategic management tool, as it will allow your company to grow, flourish and to leapfrog ahead of the competition.

[1] Some financial institution weights Collateral before Capital

[2] You could finance up to a 100 % of the cost with a capital lease.