Need Funding? Think Like A Banker

“My banker [lender] doesn’t understand my business … they just don’t understand monitoring contracts and the value of recurring revenue.” Ever heard that — or said it? The truth is it’s not a question of understanding; it’s a question of perspective.

To alarm dealers, recurring revenue (RR) is a tangible asset and has real value because they can bill it, collect it, touch it and spend it. To a lender, RR is an intangible asset because it will not recur unless the dealer and the central station both fulfill their respective responsibilities every day of every month for an extended period of time.

Additionally, subscribers have many opportunities to express their approval or disapproval of the services provided with their periodic payment under the terms of their monitoring contract. Even if subscribers do approve, they must have the continuing financial capacity to make the payment.

For the most part, lenders really do understand the value of RR. They also understand the fragile nature of RR and how quickly it can disappear if not handled with care or if competitors become aware of an account base owned by a troubled dealer.

Viewed from a lender’s perspective, a loan has an upside based upon the net earnings produced by interest charged and fees. This is a small amount compared to the principal of a loan. The downside potential is the loss of some or all of the principal, which is a considerable amount, compared to the net earnings produced by the interest charged and fees.

Lenders are in the business of quantifying risk and determining if there is sufficient reward to proceed with a loan, and if there is an achievable exit strategy in case the dealer defaults and/or the accounts do not perform to expectations. Alarm dealers need to understand these dynamics and conduct their business in a manner that demonstrates to a lender that the risks are identified and being minimized.

The following are number of specific areas that should be addressed to demonstrate to a lender that the business is well-managed and the risk is minimal. These specific areas also fall into the category of best business practices under any and all circumstances.

Monthly/Quarterly and Annual Financial Statements a Must
Lenders are creatures of habit and one of their primary habits is to look for and review financial statements. Some readers of this article may need reviewed financial statements while very few may need audited financial statements. Both are somewhat expensive and require a CPA to perform various independent verifications and confirmations in order to provide different levels of assurance that the financial statements have been prepared in accordance with Generally Accepted Accounting Principals (GAAP) and that they do not contain material misstatements.

At a minimum, alarm dealers should prepare what is known as a compilation on a monthly or quarterly and annual basis. This type of financial statement is based upon information provided by the company with no independent verification or confirmation of that information.

There are many accounting programs available that, if used properly, will accurately track assets and liabilities, identify trends or variances and confirm which segments of the business are profit centers and which are being subsidized by those profit centers. Without reliable financial information, it will be difficult to convince a financing source that the business is being properly managed on a timely basis.

A word of caution in the preparation of balance sheets: Do not include a balance sheet entry that places a market value on RR. This is sometimes done in an effort to “dress up” the balance sheet and communicate the sale or liquidation value of the company.

This is not by itself an acceptable accounting entry and will only raise questions as to the validity of the other financial statement information. Any explanation of the sale or liquidation value of RR should be provided in a footnote format.

Keeping Track of Accounts and Minimizing Attrition
Lenders are very familiar with attrition, or “churn” as it is referred to in other industries such as cellular phone and paging. Attrition is the bane of an alarm dealer’s existence because it can quietly and effectively erode an account base and cash flow (the very cash needed to repay debt).

A documented, low rate of both gross and net attrition is a critical element when seeking financing, or when it comes time to sell and retire.

While there is no single industry standard for defining and calculating attrition, a useful and straightforward method is a simplified version of what is called static pool analysis (see sidebar on page 102). To conduct this analysis, it is necessary to identify a specific group or pool of accounts and then track the performance of these accounts during a specific period of time, usually one year.

With attrition held to a low level, you should be able to demonstrate to a lender the projected annual increase in cash generated from your growing account base, as well as the increased market value of that account base. Ideally, you will also be able to demonstrate to a lender that while your debt is decreasing (assuming a term loan with level payments of principal and interest), the value of your account base and the lender’s collateral is increasing. That’s a good combination!

Why It Is Important to Have Errors & Omissions Insurance Coverage
The security alarm industry is perceived by many, including lenders, to be a risky business that carries a high degree of liability exposure. From within the industry, we know there are several layers of protection starting with well-drafted subscriber contracts that are periodically updated.

Most alarm dealers would then point to their general liability or products-completed operations coverage as another layer of protection. For many alarm dealers, this unfortunately is also the final layer of protection. The next layer of protection should be errors & omissions (E&O) insurance.

