Five Reasons Companies Are Not Financed

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In our confused and even schizophrenic economic atmosphere, the back-to-basics movement has taken over the financial sector of business. This means that you have to keep profitability and risk, the two keys to all finance, rule. This means that financiers, both equity investors and lenders, are really focused on the basic "Five Cs" of banking:

Character
Capacity
Capital
Collateral
Condition

Companies that exceed the minimum of these basic Five Cs pose less risk, and tend to be more profitable. This means that now, more than ever, the Five Cs of banking are being ticked off as the reasons that financing is being denied.

The Five Cs are an anchor - if not a lifeline - for financial
industry. That is why these five points cover the entire expanse ofyour financial relationship with investors and lenders.

CHARACTER
Character simply refers to the people involved. VC's, angel investors, lenders alike all invest first and foremost in the people owning and running the company. No matter what the economic climate, it is the people who are judged. Even if the deal is perfect, if the people fail the test, no deal will be done. Bankruptcy, felony convictions, use of drugs, excessive use of alcohol, greed, stupidity, lechery, and general creepiness stops consideration of the deal. Because it is hard for small companies, and almost impossible for early-stage companies, to do adequate background checks, one member of the team can be the deal killer and no one in the company is aware of the cause of the problem. Financiers are hesitant to reveal why they are turning something down when it is based on an individual because they fear slander or liable suits and other liabilities. Also, there is a
deep-seated belief that if the rest of the management team were up to par, they would know about the problem.

However, you do not have to have something bad in your background to fail on character. For example, a company with a fairly nice deal never broke through the friends and family funding because the investors found that entrepreneur came across as a "loose cannon," a "squirrel," and "immature." Recently, another company had to spend a lot of time justifying a key member of the management team whom theywere bringing on board because he was "unemployed." The question was, "If this guy is so good, why isn't he with a company?" A third stage company recently could not get VCs interested, and it turned out that they management team was viewed as "disorganized and sleepy."

CAPACITY
Capacity refers to the revenue stream of a company. The word capacity means, in lending, the ability to repay the loan and its interest. While the word is not used on the equity side, the words revenues and cash flow basically mean the same thing, and answer the question: "will the company be able to pay back to the investors their initial investment plus a sizable return (500% to 1000% in 3 to 5 years)?"

For an early-stage company to have capacity, the company must have a finished product and be receiving revenues from at least a small customer base, which is the classic definition of a first-stage company. This means that very early-stage deals - defined as beforethe product is finished and customers are buying - must rely on family and friends' financing because they do not meet the capacity test.

In lending, companies with insufficient cash flow will be denied theloan based on not having the capacity to repay it. This is why early stage and struggling companies cannot borrow money.

A number of additional factors contribute to whether a company possesses the capacity for external funding: net profit margin, resilience to market downturns, a growing market, low-cost customer acquisition and retention, income history and projected growth curves. If you have an income of $40,000 per month or less, you probably do not have the capacity required for funding. A revenue stream of $500,000 per year is considered minimal. Of course, there areexceptions, but those are rare.

CAPITAL
Capital refers to the reserves, equity and holdings of a company, thatis, the financial resources and assets or the financial value of assets a company has: factories, machinery, and equipment owned by a business. This is a loose term, so capital can also be real estate, stocks and bonds, accounts receivable, saleable inventory, retained
earnings and cash. Capital and capitalization are basic measures of the health of a company: its worth.

Capitalization is the total of a corporation's stock, minus long-term debt, plus retained earnings. In good times it can also be the value of a company's outstanding shares times its share price, which is its market capitalization. Companies that do not accumulate capital (a corporate tax-avoidance technique) put themselves behind other companies that have built up capital. The debt a company carries, including credit card debt, loans from founders or shareholders, debt to vendors, and liens, decreases a company's capitalization or value.

In lending, capital is the basis for the loan-to-value (LTV) ratio. In today's economy, the usual LTV range is 50:100, which means they will loan up to 50% of the value of the assets, to 75:100. The LTV may be increased through additional, outside collateral. Collateral is discussed below.

In equity funding, capitalization sets the price of the shares sold for the equity. For example, if a company's capital is valued at $4 million and the investors are adding $6 million, the post investment value of the company is $10 million, and the investors receive a minimum of 60% of the stock.

COLLATERAL
Collateral is what you are willing to pledge, and, in the worst case, give up to get the money. It is a requirement that banks cannot do business without it. Collateral is the pledging of capital assets, which were discussed above.

Most small and early-stage companies have very little capital, so it has to be buoyed up by additional capital contributions by the founders and major shareholders. Equity investors sometimes look at the cash contributions by the founders much the same way that banks regard collateral: as the entrepreneur's personal stake in the deal.

The issue of personal guarantees comes up regularly, and I often hear from those seeking money that personal guarantees will not be needed because the company is a corporation. Not so. The practice of requiring personal guarantees has nothing to do with the legal structure of the company. As a matter of general practice, a personal
guarantee for any small company (for our purposes under $30 million in capitalization) is required, and the lack of it is a deal killer.

For companies seeking debt funding, capital can be augmented by personal guarantees by the founders, stockholders/investors, management team, or others. The person providing the guarantee usually is remunerated for this, and probably will require veto power over all expenditures that are not predetermined and within agreed upon budget guidelines.

Even equity deals may need some personal guarantees. Often, infusions of equity come with warrants that need to be guaranteed, and a requirement of an operating line of credit that is guaranteed by both the investor and the company.

A reluctance to provide personal guarantees is often viewed as a character issue: the company principals lack confidence in themselves and the guts to take a financial risk.

CONDITION
Condition is the general health of your company. Robust companies are the most favored in both lending and investing. Robust companies have products with room to increase their market share; a customer pool that is growing; strong revenues that pay for operations and provide a
greater than 15% net profitability; and nothing but upside. Well, enough of that dream. Financiers look carefully to whether a company is on the slippery slope of failure, stuck in a rut, or has an honest chance of growth. The failing and stuck companies do not get funding.

The only way to express the growth potential for a company is with a business plan. The plan must describe the economic environment the company needs to survive, the operating business model, customers, products, and financials. It makes no difference whether a company is
seeking equity or debt financing, a competent business plan is required. A weak business plan can make a financier move on to the next company without a second thought.

COLLECT THEM ALL
If you are seeking funding and cannot not get it, hire a knowledgeable firm to review your Five Cs and be prepared to make the tough changes needed to be a fundable company - a company with all Five C's. Without on honest and brutal self assessment of where your company falls in
relation to each of these, you may be found wanting at the very time you need funding.


Each investor and lender has their own criteria for the weight they give each of the Five Cs. These are highly subjective criteria, but there is a general basis for Five Cs, and exceeding the minimum criteria helps. Planning and preparation to be the ideal investment, whether debt or equity, will take you a long way to getting funding.