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What is Senior Debt Financing
- 3. Sources of External Capital Equity financing > raising capital through the sale of ownership in a business – permits an equity holder to claim a proportional interest in a companies assets or profits Quasi equity financing - Mezzanine/ Subordinated debt > this type of financing is a hybrid between debt and equity. Usually a fixed interest rate payment is involved (similar to debt) and a variable component that is tied to the performance of the business, such as royalty’s or equity ownership in a business (similar to equity) Senior debt financing > capital raised from senior lenders that must be repaid by way of scheduled principal + interest payments and is secured by assets of a business *options for companies staying private not looking to go public*
- 4. Sources of External Capital Assets Highest Claim Liabilities & Equity Senior Junior Key Characteristics Senior Debt • Assets > First position/ highest claim on a company’s assets • Expected return > 4-10% • Repayment terms > Fixed – scheduled principal + interest payments • Control > Owners have full control of the business • Capital Provider > Commercial banks Quasi Equity - Mezzanine/ Subordinated • Assets > Second lien/ subordinated claim on a company’s assets • Expected return > 10-20% • Repayment terms > Flexible - fixed interest rate payment and a variable component that is tied to the performance of the business; royalty’s or options/warrants to purchase equity • Control > May have a seat on the board – may have some influence on management decisions • Capital Provider > Commercial banks, insurance companies, private debt funds, hedge funds, pension funds Equity • Assets > No recourse on a company’s assets • Expected return > 20%+ • Repayment terms > Flexible - an investor will earn a return by way of an exit or through distribution of a % of profits • Control > Some investors may want more control over management decisions • Capital Provider > Business owner, family, friends, angel investors, venture capitalists, private equity
- 5. Advantages of Senior Debt Financing Cheapest cost of capital Tax deductible - the interest on debt is an expense that is recognized on the profit/ loss statement which lowers a businesses tax bill Management retains full control No equity dilution - owners retain ownership of the business > senior lenders have no right to participate in the growth and appreciation of a company Retaining profits – the only obligation to a lender is the agreed upon principal + interest payments > once obligations are settled a lender is not entitled to the future profits of a business
- 6. Disadvantages of Senior Debt Financing Mandatory payments – scheduled repayments of principal and interest Covenants – may restrict management from acquiring further debt, distributing profits to shareholders, making acquisitions or investments in capex Accessibility – some companies may find it difficult to attain debt financing Collateral – some businesses may not have enough assets to secure debt which may make it difficult to qualify, personal guarantees may be required
- 7. Conclusion In summary, if a business has consistent cash flows/ profits to make scheduled payments and enough assets to use as collateral then senior debt financing should strongly be considered. It’s the cheapest cost of capital, results in no equity dilution and allows shareholders to maintain full control of a business. Coming up next will be reviewing how lenders underwrite senior debt > what information is required and how lenders complete their financial analysis
Editor's Notes
- Hello and welcome to this presentation on senior debt financing. In this presentation we’ll be going over what senior debt financing is, what makes it different from other sources of capital and to finish off we will go over the advantages and disadvantages of using this type of financing to fund a company.
- A business will require capital for a wide range of purposes. From funding working capital (capital used in day to day operations) to investments in equipment, software, real estate etc. If a business doesn’t have spare cash in the bank account to finance these expenses, then a business will have to turn to an external provider of capital.
