This article is the second of four installments in our new series, How Fintech Companies Can Simplify Their Funding Strategy. Read part one on Choosing the Right Funding Structure here.
In our prior installment of this series, we explored a variety of funding options for startups looking to launch a new financial product. In this article, we’ll do a deep dive into negotiating your first warehouse facility and how to think about important trade-offs when evaluating key terms in the credit agreement.
Far too often, we see early stage founders focus exclusively on finding the lowest cost of capital. From our collective experience helping startups raise dozens of facilities and working with a variety of lenders, we believe that this approach can overlook many other—and often more important—variables that can have a significant impact on a company’s trajectory, especially for those companies still looking to find product-market fit.
Our belief is that one’s capital markets efforts should be an enabler for future growth and never a bottleneck. As a result, it’s critical for one’s strategy to be in close sync with the company’s overall financial plans (including current cash position and future equity raises), customer demand and credit risk (including for current and future financial products along with their potential yields), as well as product development and marketing organizations, both of which may have tactical views into the company’s ability to deliver and scale these products in the market.
It’s important to recognize that diligence is a two-way street and that not all lenders are created equal. As a founder, it’s your responsibility to assess whether your capital markets counterparty is the right fit for a company at your stage. Also, keep in mind that these facilities can take months to negotiate and upon signing, are typically not replaced for the next 12-24+ months. Your business model will be dictated by the key terms in these agreements, so be mindful when entering a new relationship.
We’ll discuss each of these in more detail, but key terms generally fall into three broad categories: 1) Economics, 2) Flexibility, and 3) Scale.
As we’ve mentioned, many founders think that the only term that matters (as it’s often the easiest one to understand) is the cost of capital. In our view, cost is important, but it’s a secondary consideration in the earliest stages of a company’s life cycle. While more mature companies need to optimize for unit economics, early stage companies often need to be more mindful of their cash and their ability to iterate on the product to meet customer demand. One credit fund we spoke with said that companies will sometimes balk at 12-15% all-in costs (which can seem very high relative to, say, venture debt, which is in the mid-single digits). However, the cost should be compared relative to their equity, which has a much higher implied cost of 30-50%+ as well as the flexibility and availability of capital. For example, venture debt tends to be sized at roughly 30% of the latest equity raise size, while initial facility commitments can be 10-20x that amount.
The main trade-off to think about with regard to economics is between the advance rate and the interest rate, as both will impact the overall borrowing cost. The advance rate represents the percentage amount of collateral that a lender is willing to provide relative to the equity the borrower is required to pledge alongside it; it’s also known as the loan to value (% LTV). This ratio is of vital consideration as it directly impacts the amount of cash the company will need to put up relative to the scale of originations. An 80% advance rate means that 20% will be required to be pledged in equity. Furthermore, the equity is typically required to take the “first loss,” which means that it absorbs the impact from any portfolio losses prior to the lender being impacted by defaults. As a result, these two terms are often directly correlated with one another. A higher advance rate (meaning a lower amount of required equity) will often result in a higher interest rate (to offset the more limited protection a lender has in the facility).
Given these variables, it’s important for founders to assess whether they have enough equity to support a lower advance rate and the relative trade-off between cash (and dilution/potential impact from losses) versus a more favorable interest rate (and improved unit economics).
In our previous post, we discussed many of the variables that impact the type of facility one can expect to put in place. Considerations for the duration of a loan directly impact the frequency with which equity might be able to be recycled (a shorter duration loan might be able to support a lower advance rate as a result). Furthermore, a higher gross yield and lower expected loss rate may mean that the initial interest rate in a facility may not be of the highest importance as the net return may be sufficient in the early days of scaling. In contrast, lower-yielding or longer-duration products are significantly more impacted by both advance rate and interest rate. As a result, many founders look to other types of debt arrangements, such as forward flow agreements, versus keeping these products on a balance sheet in a warehouse facility.
With any financial product you’re looking to launch, it is important to gather as much evidence as possible to support your argument for both expected customer demand and net returns. You may be able to do this by originating a volume of loans using your equity and/or by investigating other portfolios with similar borrower characteristics and their related performance (i.e., the credit bureaus often have data, which you can purchase, on the statistical probabilities of default against key consumer variables like FICO, and the rating agencies have pre-sale monitoring reports on securitizations). The more confidence you have in these results, the greater potential you have for negotiating more favorable economic terms.
