Quick Guide to Debt Optimization

Intro

The good news is there are more credit options than ever before. Credit exists for every stage from early revenue through bankruptcy. And thanks to banking regulations, 2023’s regional banking crisis, high interest rates and investors’ appetite, new credit options are going to expand both in variety and in providers.

The bad news is the playing field isn’t level and it’s tilting ever more in the lenders’ favor. Credit providers are smart and sophisticated and have been around long enough to see it all. What they have done hundreds or thousands of times you have done a couple of times.

This post is meant to be a starting point for leveling the playing field. It is meant for the borrowers who have the time, cash and capabilities to optimize their debt. If you are desperate for capital now, give this a quick scan, but your top priorities should be sufficient funds and certainty of closing within the timeframe you need. I will cover criteria for desperate borrowers in a future post.

The Lenders’ POV

Lenders or credit providers are not VC’s! They are not trying to 100X their capital and they are not going to make a billion dollars if you are massively successful. Lenders care about getting their money back in the way they expected. In other words, they care about downside risks a TON and care about upside very little. Maybe they have warrants and maybe they want to lend more to you in the future. But their success is predicated first and foremost on not losing capital.

Your lender is also really two people. It’s Dr. Jeykll and Mr. Hyde or good cop/bad cop. Your Account Executive or Partner is the nice guy. He’s trying to win your deal and keep you coming back. His credit officer is the bad cop. He’s trying to avoid losing money. There is constant tension internally between these two. Not enough bad cop and the fund loses money. Too much bad cop and deals can’t get done and borrowers go elsewhere.

What’s important to you is to always provide information as if both are listening.

Don’t waste time. Know your real options

Maybe you know another company that got a huge bank loan at what sounds like a great rate. Or maybe you hear about a credit fund providing a huge facility to a company that is in your space. The temptation is to go out to that lender or type of lender and see if they are interested in you. The explosion of credit options means you can waste a lot of time and effort chasing down providers who are not a good fit for you. Not only are you burning a lot of time and effort, your data and story is being presented in a less than ideal way. In one sense, lenders are like VC’s in that they have certain types of deals they like to do. They also don’t like to burn bridges. So the lender may know you are not a fit, but will initiate a process in order to build a relationship and get access to your current financials. The more you know about your stage and which lenders like your type of deal, the less time you waste and the faster you get to money.

Be prepared

1. At a minimum, you should have a good forward cash flow model that extends well past the repayment periods of the type of debt you are seeking. This model should be able to produce your base plan as well as various downside scenarios.
2. You should also have a good data room ready to go. Nothing signals ‘we don’t have our shit together’ better than taking weeks to respond to requests for financials, data and other basic due diligence requests.
3. Have your team ready to go. Some debt like MCA’s can be done internally and with minimal legal review. But if you are taking money from a fund, a bank or a family office, you want a good attorney experienced in lending on your team.

Stack rank of criteria

Getting debt funding is a negotiation and as in all negotiations, you want to know going in what you need and what you want and the relative importance you place on those things. The following is the stack rank I suggest.

1. No personal guarantees
2. Seniority and collateralization places manageable constraints on future capital
3. Right amount
4. Funding and repayment matches your needs
5. No or low warrants
6. Reasonable covenants
7. Interest rate

No personal guarantees

Walk away from any lender who insists on a Personal Guarantee (PG) and a red flag should go up for a lender who includes a PG.

Direct lenders like credit funds sometimes have a ‘bad boy’ clause, especially for new borrowers. As they explain it, this clause is meant to protect themselves from borrowers doing something stupid like using the money to buy a Ferrari. But they get to decide what is ‘stupid’ and you are also at risk if your co-founder or CFO or someone else with access to the funds does something stupid. I would negotiate this away or find ways to limit it and have it expire.

Seniority and constraints on future capital

All loans have concepts of seniority and collateralization. Seniority determines place in line should the company fail. And collateralization determines which assets of the company the lender has rights to.

Through these concepts lenders will create terms which may constrain your ability to get other loans and types of capital. For example, if you take a senior secured loan backed by the assets of the company, you aren’t going to be able to get an Asset Based Loan (ABL) secured against your inventory. And while the lender may leave open the possibility of an unsecured loan junior to them, it will require an intercreditor agreement which leaves them in control of saying yes or no.

Borrowers will also think they can take a senior loan and then continue layering on MCA loans. There may be senior lenders out there who allow this, but I have yet to meet one. And doing it and hoping your senior lender doesn’t find out is a good way to ruin the relationship or worse trip a covenant.

So, understand what constraints are being placed on you and how that will impact your future capital raising. If you are accepting constraints, then make sure the capital provided is sufficient to achieve your goals.

Sufficient amount

It is critical that you know how much you must have and how much you would like to have. These amounts should be determined by your pre-established plans and not rationalized either up or down by what is offered. For example, if you need $5 million to achieve the growth you want, it would be a mistake to take $2 million because it has a great rate, but with the constraint that you can’t borrow any more.

Funding and repayment matches your needs

In addition to the right amount for your plans, you need to know when you need it. A good forward cash flow model is critical here. There are two things to watch out for. The lesser worry is taking all the money now, but not needing it for several months or more. You pay for it to sit on your balance sheet and it drags down Levered Free Cash Flow (the cash you can generate organically) and your margins.

There are two things to watch out for. The lesser worry is taking all the money now, but not needing it for several months or more. You pay interest to have a cash sit on your balance sheet which drags down Levered Free Cash Flow (the cash you can generate organically) and your margins.

The bigger worry is a negative debt spiral which can happen when your repayments are faster than your ability to use the capital. If you are taking short term loans including Merchant Cash Advances, pay attention to this.

