We have discussed financing via Convertible Debts and Equity Financing. There is a third element that is equally important and ought to be in the arsenal for financing the working capital requirements for the company.

Here are some common Term Sheet lexicons that you have to be aware of for opening up a  credit facility.

Formula based Line of Credit: There are some variants to this, but the key driver is that the LOC is extended against eligible receivables. Generally, eligible receivables are defined as receivables that are within 90 days at an uber level. There are some additional elements that can reduce the eligible base. Those items that can be excluded would be as follows

Accounts outstanding for more than 90 days from invoice date

Credit balances over 90 days

Foreign AR. Some banks would specifically exclude foreign AR.

Intra-Company AR

Banks might impose a concentration limit. For example, any account that represents more than 30% of the AR that is outstanding may be excluded from the mix. Alternatively, credit may be extended up to the cap of 30% and no more.

Cross Aging Limit of 35%, defined as those accounts where 35% or more of an accounts receivable past due (greater than 90 days). In such instances, the entire account is ineligible.

Pre-bills are not eligible. Services have to be rendered or goods shipped. That constitutes a true invoice.

Some instances, you may be precluded from including receivables from government. Non-Formula based LOC: Credit is extended not on AR but based on what you negotiate with the Bank. The Bank will generally provide a non-formula based LOC based on historical cash flows and EBITDA and a board-approved budget. In some instances, if you feel that you can capitalize the company via an equity line in the near future, the bank would be inclined to raise the LOC.

Interest Rate

In either of the above 2 cases, the interest rate charged is basically a prime reference rate + some basis points. For example, the bank may spell out that the interest rate is the Prime Referenced Rate + 1.25%. If the Prime rate is 3.25%, then the cost to the company is 4.5%. Note though that if the company is profitable and the average tax rate is 40%, then the real cost to the company is 4.5 %*( 1-40%) = 2.7%.

Maturity Period

For all facilities, there is Maturity Period. In most instances, it is 24 months. Interest is paid monthly and the principal is due at maturity.

Facility Fees

Banks will charge a Facility Fee. Depending on the size of the facility, there could be some amount due at close and some amount due at the first year anniversary from the date the facility contract has been executed.

First Priority Rights

Bank will have a first priority UCC-1 security interest on all assets of Borrower like present and future inventory, chattel paper, accounts, contract rights, unencumbered equipment, general intangibles (excluding intellectual property), and the right to proceeds from accounts receivable and inventory from the sale of intellectual property to repay any outstanding Bank debt.

Bank may insist on having the right to the IP. That becomes another negotiation point. You can negotiate a negative pledge which effectively means that you will not pledge your IP to any third party.  

Bank Covenants

The Bank will also insist on some financial covenants. Some of the common covenants are

1. Adjusted Quick Ratio which is (Cash held at the Bank + Eligible Receivables)/ (Current Liabilities less Deferred Revenue)
2. Trailing EBITDA requirement. Could be a six month or 12 month trailing EBITDA requirement
3. EBIT to Interest Coverage Ratio = EBIT/Interest Payments. Bank may require a 1.5 or 2 coverage.

Monthly Financial Requirements

Bank will require the monthly financial statements according to GAAP and the Bank Compliance Certificate.

Bank may seek an Audit or an independent review of the Financial Statements within 90-180 days after each fiscal year ends.

You will have to provide AR and AP aging monthly and inventory breakdown.

In the event that there is a reforecast of the Budget or Operating Plan and it has been approved by the Board, you will have to provide the information to the bank as well.

Bank Oversight and Audit

Bank will reserve the right to do a collateral audit for the formula based line of credit financing. You will have to pay the audit fees. In general, you can negotiate and cap these fees and the frequency of such audits.

Most of the above relate to a large number of startups that do not carry inventory and acquire inventory from international suppliers.

Bankers Acceptance

BAs are frequently used in international trade because of advantages for both sides. Exporters often feel safer relying on payment from a reputable bank than a business with which it has little if any history. Once the bank verifies, or “accepts”, a time draft, it becomes a primary obligation of that institution.

Here’s one typical example. You decide to purchase 100 widgets from Lee Ku, a Chinese exporter. After completing the trade agreement, you approach your bank for a letter of credit. This letter of credit makes your bank the intermediary responsible for completing the transaction.

Once Lee Ku, your supplier, ships the goods, it sends the appropriate documents – typically through its own financial bank to your bank in the United States. The exporter now has a couple choices. It could keep the acceptance until maturity, or it could sell it to a third party, perhaps to your bank responsible for making the payment. In this case, Lee Ku receives an amount less than the face value of the draft, but it doesn’t have to wait on the funds. Bank makes some fees and the Supplier gets their money.

When a bank buys back the acceptance at a lower price, it is said to be “discounting” the acceptance. If your bank does this, it essentially has the same choices that your Chinese exporter had. It could hold the draft until it matures, which is akin to extending the importer a loan. More commonly, though, the bank will charge you a fee in advance which is a percentage of the acceptance. Could be anywhere from 2-4% of the value of the acceptance. In theory, you can get anywhere between 90-180 days financing using BA as an instrument to fund your inventory.
 

Dangers of Debt Financing

Debt Financing can be a cheap financing method. However, it carries potential risk. If you are not able to service debt, then the bank can, at the extreme, force you into bankruptcy. Alternatively, they can put you in forbearance and work out a plan to get back their principal amount. They can take over the role of receivership and collect the money on your behalf. These are all draconian triggers that may happen, and hence it is important to maintain a good relationship with your banker. Most importantly, give them any bad news ahead of time. It is really bad when they learn of bad news later. It would limit your ability to negotiate terms with the bank.

Manage Debt

In general, if you draw down against the LOC, it is always a good idea to pay that down as soon as possible. That ought to be your primary operational strategy. That will minimize interest expense, keep the line open, establish a better rapport with the bank and most importantly – force you to become a more disciplined organization. You ought to regard the bank financing as a bridge for your working capital requirements. To the extent you can minimize the bridge by converting your receivables to cash, minimizing operating expenses, and maximizing your margin … you would be in a happier place. Debt financing also gives you the time to build value in the organization rather than relying upon equity line which is a costly form of financing. Having said that, there will be times when your investors may push back on your debt financing strategy. In fact, if you have raised equity prior to debt, you may even have to get signoff from the equity investors. Their big concern is that having leverage takes away from the value of the company. That is not necessarily true, because corporate finance theory suggests that intelligent debt financing can, in fact, increase corporate value. However, the investors may see debt as your way out to stall more investment requirements and thus defer their inclination toward owning more of your company at a lower value.