There’s a sustainability issue in this industry that often gets overlooked. We discuss concerns about groundwater, energy and mineral resources, but fail to address the sustainability of the contracting firms responsible for supplying access to these resources. The success and longevity of local drilling companies is a sustainability issue of its own and, while many factors contribute to the success of a business, it’s worth seriously considering the financial aspects that have historically led to profitability and growth for contracting firms.
One of the keys to building a long-lasting business is to position your company so that lenders seek you out. I know this because I have the pleasure of working with successful business owners every day as a direct lender. I’ve been looking “under the hood” at thousands of businesses for the past 20 years, and I’ve seen how companies that earn favorable terms from lenders thrive and grow with unmitigated success.
There are five “C’s” to a credit decision and, although you may not be currently seeking to engage in any business borrowing, addressing the five C’s can only improve your business’ value and generally help to keep your business in the black.
The first “C” is character because it’s the first thing that lenders look at when considering a potential borrower. If the character of the borrower is not suitable, then there is unlikely to be any lending. Why? It’s all about the sustainability of the business.
Many business owners start their business with a former co-worker, friend or family member. Forming a partnership is a traditional way to start a business and is often very effective because the duties can be shared among those that are most skilled at each task. Unfortunately, many partnerships include at least one member who has poor credit or some sort of skeleton in his closet. These issues can severely limit the ability of the business to obtain financing and lessen the company’s chances of success.
This doesn’t mean that a friend or family member with credit issues can’t be involved in your business. The important thing to remember is that before bringing in a partner, you should make the partnership conditional on credit. It will save the business a great deal of aggravation and money if the majority owner has good credit and character. Once the business is on firm footing (usually after two to five years), you can reward those that helped you build the business with equity without diminishing your ability to secure financing.
Character is also evaluated by lenders in other forms, such as social media activity, customer reviews, industry performance and geographical performance, among other factors. By looking at these and using nontraditional underwriting methods, lenders may recognize a higher evaluation of a business’ credit worthiness. This type of underwriting is known as Fintech, and when properly utilized, Fintech can show the likelihood of a business being able to repay its debts. For this reason, it’s very important to post your business accomplishments publicly and request reviews for your company.
Capacity is number two since you can only grow at the rate that you can afford. Simply put, don’t try to grow at a pace that your business cannot support. You may be significantly more efficient with a brand-new drilling rig, but if your cash flow can’t support a $10,000 per month payment, it’s a recipe for disaster. Rapid growth is not a bad thing if it’s manageable. A good rule of thumb is to maintain a bank balance that is at least five times what the monthly debt service will be.
Capital and Collateral
Capital determines how much “skin in the game” a business is willing to put forth. The best example of capital is a down payment. Lenders want to see that the business is willing to share in the risk of a loan because it promotes confidence that the borrower is incentivized to pay off the debt. A business that injects capital into a project or equipment purchase is less likely to default since they have a proportional risk.
The type of collateral, which may be equipment or other form of property, will also influence the amount of capital required by lenders and the business’ ability to grow. When a business owner seeks to borrow for a used equipment purchase, a lender will look at the “LTV” or loan to value. This is the amount of the loan in relation to the value of the equipment. Lenders don’t want to provide financing for more than the equipment is worth, so they look for a LTV below 100 percent.
Broad economic conditions often impact the value of equipment. As a result, lenders must examine auction reports and comparable sales to determine the equipment’s worth. Although supply and demand determine the current price of equipment, LTV can only be established through historical sales numbers.
This is important for business owners to understand because it means that if you’re interested in financing an equipment purchase for $80,000, but the collateral is only valued at $70,000, you may need $10,000 of capital, or down payment, to make up the difference. Without a strong understanding of the relationship between capital and collateral, business owners may be surprised to find that they’re not as well positioned for growth as they thought.
Fortunately, there is a positive side to all of this: If your business is profitable and has good credit, lenders can make exceptions to LTV.
The fifth “C” simply refers to the conditions that may be placed on a loan, such as money-down requirements, the type of insurance you need to carry, whether you’ll need to submit quarterly or annual financials, etc. All financing comes with conditions and those conditions will depend upon how well the other four “C’s” were met.
There are many complexities to creating a sustainable business, but the five C’s give you a clear path toward developing the traits necessary for success. You can demonstrate character through mindful partnership choices and communicating your accomplishments. You can show capacity by maintaining a bank balance in a 5:1 ratio with debt. You can be prepared for large purchases by considering the relationship between capital and collateral. Doing these things will earn you more favorable conditions for financing the growth of your company. Ultimately, the five C’s will help you build value and wealth for a long-lasting and prosperous company.