If you haven't tuned in to our weekly installments of MSPradio podcasts, you're missing out. Luckily, we've grabbed central points from the episodes featuring Tom Fafinski, Co-Founder of Virtus Law. Fafinski frequently works with MSPs and other business verticals on a range of legal issues. Helping MSPs raise capital is a passion of Tom’s, and he’s extremely knowledgeable of which avenues to take, the process for doing it, and what MSPs need to know before setting out on this path to raise money for their business.
Growing organically is great, but sometimes you need a little outside funding in order to launch your business to new heights and capture strategic acquisitions. Raising capital is a key step in doing so. Of the number of ways to raise capital for your business, the two most common approaches we detail in our new eBook, How to Raise Money for Your Business, are through equity and through debt financing. In this post, we'll cover the latter and identify which lenders to attract and how.
Common Debt Financing Methods
The most common method of debt financing is to go to a bank. While it’s true that banks are in the business of lending money, they aren’t the only places you can go to get a loan. There are a number of private lenders you can approach as another way to raise debt for your business.
Employees can have a lending relationship with their business by lending their wages for a period of time, or even becoming investors through lending devices, which is a less common approach. However, what is becoming more common is allowing employees to participate in lending through retirement plans. For example, you could offer an employee stock ownership plan (ESOP), which is a 401(k) owned plan. Essentially what happens here is once your company adopts a 401(k), you can allow employees to invest their retirement funds the way they decide they want to invest it, including investing in the company that they are working for.
Another way to accomplish debt financing with retirement funds is through anyone who has an IRA and is not employed by the company, or not related to somebody employed by the company. These people can choose to invest their IRA funds however they want, including lending money to an operating enterprise for guaranteed returns, or pooling funds. Let’s say, for example, that 10 people come together and create a pool of $1 million. They could then lend that $1 million to the MSP so that the MSP can acquire a new company.
Although this is not a transaction that can be guaranteed by the owner, it is a great way for people to use their retirement funds, especially since no accredited investor status is required.
Hard Money Lenders
Hard money lenders are people who take their own money and invest it. It’s called “hard money” because interest rates can be hard to swallow.
Often times you’ll find that you’re going to be better off with that hard money lender, even though the interest rates are so high. But then again, you get to deduct the interest. You’re paying that hard money lender to leave, so that if the business does take off, you don’t have to share the equity with that lender.
Another common type of lender in the acquisitions area is a company owner that’s looking to sell. More often than not, a seller wants to know if they can extract their company from the grip of the buyer if the buyer defaults, and that the buyer will lose substantial amounts if they do fail in making payments to the seller. The bottom line here is that they want to make sure they feel secure in the transaction.
Aside from banks, another very common private lender is a factory company. You could go to them with your contract and say, “I’ve got a contract. I want to get the money up front. My clients are required to pay X dollars. We will sell you our rights or secure our obligation to you for 10% if you give us the money now.” That’s a factoring relationship.
The Five Cs of Lending
In order to make yourself seem like an attractive investment to banks or private lenders, it’s important to remember what drives them to make that decision. Here are the five Cs of lending that they’ll most often look at:
1. Credit Worthiness
The first C, and probably the most important one in a professional service business, is credit worthiness—not just of the business but of the individuals who work for the business. This is a very significant metric for banks and lenders because it’s the first thing they look at. Sure, an 800 credit rating is out-of-this-world impressive, however, a score like 750 is still a strong credit rating. If your creditworthiness is in the 750s range, banks and lenders will be pleased, allowing you to get a lot done without collateral.
2. Cash Flow
The next C is cash flow, which is the ability of the business to service debt. Cash flow isn’t just how you did last month, it's about the recurring revenue. It’s going to be a lot harder to secure an investment if no money is coming in to your business, however, MSPs have the advantage here. MSPs typically have automatically renewing contracts, or contracts of three and four-year durations. Cash flow is probably the next most important thing, after credit worthiness, and reoccurring cash flow is quite impressive from a lender’s perspective.
The next big thing that lenders look at is collateral. Specifically for MSPs, they look at the accounts receivable, which happens to be one of the biggest collateral items for the contracts that they have with clients. Collateral is seen as “backup” assets in case a loan were to fall through. If the collateral is really strong, sometimes banks will ignore issues with creditworthiness and cash flow.
The next most important issue is capacity, also known as liquidity. Lenders look at the capacity to take you through lean times; how fast you are able to sell the assets to recoup costs.
The final C is character—both of the borrower and of the guarantors. In this sense, character means that lenders don’t want to deal with felons or people who have had prior bankruptcies. They prefer to deal with people that are in a business line that conforms to the values of the bank.
- The Anatomy of a Successful Business Acquisition: MSPradio Episode 29
- Change the Way You Think of Cash Management!
- What You Should Look for in Mergers and Acquisitions: MSPtv Episode 40