Video: Module 7 – What Investors Look For
Presenter: Andrew Earnshaw
Investors who are looking at investing in a small business, almost without fail are all looking at the same thing. There's four standard criteria for making investment decisions. They are: management, earnings, security, and personal investment or equity. Sometimes you'll hear "the four Cs of capital" to define the same thing. Let's see if I can get it right. The first one is character, the next one is cash flow for earnings. So management is character; cash flow is earnings. Collateral is security, and capital is equity. There we go. So there's the four Cs of lending. So you'll see different terms all the time, but those are the four things that most folks are looking at.
Let's start by talking about the first one, management. You need to be able to convince a person that is going to invest in your business that you have all the skills and all the drive and all the tools and all the education and whatever else, the experience, that you need to be able to succeed in this business. It needs to be front and centre of any proposal to someone who is considering putting money into your business.
When you work with lenders, one of the main indicators that they'll use of assessing your character, assessing your ability to manage things, particularly manage money, is your credit record. So it's really important before you go looking to a lender for some money that you contact your credit bureau. If you're pretty much anywhere in Canada Equifax.ca is the main credit bureau. This is a private company that keeps information about you and about your past history with debt.
The strongest indicator that lenders have for whether you'll pay them back is your track record of paying other people back in the past. So the way they determine that is by looking at your credit score which is a complex statistical calculation based on your behaviour in the past. It gives you a score out of 900 for your likelihood of paying back debts. It's really important that you go to Equifax, get a copy of your credit score. You'll have to pay about $20 for the actual credit score you can get the information they base the score on for free, but you have to pay for the score and get advice from them on how to improve that score before you go talking to lenders.
I know personally I did that before I went for my home mortgage, and I managed to get my score increased by about 30 points, which means I saved thousands of dollars on my mortgage. So this is a really really important criteria.
What can you do to not only state that you have all the skills and abilities and knowledge, but what can you do to prove it? You can provide certificates, can you send copies of your diplomas, can you get reference letters from past employers that say you're the best salesman they ever had, these kinds of things? It's important first of all for you to stand up and say what you're offering, but then also to provide as much proof as you can, external third party proof, so that a person can believe all the things that you can provide proof for.
So now the investor is going to say, "Okay, I think this person and their team will pull it off, but are they doing something that makes sense from a market perspective? Are the earnings going to be there for them to actually succeed in this business?" You've done as much as you can in terms of surveys, you've done statistical research about the size of your market, you've talked to people that will buy your product. You put all that information together in a proposal that you're moving forward, and hopefully you'll come up and say: "I'm pretty darn sure that I can sell 1,000 units of what it is that I'm making."
So there's your first step. But the next step that you want to do in your proposal when you talk about earnings is you want to say, "I'm sure I can sell a thousand, but I only need to sell 400." What is the break even sales that you need? To do that, you take your fixes expenses, you decide how much profit you make each time you sell one of your units. So let's say that you have fixed expenses in a year of $10,000. You're selling a product that you sell for $200, and it costs you $100 to buy the parts to make it. Those are the variable expenses. So your profit from each sale is $100. You've got 10,000 of fixes expenses. So you need to sell a hundred of those units a year, 100 times 100 units, that's 10,000. So that's the break even sales that you need. So not only do you tell the investor: "I'm sure I can sell a thousand of those, but to break even, I only need to sell 400," that's the case in your business. So there's a cushion in there, there's some room that says, "Hey, I'm probably going to succeed in this business, whether I make my projections or not."
But if you're looking for someone who is going to loan you money, particularly a traditional lender like a bank or a community financial institution, they're going to want to know what security you can offer. Security can take all kinds of different forms. It could be a mortgage on a piece of property, it could be the equivalent to a mortgage on business assets. That's called a general security agreement. It might be a promissory note from you; in fact, it almost for sure will be a promissory note from you that says, "I promise to pay this money back whether my business succeeds or not." It might be guarantors that come to the table and also sign promissory notes that say, "Hey, if this person doesn't pay you back, then I'm willing to step up to the plate and make up the difference of whatever they haven't paid back." Guarantors are cosigners, another word for a guarantor.
Because security is so important to lenders, they're probably going to require that you have insurance on all the things that you pledge for security. The lender will have to be what's called the loss payee on that insurance. You'll have to go to your insurance agent, have them file a letter on your file that says if something happens and you make a claim, the cheque goes to the lender first, not actually to you. These are common practices in small business lending.
The last consideration that an investor has, particularly traditional lending investor, is equity, personal investment. That tells us two things. The first thing it tells us is that you made a personal commitment to this business, you have something to lose if things don't work out. And that's very very important. But the second thing is a little bit more difficult to assess. And that is that we know that there's enough cash in this business that the business isn't going to drown making debt payments. It comes back to that balance between debt and equity and its impact on cash flow, and that's extremely important. It's one of the strongest statistical indicators for lenders when they look at making business loans. Whenever there is too much debt, it doesn't matter how good the management is, it doesn't matter how good the earnings are, and it probably doesn't even matter how good the security is, if there's too much debt, the business is not going to succeed. So bringing enough equity to the table is really really important.
That's where it's really important, if you don't have your own money, to have the confidence to go out and look for other equity type investors.
Transcript provided by: Accurate Realtime Reporting Inc.