- The most common financing options for private SME’s include: Equity financing > Is the process of raising capital through the sale of ownership in a business. An investor will earn a return by way of an exit (selling his shares in the future that will be worth more if companies increases in value) or through receiving a % of after tax profits. Quasi equity > Mezzanine/ Subordinated debt financing – this type of financing is a hybrid between debt and equity. Usually a fixed interest rate payment is involved (similar to debt) and a variable component that is tied to the performance of the business, such as royalty’s or equity ownership in a business Senior debt > capital that is borrowed from senior lenders that must be repaid by way of scheduled principal + interest payments and is secured by assets of a business
- So – three options – why go with one financing option vs the other? This chart summarizes the characteristics of each type of financing. There is a lot going on in this chart and the simplest way to think about is if we start at the left hand side of the table Under the asset column the arrow is pointing up at the provider of capital which has the highest claim on a company’s assets Senior debt lenders have the highest security interest in a companies assets - in the event the borrower is unable to repay the loan, the lender may take title to the assets pledged as security and then sell assets to recoup losses Quasi equity lenders – quasi equity holder/ lender is in second position to a secured lender in terms of repayment. The unsecured lender waits until the secured lender is paid in full before being able to make any claims on the assets of the borrower Equity capital providers – typically have no recourse on a company’s assets in a default situation Why does this matter? Security interest in a company’s assets drives risk which is correlated to the cost of capital Senior lender – has a high chance of recouping funds in a default situation and thus has the lowest risk and as a result usually has the cheapest cost of capital Equity capital providers have no recourse on a company’s assets > if a company goings bankrupt they are left with nothing > high risk > high cost of capital > investors require a higher return to be compensated for taking that risk Quasi equity – is somewhere in between – potential recourse on some assets in a default situation So one major characteristic is the cost of capital – lowest for senior debt, highest for equity A few other key characteristics: Repayment terms Senior debt - Repayment terms > scheduled monthly principal + interest payments – capital that has fixed repayment terms Quasi - equity - Repayment terms > flexible - fixed interest rate payment (monthly, semi annual, annual) and a variable component that is tied to the performance of the business; royalty’s or options/ warrants to purchase equity – capital that has semi-flexible repayment terms Equity - Repayment terms > Flexible > patient capital - An investor will earn a return by way of an exit or through distribution of a % of after tax profits (dividends) > an exit may not occur for a number of years, dividends are discretionary – negotiated with other shareholders – capital that has flexible repayment terms Control Senior debt - Control > Owners in most cases have full control of the business Quasi – equity - Control > May have a seat on the board – some influence on the direction of the company Equity - Some investors may want more control in management and decision making Capital provider Senior debt - Commercial banks Quasi equity - commercial banks, insurance companies, private debt funds, hedge funds, pension funds Equity - Capital Provider > business owner, family, friends, angel investors, venture capitalists, private equity*
- Cheapest cost of capital –the all in costs involved with senior debt are the lowest in comparison to the other options Tax deductible - the interest on debt is an expense that is recognized on the profit/ loss statement which lowers a businesses tax bill > vs equity there is no tax advantage No equity dilution - owners retain full ownership of the business > senior lenders receive no shares in a company and thus have do not participate in the growth and appreciation of a company > all shares remain with owners of the business Retaining profits – the only obligation to a lender is the agreed upon principal + interest payments > once obligations are settled a lender is not entitled to the future profits of a business
- *Mandatory payments – Senior debt has scheduled repayments of principal and interest. It’s a fixed expense that must be paid – this can make it tough on businesses that have unpredictable cash flows (such as early stage companies, seasonal companies or companies that may experience an unexpected drop in sales or margins which may lead to non sufficient cash balances to pay for the debt) Covenants – some borrowers may have to agree to covenants which are promises between management and a lender that certain activities will not be carried out such as restricting management from acquiring further debt, declaring distributions to shareholders or restricting acquisitions or investments in capex –as a result management may lose some control over company decisions Accessibility – Some companies may find it difficult to attain debt financing due to insufficient collateral (below) or not meeting financial performance requirements – on the financial performance requirements will go over that in further detail in the next presentation on underwriting of debt Collateral – some businesses may not have enough assets to secure debt which may make it difficult to qualify, personal guarantees may be required (shareholders will be personally liable for debt if something happens to the company) which may not be favored by some shareholders
- That’s it for our presentation on senior debt financing. In summary, if a business has consistent cash flows and profits to make scheduled payments and enough assets to use as collateral then senior debt financing should strongly be considered. It’s the cheapest cost of capital, results in no equity dilution and in most cases allows shareholders to maintain full control of the business. Coming up next will be reviewing how lenders underwrite senior debt – will look at what information is required and how lenders complete their financial analysis