There are multiple types of debt and there are multiple ways to use that debt.  From the perspective of a venture backed businesses – debt can become very dangerous if used incorrectly, but can also be a very helpful low cost source of capital.  Different lenders will take a different type of lien.  A lien is a form of security interest in a business, meaning if you can’t pay back the loan the lender can take the assets it has a lien against.  A bank takes a lien against your house in a mortgage or against your car in an auto loan.  Your house or car is the collateral, against which the bank will loan you money.

Working Capital Debt – Revolvers

The easiest, lowest cost and often the first type of bank financing many businesses can access.  This is known as Asset Backed Lending (ABL), where the bank will take a lien against various forms of working capital.  Working capital financing is typically secured by the accounts receivable (A/R) of a business (A/R is the payments from customers for products and services previously delivered).  Another form of working capital that you can borrow against is inventory.

Typically venture backed businesses can borrow up to 80% or 85% (the amount you can borrow is known as the advance rate) of the total value of A/R from qualified customers, that is not older than 90 days.  This means customers with quality credit, who are current on all outstanding bills.  Inventory typically has a 50% advance rate, but is often slightly more difficult and complicated than A/R financing.

Rates for working capital financing are usually the lowest, and are based on the amount the borrower has outstanding every month. In addition to the balance monthly, there is an unused line fee or commitment fee, where the bank will charge the borrower a percentage of the total revolver amount that is not drawn.  Additionally, there is a very small warrant associated as well (a warrant is a right to a number of shares of equity, that doesn’t cost the bank anything, until the day it exercised – at which point the bank would only exercise the warrant if it were to generate more money than they cost).

Interest rates are typically set at LIBOR + 2% – 4%, with a LIBOR floor of 1.00%, unused line fees are typically 0.5% and warrant coverage is between 0.25% and 5% (warrant coverage is calculated as the value of the equity if a warrant is executed as a percentage of the full debt amount – i.e. 5% warrant coverage on a $1mm revolver would represent $50k of equity value).

Working capital facilities typically have no amortization but are simply due in full upon maturity.  Almost always, the facility will be extended, meaning it is never due.  Revolvers will have a specific lien against the assets, but they often require a blanket lien against the entire business as well.

Senior Term Debt

After working capital facilities, companies can often also raise a small senior term loan.  This is structured as a lien against the business, with no specific liens.  Often, a bank will extend a term loan in conjunction with a working capital facility.  Meaning a company can borrow an additional amount, beyond the working capital facility.  This is only known as senior debt, if it is from the same lender as the working capital facility.  The costs are similar to a working capital facility, but obviously a little higher as the risk is higher.  The term becomes a consideration, and can include an interest only period.  An interest only period is a set amount of time, during which a borrower will pay only the amount of interest due each month, with no principal amortization.  In the event the facility comes from a second lender, it is considered a subordinated loan.

Subordinated Term Debt

A subordinated loan means nothing more than it is subordinated.  It still will have a lien on a business, but the banks lien will be second in line after the senior lender.  Subordinated debt will cost the most, and will require the most consideration for a borrower.  I will cover these considerations and costs in a future blog, going into to more detail.

Other Debt

There are obviously other forms of debt as well, most common are equipment financing and vendor financing.  Equipment financing is borrowing for specific equipment (such as server racks for software companies), where the collateral is specifically defined and does not have a lien against the business.  Vendor financing is the same as equipment financing, but not from bank, rather the actual supplier of the business.  This is like getting a car loan from the dealership.

Bueller…  Bueller…  Bueller?  Anyone still reading?  Sorry.  It got dense quick.  I promise, this is interesting and fun, but there is a basic understanding of how various types of debt work, and how they interact.  We got some terms (advance rate, collateral, revolver, sub-debt, LIBOR, liens), and now have the basis for debt.