When negotiating your first facility, flexibility is key. For an early stage company still trying to find product-market fit, your ability to iterate on the types of financial products you originate, or draw from an experimental budget, can be far more valuable than optimizing for (more rigid) unit economics. We often say that these key terms can describe the perimeter of a box. It is therefore important to ensure that your business model can comfortably fit within the box and leave some wiggle room at the edges. Let’s jump into some of the most important contributors to flexibility in any credit agreement.
Eligibility criteria are the set of requirements that need to be met in order to originate an asset within the facility (you can still originate “ineligible” assets, but you’ll need to use your own capital to fund them). These often dictate risk cutoffs and help a lender build portfolio diversification. Examples of eligibility criteria can include things like minimum FICO scores for consumer loans or minimum time-in-business or debt-service coverage ratios (DSCR) for small businesses, which measure the projected net income versus the amount of debt a business might be able to support. Criteria may also include concentration limits—which cap the percentage of portfolio concentration in any given geography or industry or risk bucket—or min/max bounds on the interest rate of the products you originate (and the overall gross yield expected in the portfolio).
Negotiating these parameters can be incredibly tricky in the earliest days of a company’s lifecycle, as you may not have much (or any) prior history originating these types of financial products. As a result, you may over- or underestimate the depth of demand in the market (and the corresponding risk and return profile) depending on how you and your lender define it. As a result, it’s important to try and build as much confidence as possible in the types of products you expect to originate and anticipate which of these eligibility criteria may have the biggest impact on your ability to scale (versus those that you might be more willing to compromise on).
At Bond Street, we initially started with loan sizes between $50k and $500k, as we thought this range might serve a sufficiently broad cross section of the small business population looking for growth financing. What we didn’t anticipate was that we would have demand from very bankable companies who could afford to borrow larger loan amounts and who were willing to pay a higher interest rate for the speed, certainty, and customer experience of working with Bond Street. As a result, we felt it was critical to negotiate for a wider loan-size range in our next facility, and we were ultimately able to expand this to $10k to $1 million. Our lenders, however, were reluctant to do so, as a default on a $1 million loan would have a significantly larger negative impact on the overall portfolio versus a $10k or $100k loan defaulting. This is where things like concentration limits and minimum gross yields were imposed to ensure a diversified portfolio and protect expected returns.
In our experience, this scenario is quite common. Founders may see an unexpected amount of demand from a specific consumer or business segment or type of financial product that they didn’t expect when negotiating their initial credit agreement. This is why optimizing for flexibility and choosing your lender wisely are so incredibly important. Both can have a huge impact on the trajectory of your company.
One way to accommodate this scenario is to create an “experimental” budget in your overall warehouse facility. While you may have confidence in your ability to originate the “core” product, it can be wise to set aside a percentage of the overall portfolio for loans that fit outside of the standard eligibility criteria. Over time, this experimental budget can be used to justify widening the existing eligibility criteria or putting an additional facility in place for this new financial product.
Lenders who have experience working with early stage companies are typically more open to these kinds of arrangements, while others can be incredibly rigid. This is why doing diligence on your capital markets counterparty is critical; you’ll want to understand, based on other founders’ experiences, how a lender may react when presented with new information around customer demand, portfolio performance, or both. Are the lender’s eligibility criteria set in stone, or are they open to a conversation and willing to make accommodations and adjust the facility based on new information, potentially to accommodate a larger opportunity set?
The impact of not having flexibility could mean starting this three-to-six month process all over again (and bearing the burden of non-trivial costs) in order to set up a new facility or special purpose vehicle (SPV) to accommodate the growth of the same product. Furthermore, your existing lender may have restrictions on the types of additional facilities you can create. They may also request a right of first refusal (ROFR) on new products, as they may be incentivized to deploy as much capital as possible with a given originator/borrower, after having invested the time and money to set up the relationship to begin with.
Covenants are one of the most talked-about negotiable terms when setting up a facility. Covenants, as a reminder, are certain conditions the borrower has to fulfill to maintain good standing with the lender. They include things like minimum liquidity and debt-to-equity ratios. A breach of a covenant, or an inability to pay interest or principal payments, may trigger an event of default. Covenants can also include, among others, limits on the portfolio in delinquency after a certain number of days (30/60/90), maximum loan to value, minimum loan to value (where the funded amount must exceed at least X% of eligible receivable balance), and minimum cash/liquidity.