There is a common misconception among alarm dealers that E&O coverage is not necessary if accounts are monitored at a third-party central station. While this may mitigate or reduce certain risks, what happens if there is an error in the design specifications or in the installation of that system that results in it failing to perform in accordance with contractual representations and expectations? E&O coverage is designed to protect against claims of this type.

In addition to paying judgments against you, your legal expenses will be paid up to the coverage limits on your policy. Alarm dealers without E&O coverage are like doctors practicing medicine without malpractice insurance.

Operating Discipline Measured by Collection Policies, Procedures
It should be no surprise that well- defined collection policies and procedures that are continuously and precisely followed will reduce, or at least stabilize, attrition and enhance cash flow. It may be a surprise, however, to find that lenders use collection policies, procedures and their implementation as a gauge in measuring a dealer’s internal operating discipline. After all, if a dealer doesn’t take care of his or her own money, why will that dealer take care of the lender’s money?

Certainly, before presenti
ng an accounts receivable aging as part of your loan request, carefully examine that aging and in accordance with your policy remove the dead accounts. A lender may otherwise understandably ask, “If recurring revenue really recurs, why is so much of it 90 days or more past due?”

Maintaining Current Contracts Is Another Critical Component
Make sure you have a complete contract file with a signed contract for each subscriber. When contract reviews are conducted, there are invariably files and/or contracts missing – sometimes a good number of contracts.

You may have a number of different contract forms because during the life of the business you may have started as a sole proprietorship, then incorporated, then added a DBA and finally converted to a limited liability company.

Each of these changes in business structure should be fully documented to demonstrate to a lender that the existing legal entity in fact owns the contracts entered into while your business was operating in one of these earlier business structures.

It is not uncommon for a dealer to make an account acquisition and not have the acquired subscribers sign a new contract. Under this circumstance, complete documentation related to the purchase should be maintained. This includes the purchase agreement; public record searches to validate that the accounts were not subject to any liens or security interests at the time of purchase; non-solicitation agreements; and evidence of full and final payment to the seller. Remember, subscriber contracts document your primary asset – RR.

The completeness, consistency and neatness of these contracts and contract files will create an immediate impression of your discipline and professionalism. Make it a very good impression.

Public Records, Personal Credit Indicate Business’ Conduct

Lenders require a first lien security interest in the assets provided as collateral for a loan. This means the lender will be in front of any other claims against the dealer’s assets. Typically, the public records are examined to determine if there are any security interests (UCCs), judgments or tax liens filed against the company.

The owner’s personal credit will also be checked because personal credit behavior is an indicator of how the business will be conducted. Prior to presenting your loan request, it is worthwhile to obtain your own personal credit report and, with the assistance of your attorney, conduct a search of the public records.

Dealers are sometimes surprised to find filings against their company because the existence of a filing was not known or because an agreed upon release of a filing has not occurred.

Lenders do not like surprises. Make certain you know in advance what a lender will find when the public records are searched and when your personal credit report is pulled.

If business is being conducted as a corporation, it is normally necessary to file an annual report with the state of incorporation. Failure to do so may cause the company to lose its “good standing” to conduct business as a corporation and, ultimately, may result in dissolution of the corporation with the loss of certain liability protection afforded by the corporate business structure.

Receivables, Cash-flow Projections Demonstrate Repayment Capacity

Lenders will want to see a repayment plan. If the financing is short-term and based upon the ongoing creation and collection of accounts receivable (the monthly billing of contractual RR), repayment capability can be demonstrated through the ongoing collection of the accounts receivable.

If, however, term loan financing with fixed monthly payments of principal and interest is your objective, cash-flow projections will be necessary to demonstrate projected repayment capacity. These projections must reasonably show there will be sufficient pretax income to pay interest expense and sufficient after-tax cash flow to make the required principal payments. This type of analysis will help identify whether borrowing is the correct business strategy.

Advance Planning and Organization Are Key to Success

Other important considerations include: timely filing of tax returns; current licensing; back-up and recovery plans; quality of third-party central station if monitoring is subcontracted; control of the phone numbers to which accounts are programmed for monitoring; and availability of references.

A key to success in obtaining financing is advance planning and organization. Haphazard business practices cannot be corrected overnight. The sooner the process starts, the sooner you will be able to convince your banker to become a lender to your company.

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