In DWM’s final story in a series regarding security equity capital, today Mike Collins, partner at Building Industry Partners, warns of mistakes and misconceptions to avoid when searching for a capital provider, and explains ways to improve your capital position.

Mistakes to Avoid

• Beware of investment bankers calling to say they’ve been asked by a client to inquire as to whether your business is for sale, says Collins. “This is often a bait and switch to a sell-side assignment. If they can’t describe their client (even generically) in some detail, this is likely the case.”

• Whenever you make a key decision, imagine for a moment that you were about to extend capital to or buy your company. Would this decision seem like a good decision in that light?

• Beware of companies wanting $25,000 to perform a valuation of your company. “A thumbnail valuation is often sufficient and would cost far less (or be free),” he says. “Often times, these companies are seeking to convert that assignment into a sell-side investment banking assignment.”

• Beware of companies seeking large up-front retainers to find capital for you. “This is particularly risky if your company is troubled (a difficult assignment to complete),” he says. “Once they have that retainer, their incentive to work drops sharply.” Instead, he advises to go for smaller monthly retainers make it easy to pull the plug if the capital finder doesn’t show results.

• Don’t give anyone a right of first refusal to acquire your company. “This includes executives, competitors or investors,” he says. “Such options are valuable and should not be given away. Once they are in place, they can complicate or stop altogether the process of raising capital or selling a company. Want more reasons to say no? “Some companies have had to pay key employees as much as $50,000 to sign a waiver of such an agreement,” warns Collins.

• Don’t overbuild your facilities in anticipation of growth. “If the growth doesn’t come, the additional expense could sink the company,” he says.

• Don’t underinvest in sales and marketing or machinery and equipment in the period leading up to a capital raise or sale. “Smart investors know how much companies should be spending on marketing, cap expense, etc. and will treat any shortfalls as negative addbacks, reducing their valuation,” says Collins.

Myths Debunked

• Myth: It is easier to find someone to invest $1 million or $3 million than $5 million or $10 million.

Fact: The smaller the amount of money, the more difficult it is to find. “All deals cost roughly the same amount in due diligence and legal expenses, so investors and buyers want to get as much capital to work as possible, per dollar of fees,” says Collins. “If a $500 million fund invests in $2 million deals, those 250 companies would generate 3,000 monthly financial statements per year and require attendance at 1,000 yearly board meetings.

Myth: It is easier to convince someone to buy a non-control investment than to buy control.

Fact: Depending on the group, it may be more difficult or even impossible. Many investors will not even consider non-control positions.

“Most investors are deploying someone else’s capital so a rigorous due diligence is required, regardless of investment size or percentage ownership,” says Collins. “Non-control investors are at the mercy of the majority owners on many points, so they must be completely comfortable prior to investing.”

Improving your Capital Position

• Maintain a strong relationship with your bank. Collins says when working to improve your capital position, it is important to revisit your current bank relationship.

“Many door and window dealers are still working with the bank that worked with them through the downturn,” says Collins. “That customer loyalty shouldn’t get in the way of marking the loan to market.”

He advises companies not to move lending business or threaten to do so until an alternative is ready to be dropped into place. The same is true of high-cost providers, such as receivables factors.

• Reducing working capital. Many businesses make inventory stocking decisions on a “you never know” basis, says Collins. Often, the contingencies and possible shortages against which they’re planning never come to pass. “Every distribution business should analyze its inventory turns on a product-by-product basis,” he says. “This information can be used to determine the appropriate level of each item to keep in stock. Letting inventory drift downward reduces the capital tied up in the business.

• Firing customers that consistently pay late. If a customer pays later than 60 days, their receivable typically becomes ineligible for lending, creating a hole in the capital structure, says Collins, who advises companies to consider a term loan.

“This is a loan for a fixed dollar amount, due at a specific time (the end of the term) and paying a fixed or variable rate of interest,” he explains. “Term loans are typically backed by machinery and equipment. Certain banks will also loan against rolling stock (trucks, vehicles, forklifts, etc.) but this is less common.”

To review the previous two articles in the series read part one and part two.

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