Earlier this month, in Treasury Part 1, we wrote about capital planning for your business. The planning process will identify how much outside capital you expect to need in the coming years. The financial position, risk profile and objectives of the company will determine if that capital is in the form of debt or equity. This week we explain debt financing options and when you should consider them. Debt financing allows you to maintain ownership and control of your business while being less expensive than equity. In many countries interest payments on debt are deductible for tax purposes. 1
Several forms of debt financing exist, including:
- Vendor Financing through payment terms
- Customer Financing through deposits or advances
- Senior Debt
- Subordinated Debt
Vendor Financing (payment terms)
Vendor financing is often more economical than the alternatives. Your vendors know you, they depend on your business, and are in one of the best positions to understand your credit profile.
To make the most of vendor financing time needs to be invested in the relationship. When the vendor connection is viewed as transactional (the lowest price always gets your business), you can’t expect a vendor to be committed to your success.
Vendors should be an integral part of any company’s financing plan. They can frequently provide the lowest-cost capital. However, they normally have the highest flight risk among potential capital providers. Make sure you have a back-up plan if a critical vendor is no longer willing or able to supply you.
Customer Financing (deposits and advances)
Sometimes customers will place a deposit to secure an order or pay in advance for the goods or services they are purchasing. Such deposits and advances are common in industries with long lead times where a significant investment must be made before a product or service can be delivered. The construction industry is a prime example: customers advance builders money to buy materials and pay for labor before the work is done.
These arrangements can give a false sense of security to businesses that aren’t fastidious with their cash projections and margin forecasting Without these disciplines, a large bank balance at the start of a project can evaporate quickly as bills come due and lower than hoped for margins materialize. With these disciplines, customer financing is a great way to reduce costs and share financing risk with your customers.
Many CEOs and financial executives go to a bank as their first financing option when vendor and customer financing isn’t enough. A common form of financing provided by banks is senior debt. Senior debt is given priority payment status over all other creditors. In a liquidation scenario, senior debt-holders are the first creditors paid. The interest rate on senior debt may be fixed or linked to a benchmark (LIBOR, for instance). Repayment schedules or maturity dates for senior debt are normally set when the loan documents are executed.
To protect its loan from a borrower’s default, a bank may tie up the company’s collateral by placing liens on personal assets, mortgages on real estate or requiring a personal guarantee from the owners. The bank may also impose covenants which require maintenance of certain financial ratios or other stipulations. Unmet covenants allow the bank to call the loan. These restrictions reduce the bank’s risk and allow it to offer relatively low interest rates for senior debt.
Banks are also very particular about choosing who they lend to. If a company is new and has no track record, it may be deemed high risk of not being able to meet its loan obligations. Banks frequently direct these companies to other lenders or investors who are prepared to take on a higher risk profile borrower. In order to enter into a financing relationship with a bank, companies must first prove they meet the requisite borrowing criteria for the bank. The company should be prepared to provide:
- A well-articulated business plan covering all key aspects of and risks in the business
- How the loan proceeds will be used
- Industry overview
- Competitive position
- Personnel summary
- Growth plans
- Financial projections that support the business plan and wherewithal to repay the bank
- 3 or more years of independently reviewed financial statements or tax returns
- Minutes from past Board of Directors and Management Meetings
Senior debt is a perfect fit:
- when lines of credit have liquid collateral,
- when financing is secured by other corporate assets,
- when personal guarantees are requested.
Subordinated (sub) debt is less secure for the lender than senior debt. As the name implies, “subordinated” lenders take a back seat to senior debt holders in the event of bankruptcy or liquidation. They are paid back after all senior debt lenders are repaid. Because of its higher risk profile, sub debt commands a higher interest rate. Before a company takes on subordinated debt, it usually needs permission from the holder of its senior debt.
Sub debt is often used in tandem with senior debt on financings. If a company needs a fixed amount of new or refinanced capital, but the company’s balance sheet or cash flow can’t support that level with senior debt, a tranche of sub debt can be added to firm up the position of the senior lenders.
A key benefit of sub debt is senior lenders treat it similar to an equity infusion due to sub debt’s inferior position in the credit pecking order. New sub debt is added protection for senior lenders. Also, taking on sub debt is normally less expensive than equity with the added benefit of the business owner maintaining full ownership of the company. Sub debt can also be useful when a company needs covenant-light borrowing, where fewer restrictions are included in the terms of the loan agreement.
Planning an appropriate financing strategy long before your company needs capital will prepare you and your business to gain access to the maximum amount of capital at the lowest cost. Taking the time to create a clear business plan with sound financial forecasts and analysis will make it easier for you to accurately determine your future capital needs. A thorough analysis of your credit risk profile will help you pin down the mix of financing tools described above that will best fit your business. Based on the financing mix you select, you should be able to approximate your cost of capital and make sound long-term investment and financing decisions.
Catch up on our CFO Success Series:
Treasury Part 1: Capital Planning
Treasury Part 3: Equity