Financing a business, whether during the startup phase or for the purpose of expansion, is a central challenge for its founders.
Faced with multiple sources of accessible financing (loans, subsidies, etc.), a developer can sometimes be overwhelmed when it comes to taking advantage of the best mode of financing. Regardless of the source of financing selected, it is of utmost importance to determine the type of activity to be financed and ensure that the selected financing corresponds to your financial situation and business profile as closely as possible.
Funding organizations finance businesses using two complementary methods: namely debt financing and equity financing, or both at the same time. The two methods share a couple of common objectives: to be reimbursed and to obtain a return on their investment. Therefore, before giving you a single dollar, funding organizations will want to evaluate the risk they are taking by examining certain criteria.
1. The entrepreneur
The career path of the entrepreneur or team of entrepreneurs is one of the elements that investors take into consideration from the outset. In the eyes of lenders, education, experience and personal financial management speak to credibility. A project with an entrepreneur who possesses solid management skills that have been demonstrated throughout their career has a much higher probability of success than a project with a less qualified entrepreneur. After all, investors invest primarily in the entrepreneur. At the end of the day, regardless of the source of financing selected, all funding organizations want to know whether the developer can execute the project successfully, respect their commitments and manage their daily business in a way that guarantees its viability.
2. The market
Funding organizations also evaluate whether the business is operating within a market that is saturated, in decline or growing. In the case of a saturated or declining market, your product or service must demonstrate a competitive advantage that makes it significantly better than the competition in order to gain a share of the market. In the case of a growing market, there is room for new players, which confers an interesting potential for success on the project.
3. Financial statements
You will have to prepare your projected financial statements (generally over a period of two or three years), including the balance sheet, the income statement and the cash budget. The main errors that lenders see most often, and that can derail your application, include unrealistic projected sales and over-estimating future income.
For potential lenders, it is extremely important for the developer to be able to justify the projected income, and especially sales figures, with a certain degree of precision. If this is not the case, a potential lender or investor will have a hard time believing in the accuracy of the numbers, and by extension, in the reliability of the developer and the project.
A funding organization will also analyze a company’s financial statements to determine its financial health by calculating a number of ratios related to liquidity, profitability, management and financial structure. The debt coverage ratio will be of particular interest.
These ratios will then be compared to the industry in which the business operates. For example, a business may have a favourable debt ratio that turns out to be very low compared to the respective industry. That being said, a ratio that cannot be compared to that of the industry will have no significant meaning.
4. The portion of risk assumed by the founders
When analyzing an application for financing, funding organizations assign a great deal of importance to capital outlay. In effect, this allows them to determine both the portion of risk that the owner is prepared to assume with respect to the business project and their capacity to inject addition funds at any time, if required. In general, based on the criteria for various funds, a capital outlay on the order of 20% of the financial undertaking is required for the application to be considered eligible.
The means of production of a product or service to be sold is at the heart of the analysis, which may include the following questions, among others. Is a major investment required to attain the projected sales numbers? Has the cost of the equipment used already been amortized? Will the existing equipment be sufficient to attain the projected production volume?
These elements are generally essential to the evaluation of any application for financing. However, these elements are not exclusive, and their importance may vary based on the type of investor. For example, banks generally require certain guarantees to ensure that they will recuperate the entire loaned amount. For a term loan, the main guarantees are personal guarantees and mortgage guarantees (on equipment, a commercial building, etc.). It all depends on the funding organization’s internal investment policy and risk management approach to their portfolio of loans.
This article was written by Gilbert Samaha, Deputy General Manager