What happens when you trip a covenant, and what must you do afterward? If you trip a minimum cash balance covenant, for example, what will the lender do? Will they shut you off completely or accommodate you for a period of time? It’s often hard to discern this from a set of terms, so it’s important to do reference checks on your lenders and talk to other founders and your investors before locking in a financing partner. Minimum cash covenants coupled with advance rates will have a significant impact on your runway. It’s important for founders to anticipate this, as the facility could eat away their precious equity while the company is scaling quickly.
For a small portfolio of receivables, consider what the portfolio will look like when it matures and is much larger. This will help dictate terms like concentration limits, delinquencies, and default rates, which may feed into covenants. It’s also important to consider building in time for the portfolio to grow. You don’t want to have strict performance triggers with a portfolio with a small N of loans. Building in three to six months of growth will allow you room for error so that one bad loan won’t put the entire portfolio in default or delinquency and shut down the entire facility.
Make sure you’ve done worst-case scenario planning in case you have to refinance or get out of a facility early. There could be some extremely high penalties or limitations placed on future capital providers working with your company if you do so. The terms you settle on now will likely set the stage for the next 12 to 24 months before you can bring in another capital provider or potentially refinance to a lower cost of capital. Prepayment penalties could cost millions, if not tens of millions of dollars and can be detrimental to a company at the early stage. Sometimes it’s hard to get out of agreements without having to pay additional fees (such as prepayment fees, minimum returns, or exit fees).
Capital providers will sometimes negotiate for future capacity rights (i.e., $50 million today in exchange for 30% of future flow). These future capacity rights are often important for them to be able to raise future capital, and in most cases, lenders want to build depth with a smaller number of borrower relationships. That said, you want to try to build in as much optionality for yourself and your future growth as possible.
You want to make sure to get the biggest, most flexible facility while making sure you’re not locked into something you don’t want to pay for now or in the future. You’ll need to anticipate future needs and limit having to re-negotiate every 12 to 24 months. Building your capital markets strategy closely with your company’s overall growth plans is critical. One of the most painful mistakes you can make is being forced to halt growth (for months) because you didn’t put the right facilities in place to scale customer demand. Do whatever you can to anticipate future company and customer needs and negotiate for these well in advance.
When thinking about sizing, there’s often a cost to what you haven’t drawn. If the portfolio is anticipated to grow to $10 million after two years, then it doesn’t make sense to raise $50 million upfront and leave it undrawn. Unused fees can range from 0 to 1.0%. The amount you raise should be based on the size of your portfolio and what you expect to scale into. If you anticipate volume increasing 10x, you need to build that flexibility into the initial facility or negotiate for the ability to accordion the facility size to accommodate further growth and demand. Choosing a lender who can scale with you (ideally at a lower cost) or who may be alright with you growing with another, potentially parallel facility (without severe penalties) is critical.
Each credit agreement can have nuances or special arrangements. Sometimes credit funds or banks will ask for equity kickers, warrants, and other minimum-return guarantees (especially for early stage businesses). While this may be appropriate for the risk they are taking, it’s best if you can structure these based on the value they are delivering to you versus just signing a credit agreement. For example, it may be beneficial to structure the agreement so that warrants are earned in tranches after a specific dollar volume or portfolio-financing milestone is met.
Another unique term that we’ve seen recently was that of an SPV that was wholly owned by the lender, whereby the lender could wind down the SPV at any time—and the company couldn’t do anything about it. Obviously, the more control you have over your business and financing relationships, the better.
A strong capital markets strategy should be an accelerant for growth and not a roadblock. As a result, it’s important to keep your funding strategy at the center of your business plan. Do your homework in advance to anticipate potential customer demand, portfolio performance, and the key terms you’ll want to prioritize when negotiating your first credit facility.
As we’ve hopefully illustrated, the cost of capital isn’t the only variable at play. In fact, optimizing for flexibility and partner quality can have a much bigger impact on your company’s trajectory—especially as new information inevitably comes to light and requires you to adapt in order to meet customer demand and find product-market fit.
Stay tuned for the next part of our debt series, where we’ll dig into raising your first facility and the steps necessary to get that done.
Thank you to Edward Goldstein and Haley Johnson at i80 Group for contributing to this piece and to Coventure, Pollen Street, Atalaya, Tacora, SVB, Victory Park, Neuberger Berman, and others who have shared their views.