The commonly cited negatives to MCA and other short term loans is the high annualized interest rates and the reduction of Free Cash Flow through the payments taken ‘off the top’ from a percentage of sales. Those are true. But the mismatch between the speeds with which you can generate cash and your repayments on debt is actually the most dangerous potential downside from this type of financing. There are two big problems from mismatches.

One, the greater the mismatch between repayment and your cash cycle, the faster you will be creating the need for more borrowing. This need can be difficult to spot, especially if you are growing, have seasonality and are stacking multiple loans. But it’s there churning away below the surface. Let’s say it takes you 210 days from when you pay for inventory to fully sell through that inventory at a healthy enough margin to generate free cash flow. You finance that inventory buy with short term debt that pays off in 150 days. At Day 150, your lender is fully paid back. But you still have two months before you get all your return from the original investment in inventory. You need more capital for another inventory buy, but because your cash flow has been reduced by the payments, you have less cash on hand. And because you still have 60 more days until your original investment fully pays back, you can't use that money. So you go back to your lender for another tranche.

Two, using short term financing to fund longer term needs means your access to capital and maybe your ability to stay solvent is at the mercy of your lender. If you have a profitable business, generating cash flow and your lender is a bank, this may not be much of an issue. You might get some minor interest rate adjustments. But if your lender is a start up whose source of capital is a credit fund, you may find your credit limit and rates varying dramatically. Worse, your solvency may be in the hands of lender who has over extended themselves and is having credit issues themselves.

No or low warrants

I sound like a broken record saying that to founders, but it bears repeating. Some lenders will simply not move forward without warrants. And this term goes back and forth over market cycles. When lenders have the upper hand, warrants come back. When borrowers have the upper hand, warrants begin to disappear.

Unlike public companies, you can’t price warrants based on any market data. There is no Black-Scholes for private company warrants. But you should create a price for what they are worth to you. You can decide if you want to share this in your negotiations, but pricing what you are negotiating for will likely make you negotiate harder. Here’s a simple way to do this.

1. Decide on the most likely value of the company when you exit. This isn’t your dream price, but the valuation you think most likely. We are going to ignore when for now.
2. Estimate the number of shares outstanding at time of exit. To do that you estimate how much more equity you are likely to sell to investors before exit. In other words, how much dilution you expect. For example, if you believe you need one more round and the new investors will want 20% and you currently have 1 million shares outstanding, then for the new investors to end up with 20% after their investment, you will need to issue 250,000 additional shares bringing the new total shares outstanding to 1,250,000.
3. Divide your expected valuation by the expected shares outstanding to get the share price at exit.
4. Multiple the share price at exit by the number of warrants the lender is asking for.

I know, I know. This ignores (i) who is paying for the dilution of the warrants e.g. it’s likely pro-rata to current investors (ii) the exercise price of the warrants (likely a penny per share, so not a big deal), (iii) the warrants themselves in the new shares outstanding calc (iv) time value of money and maybe most importantly (v) the range of outcomes at exit most of which are almost certainly below your expected valuation. But, it puts a price on the warrants and that price is likely sufficiently high to make you care about negotiating for them. The lender places value on your warrants as should you.

Reasonable covenants

The key here is to carefully think through and game play the various covenants. Entrepreneurs are optimists. But lenders are realists. They know from experience that things will not go as planned and often go wrong. Through decades of collective experience, they have developed covenants and terms to protect their downside.

Covenants around financial metrics and performance can be troublesome. For example, one company I worked with tripped a covenant for cash as a percent of revenue in their first month. Post funding, the company paid a bunch of bills, cash declined and when it came time to calculate the ratio, they were below the minimum threshold. Luckily, the lender was understanding. But I can still hear the tension in the voice of the founder when he called for advice.

The right approach here is to model out various scenarios and then think through whether they will trip a covenant. Once you understand that, you want to know what metrics or warning signs are pointing to a potential covenant issue. You next want to understand the impact of a tripped covenant. Can the lender seize all cash? Can they force you into bankruptcy? Most lenders are not predatory and don’t want to take the business over from you. But circumstances change and remember when something goes wrong, you are dealing with Mr. Hyde the bad cop so you can’t predict their reaction.

You are negotiating to remove covenants, restrict them, define them carefully and make absolutely clear what will happen. The lender can always choose to ignore their rights and in your benefit, but you do not want to rely on that when things go wrong. So be crystal clear about what they can do.

Lastly, you want to put in place the metrics, tests and warning flags for covenants into your dashboards and reporting.

Interest rate

And finally we get to interest rate. My view is that getting the money you need, in the way you need it, is far more important than what you pay for it. First of all, you are not a AAA risk. From the lenders’ POV, you are high risk. Second, all lenders are middlemen. They have to pay for their capital. As interest rates rise, their cost of capital rises. As economic consensus becomes more uncertain, the premium they charge for that capital will increase.

If the capital enables you to achieve your plans without putting you into a cash crunch or negative spiral, then a high interest rate is worth paying. Of course you want your interest rate as low as possible, but trade price of capital for the right amount in the right format. Remember, this capital is to get you to the next stage of your company. As you grow and improve your key financial metrics, your access to better capital increases.

You can learn more about the key financial metrics and how to improve them in this post.

Summary

1. Understand the lenders’ POV
2. Know your real options to avoid wasting time
3. Be prepared
4. Establish your criteria
5. Move quickly. Time is the enemy of all deals. Get momentum and keep it going. A deal isn’t closed until the money is in your account.

If you would like help with getting better debt, let’s have a chat. You can schedule time directly or email me at ben at elephantherdconsulting.com