If you have borrowed (or tried to borrow) money from a lender, you have probably seen the five Cs of credit analysis in action. These key elements provide a framework and help lenders quickly analyze and evaluate prospective borrowers:
Lenders look at Capacity. Put simply, this is a yardstick to measure whether the borrower will be able to make payments on a loan. It reflects credit history but also current income and other obligations which may make it difficult for the borrower to pay the lender back.
Next is Collateral. Secured loans are backed by collateral, which is an asset the bank can claim in the event of a default. Collateral may take the form of real property — including the business’ receivables; financial assets, such as cash or securities; or recurring monthly revenue (RMR) contracts as is typical for the security industry.
The third element, Capital, is closely related to collateral. Lenders like to see assets such as savings and investments that can help pay back the loan in the event of a business downturn or other unexpected event.
Lenders also look at Conditions — the purpose of the loan and how the money will be used. A loan might be used for business expansion, for example, or to purchase an adjacent account base or competitor.
Finally, lenders look at a prospect’s Character. The lender will form an opinion as to trustworthiness and likelihood of repayment of the loan. Considerations include educational background, experience in the industry, and track record with other lenders and/or investors.
The five Cs are helpful, but they are really only a starting point for lenders. There are tremendous variations from industry to industry, and criteria that work well in one industry might be misleading in another.
What Lenders Specifically Want from a Security Business
Over time, Capital One has developed its own set of criteria, which we use in working with companies in this industry. These include the following:
Solid, Stable Metrics. We want to work with companies that have solid operating metrics, usually expressed in ratios. These include:
- Attrition — how many customers (as measured in RMR) leave each year as a percentage of the total customer base? This is a good indicator of service levels and whether the customers feel they are receiving value for money.
- Creation cost multiples — how many dollars of investment does it take to create one dollar in RMR? The industry average is about 32x, meaning that it typically takes 32 months (at a 100-percent profit) to recoup this up-front cost. We look at the company’s average length of engagement, how long they receive revenue from a customer and how profitable that revenue is once break-even has been reached.
- Monitoring margins — how much income is generated from RMR net of monitoring costs. This metric helps a lender better understand the revenue profitability and value proposition along with the company’s ability to manage costs.
A Strong Management Team. The character and quality of the company’s management team are paramount considerations for us. This is where deep industry knowledge is a real benefit. The security industry is a relatively small one, and the people in it know each other personally and by reputation.
We meet personally with management teams and conduct detailed discussions to determine the team’s understanding of effective operations. We like to work with people who are active in industry associations and who take a role in their communities.
The security industry is active in the merger and acquisition space, and if a company wants to borrow money to finance a substantial acquisition, we typically like to see some history of successfully integrating other acquisitions — integration can be a difficult and complex undertaking, and we want to know that the buyer is up to the task.
Reporting Capabilities. This is another area where financial skills and talent are essential. A surprising number of privately held companies find it difficult to present well-organized, accurate and timely financial reports. They may have restated previous numbers, or cannot produce necessary data.
Borrowers also need to demonstrate capable financial management. Many companies — in all industries — fail to invest in the financial talent and resources needed to keep the business on track. We find this can be shortsighted, as some owners/entrepreneurs lack the skills needed to effectively manage a company’s finances.
This disorganized approach to reporting tends to create doubt. No lender, or investor down the road, wants to see poorly organized or out-of-date financial statements. A company that cannot deliver on basic reporting requirements creates uncertainty over how effectively they can serve their customers or meet other business obligations.
A Clear Value Proposition to the Customer Base. The management team needs to present a clearly defined business model to create confidence. Some companies, for example, seek to be the commoditized, low-cost provider in the region — this can be an effective model, as long as they understand how to control costs while keeping customers satisfied. Other companies may focus on high-end residential installations, an approach which can succeed if the level of service provided meets the expectations of customers.
There are many different paths to success in the security industry, but, in our experience, the most successful companies are the ones that have a clear understanding of what they are offering the customer. Other elements we look for include:
- Differentiation — how does this company stand apart from its competitors?
- Market position — is the company operating in a crowded sector? If so, what is its specific niche?
- Specialization — is the company capitalizing upon its knowledge of a particular industry or type of customer?
Prospects for growth. We rarely encounter companies that lack the ambition to grow; in fact, it is common for companies to seek financing for growth, either organic or inorganic. We like to see aggressive but realistic plans to grow market share, to enter new end-markets or geographies, or to offer new products.
Additional Considerations
Of course, other tangible and intangible elements affect a loan decision. For example, a prospective borrower who already uses other Capital One banking services, such as cash management or corporate card services, is more likely to be viewed favorably given the track-record and previous experience.
We also value candor and honesty. Not everyone has a perfect background or an unblemished record as a borrower, but we want to learn about a problem directly from the prospective borrower, rather than finding out via a background check. No one wants to think that a potential business partner is hiding something from them.
We have a long track record of serving the security industry and have managed over $3.0 billion in security industry financings. In our view, nothing takes the place of highly focused, industry-specific expertise in making lending decisions.
Overall, we have been very pleased with our experience as lenders to the security industry. We see it as a robust industry with great people and a bright future, especially as new technologies open new doors for forward-thinking security providers. Companies seeking financing for growth opportunities can, we believe, significantly improve their chances of success by learning what lenders are looking for and delivering it in a way that increases the bank’s overall comfort level.
John Robuck is Managing Director of the Security Finance lending practice within Capital One Bank's Commercial and Specialty Finance business. Request more info about Capital One at www.securityinfowatch.com/12070948.
