Types of Financings
SPECIALISTS IN PRIVATE EQUITY with the expertise and understanding where your company is in the business cycle with respect to valuation metrics such as cash flow normalizations, EBITDA multiples, leverage ratios, working capital expectations and redundant assets which are keys to a successful transaction.
There are various types of debt financings that a company can enter into to capitalize their business. Each type of financing comes with a different set of related costs, covenants and conditions.
Operating Lines of Credit
Operating lines of credit are financings typically provided by chartered banks that margin accounts receivable and inventory based on certain percentages which may be capped by the bank.
Accounts Receivable may be margined at 75% for all receivables under 90 days
Inventory margined at 50% capped at a total maximum amount of finished inventory at $4.0 million
The bank may place working capital, cash flow coverage and debt covenants on the financing and will review the accounts receivable and inventory on a monthly basis. Operating lines of credit may be renewed on annual basis and the pricing of the financing will be based on the strength of the company. Operating lines have a maximum authorized amount and the borrower may or may not choose to use any amount of the operating line. As long as the operating line is maintained within the authorized amount there are no required principal payments and only interest payments are due monthly. Inactive loans may be subject to standby fees.
Senior debt is a longer term fixed amount of financing (5 years and longer) that is typically secured by certain assets like land and building or equipment, other assets may also be pledged as security. Providers of senior debt may be chartered banks and other niche finance companies that are willing to take a security interest in the assets. Senior debt usually will take a second charge in security behind the operating line of credit. Pricing of debt will be based on the financial strength of the company and the value of the underlying assets that are being secured. Senior debt may also have working capital, cash flow and debt covenants as part of the agreement. Senior debt typically has a fixed principal payment and interest payments (may be fixed or floating interest) that must be paid as per the scheduled payment plan.
Asset Based Lending
More aggressive lending that is typically found from chartered banks and other niche finance organizations. These loans typically prefer more liquid assets such as accounts receivables and inventory which are typically margined higher percentage and caps than what are found with operating lines of credit. Asset based lenders will also consider equipment and other security that the company may be able to provide. There are more stringent reporting requirements when compared to a typical operating lines of credit, as these lenders are taking more risk and will very closely monitor all financial aspects of the company, especially the cash flow of the business and the variability in the value of the current assets. The cost of asset based lending is typically higher than what one would expect to pay for an operating line of credit.
Generating sufficient cash flow is the main characteristic for the subordinated debt lender as they have little or no security. From a security standpoint the subordinated debt sits behind the operating line of credit and the senior debt who both hope to be fully secured.
A typical structure for a subordinated debt financing is very similar to senior debt, the only difference being is the security position of the debt. The subordinated debt lender does not want their debt paid off in full till the end of the term. Their main objective is to earn the coupon that they are charging on the debt. Dependent on the structure of the loan and the inter-lender agreement, the subordinated debt may be viewed as equity in the eyes of the senior lender. Subordinated debt lenders may have provisions in the loan agreements that allow for changes to interest or other clauses should the performance of the company not meet the projected forecasts or maintain covenants established by the lender.
Convertible debt is very similar to subordinated debt with the exception that the debtholder has the right to convert the debt to equity at a previously agreed upon price.
Mezzanine debt is comprised of term debt and an equity component based on a valuation that is less dilutive than an all equity transaction. The term component has a coupon rate that offsets some of the risk allowing for less dilution from a share perspective. The mezzanine lender receives an equity position at nominal cost in the business (not control), and they want their debt paid off as quickly as possible to increase their internal rate of return on the investment.
A typical structure for a mezzanine debt financing would be very similar to subordinated debt from a debt perspective but with additional clauses that make the investment as whole act more like equity.
Expectations over and above subordinated debt conditions may include the following:
- More rigorous due diligence
- Annual cash sweeps based on free cash flow that reduce the amount of the principal quicker
- Pledge of shares
- Voting trust agreements
- Shareholder agreements
- Board of director’s representation
- Call and put rights