When you need money, it’s tempting to take it from any source. However, decisions made in desperation rarely turn out well. Before you take on debt, it’s imperative you know what type of lender is right for you and what price and terms are fair. This article will give you a good outline for standard lender profiles, types of debt, and terms and costs you need to be aware of.
The easiest way to view lenders is in two camps, commercial banks and specialty lenders. Commercial banks are where you have checking and savings accounts. They usually offer the lowest interest rate but are strictly regulated, so they lack the ability to offer flexible terms and might not be able to lend to you at all.
Specialty lenders can be anything from a fund to a factoring group. It’s a large classification that basically means “not a commercial bank.” These groups are more likely to lend to you with less restrictive covenants (i.e., rules a lender will impose on you), but you’ll pay a higher price. Many specialty lenders have a type of debt or industry they focus on, so you’ll know pretty quickly if you fit in their wheelhouse.
When looking for debt, the standard practice is to first start with your commercial bank. Odds are you will get the best price (interest and fees) by going with them. However, the process can take time and often doesn’t give you the amount of money and terms you want. Therefore, it is worthwhile to talk to specialty lenders at the same time and compare offerings.
Debt is full of jargon, and if you are not careful, you could end up agreeing to terms you don’t want. Below are some of the major concepts to know when evaluating debt terms.
• Covenants: The restrictions you agree to in order to get and keep your debt. If you violate them, you are in default, which has bad consequences (e.g., immediate repayment of debt borrowed, loss of control of your company, etc.). Covenants are designed to restrict the borrower’s behavior to make the investment less risky for the lender. Some restrict certain behaviors, such as taking on more debt, and others require certain financial performance.
• Committed Amount: What the lender has agreed to lend you in total. You might not be able to borrow all of the money at once, and some of it may become available as you hit certain performance milestones.
• Net Liquidity: How much money you actually get to use. Some covenants require you to maintain an “unrestricted cash balance,” or basically have a certain amount of cash available at all times. This is designed to protect the lender’s principle (the money they lent you). However, it prevents you from using all the money. If you were lent $4 million but were required to hold $1 million in reserve, your net liquidity would be $3 million.
• Implied Interest: If your cash availability is less than the total committed amount, your implied interest is higher than the stated interest. Take the $4 million example. If you have an interest rate of 10%, you are paying $400,000 per year. However, with $3 million of net liquidity, you are really paying $400,000 for $3 million, which is an implied interest rate of 13.3%.
There are many types of loan structures, but they normally fit into two categories: cash flow or asset based. A cash-flow loan is a loan against your future cash flow. It’s a bet you will perform well enough in the future to be able to pay back your debt plus interest. An asset-based loan uses your assets as collateral — so if you default, the lender gets the asset.
• Term Loans: These are basic debt instruments, an amount due at a future time (term). These are normally cash-flow based, and milestones are pretty common. Sometimes you can have a draw period — usually you pay a smaller interest (or no interest) amount for a period where you can decide if you want to borrow the money. If you do borrow the money, the debt terms kick in at that point.
One main advantage of this type of loan is locked-in financing. You are guaranteed a specific amount of money at certain terms and interest rates.
There are disadvantages, though. Locked-in financing is expensive to leave (e.g., prepayment penalties). These loans also can potentially have onerous covenants that can constrain your ability to invest and do other capital projects until the loan is paid off.
• Line Of Credit: This is an amount of money a lender allows a borrower to “draw down” (borrow). Normally you only pay for what you draw.
This kind of structure offers flexibility: You get and pay for only what you need.
However, a line of credit can disappear (lenders can easily rescind the draw availability). These also generally can’t grow as fast as a company needs in high-growth industries.
• Asset-Based Lending: These loans are backed by the value of the borrower’s assets. There are several types:
Working capital financing normally exists to fund asset-based sales (e.g., help finance your inventory). This category is divided further into factoring/receivables, where your receivables due from customers are the collateral, and inventory, where your inventory is the collateral.
Another type is equipment financing, which funds the purchase of equipment or which allows you to borrow against your equipment’s value.
Asset-based lending is cheaper than term loans since there is collateral. However, it is tied to the value of the asset, so availability can fluctuate.
There are endless combinations of debt structures all of which obligate your company to future agreements, potentially onerous and expensive. By knowing the major debt structures and lender types, you increase your chances of finding the right debt and terms for your company and situation.
