104: Debt

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On your balance sheet, there are certain liabilities that are due repayment ahead of others. If you have a “senior bank,” they are due repayment first. There are primers on the notion of liquidation preference all over the internet.

For the sake of simplicity, let’s divide debt into three buckets: (1) Cash Flow Loans for companies with at least $2 million in annual EBITDA, (2) SBA or USDA backed debt to finance real estate, regional developmental projects, and (3) asset-based debt. The debt is administered in what we will call “facilities,” which generally come in three forms: (a) term loans, (b) lines of credit, and (c) hybrids. 

I have provided a simplified summary in the chart below, but nuances abound in the debt world. This serves to provide a sketch of the general landscape. Below the chart, I explain key terms.

Before we dig in, let’s discuss personal guarantees. Unless your company is majority owned by a private equity firm or you are an exceptionally wealthy individual who banks are dying to work with, you’ll likely have to “guarantee” the debt with your personal assets. This means that if you do not repay the bank, they can come after you, make you sell your assets (e.g.: your house, your retirement accounts, etc.), and use those proceeds to repay them. Usually they exercise other remedies first (like helping you find a lender of last resort or an equity partner to take them out), but this is just a reality tied to borrowing money from other people: they want you to repay them.

Cash Flow Loans 

This term describes loans to private companies with at least $2 million by banks and private institutional funds. They base availability on a multiple of EBITDA. They look for businesses who will eventually sell. If a business is worth 9x EBITDA, they will lend 4.5x, betting that, even if things go poorly, the business will probably never dip below the value of their loan, so they’ll get repaid since they are senior, and first in line. That said, there are second lien cash flow loans available too. This lender is taking a little more risk since they are second in line, so they’ll take a higher interest rate (usually 12%-14%). 

Below is an illustration of how this works. Say your business is worth 8x EBITDA. Senior lenders might be willing to give you 3x EBITDA, and mezzanine cash flow lenders could give you 2x EBITDA. Note: there are institutional debt funds called unitranche lenders who provide both. 

Why would you do this? Some owners do this as an alternative to selling their companies. This is also generally the way “employee owned” companies are funded. The “employees” form a stock option plan called an ESOP, and they borrow this money, pay the owner, and the ESOP owns the majority of the business. 

You will notice the red portion below is the equity. This is the amount of enterprise leftover after the debt.

SBA or USDA Backed Loans 

This area is highly nuanced, and your local community bank probably has someone who specializes in this area. Essentially, if you have a small business and/or live in certain areas of the country, the SBA or USDA might incentivize banks to lend to private companies by offering to “guarantee” the loans. In effect, the SBA or USDA says “go ahead and lend to this company; we’ll guarantee you get 70%-80% repaid by taxpayer dollars if something goes wrong.” 

Asset Based Loans 

In most industries, Asset Based Lenders (“ABLs”) are lenders of last resort. In CPG, however, they can be growth tools. There are lenders, such as Stonegate Capital, who understand how to underwrite brands, and will give cash flow negative companies ABL loans based on the value of receivables and inventory. 

The ABL will give you an “advance rate” against accounts receivable (“AR”), inventory, and the appraised net orderly liquidation value (“NOLV”) of your equipment. Usually the lender will conduct the appraisal using a few credible firms around the U.S. Perhaps the most popular is Great American Group. In most cases, you’ll get 80% to 85% of AR, 50% of inventory, and 70% of NOLV equipment (if you want that much). Each month, your head of finance will provide the lender with these balances, and they will make this amount available to you in the form of a line of credit. After a year, they’ll review your account.

See below for an illustration of how this works. 

I seldom advocate for the use of debt (nor am I against it – it is a sharp tool that can be useful but easily mishandled). An ABL facility, however, is usually a pretty good emergency option for a brand. You do not have to draw on it, but it’s better to have it already in place if the need ever arises.

Click here to read 105: Traditional Private Equity.

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