A guide to important terms in a debt term sheet
The number of fintech startups is growing quickly. Since the pandemic, all areas of financial services are being rebuilt for consumers and businesses. But growing credit businesses require debt capital. And raising debt is not commonly talked about or discussed in the public domain. Talking to many founders, I realized there aren’t good resources available and founders are shooting in the dark.
Since we started Stilt, we have negotiated $750M in debt facilities and closed $225M+ over the last few years. In my previous post, I discussed raising debt capital at various stages of your startup.
This is part 1 of upcoming debt term sheet posts. In this post, I’ll share key terms of a debt facility term sheet. In future posts, I will discuss negotiations, what’s important, and sneaky terms to look out for.
The following terms generally apply to 2 types of debt facilities — forward flow and warehouse/revolving.
Forward Flow facility:
A facility where you sell the loans (generally, at par*) to a debt provider after they are originated. This is not a revolving facility. Once the facility is used, the loan repayments can’t be used to lend again. The originator (your startup) gets to keep the origination fee and earns a servicing fee. In most cases, the facility provider will keep the economics from the loans.
*at par = price paid for the loans sold equals the cost of the loan (at the time of sale) — it includes outstanding principal and remaining interest
A facility where the debt provider will fund against a pool of loans originated by the platform. In a revolving facility, loan repayments replenish the outstanding facility balance. So, this facility amount can be rotated multiple times (depending on the duration of the portfolio). Generally, warehouse facilities are lower cost, have stringent requirements, and lead to securitizations down the line.
A few things to note about raising debt capital:
- Debt is a fixed-income asset (as opposed to equity). The lenders want predictable and consistent cash flows every month. They earn a maximum X% return if everything goes well (there is no 100x upside), so they are cautious.
- It takes a long-time to close a debt deal (3 months — 12 months).
- It can be a continuous process (unlike equity fundraise). In other words, you can go to raise every few months as you generate more performance data.
- The best time to raise debt is immediately after a large equity fundraise.
- The more equity you have, the more leverage you have, and the simpler the debt terms.
Let’s get into the key terms:
- Interest Rate — the most important term in the facility. This is the interest rate you expect to pay on the outstanding principal balance. The interest is calculated daily (360 or 365 days) and paid weekly, biweekly, or monthly depending on the waterfall (explained below).
- Advance Rate — the % of the outstanding loan balance that will be funded by the facility provider. If the advance rate is 75%, the lender will fund $75 for $100 of originated/outstanding loans. The platform has to come up with the remaining amount. Advance Rate also determines expected equity funding. A $100M facility at full deployment will need $25M in supporting equity.
- First Loss Position — it is the percentage of loan volume not funded by the lender, which is 100% minus the “Advance Rate”. The first loss position protects a debt investor’s principal. The best analogy is a down payment on a mortgage. If an investor doesn’t receive their expected interest or principal, the first loss position capital is used to pay them back. It is also one of the biggest reasons why lending startups have to raise large equity rounds. Important to note that the lender will not earn a return on the first loss position.
- Commitment Amount — This is the initial committed amount after closing the facility. e.g. A $100M facility may have only $25M committed at close with $25M increments. So, after the first $25M is deployed, future tranches become available in $25M increments — if the loan portfolio performance holds and other conditions are satisfied.
- Warrants — This is the equity kicker for debt investors. These warrants are dependent on the stage of the company and the size of the facility. Most debt investors ask for a small percentage of the company in addition to the interest rate. This helps them align interests and earn a higher return if the company does well. They want to be rewarded because their debt helped the company.
- Legal Structure — A debt facility is, generally, non-recourse lending against the loans (or any other product such as leases). Doing this correctly requires that new legal entities are set up with defined responsibilities. Generally, the lender will set up a “bankruptcy-remote entity” (separate from the parent company) that is responsible for lending operations. In most cases, the parent company (your startup) acts as a “Servicer”.
- Bankruptcy Remote Entity — Sometimes called a Special Purpose Vehicle (SPV). This entity is created only for the purposes of managing the lending facility. SPV buys the loans originated by the parent company and the lender funds those loans. SPV also has separate bank accounts where the lender deposits the money for funded loans and collects repayments from. This minimizes the risk of the loans getting impacted if the parent company isn’t around or gets into an existential problem for some reason. A lender’s primary goal is to protect their asset (loans). Every debt facility provider will either create their own SPV or ask the parent (your startup) to create one.
- Reserve requirement — In some cases, lenders want startups to set aside a percentage of repayments for extra cushion. This amount is accrued from the extra interest from the loan repayments. If the performance of the portfolio falls below expectations, the lender will start receiving additional payments from the reserve account to make up for the shortfall. Sometimes, lenders may ask reserve accounts of up to 2.5% — 5% of the outstanding portfolio balance. A high-quality loan portfolio means a smaller reserve account.
- Servicer — A servicer manages the loans for the debt provider. This includes collecting payments from the borrowers and disbursing funds the right way to the provider. A Servicer also keeps track of loan balances for borrowers and facility balances for the lender. This is generally performed by the startup. Servicer also earns a fee, generally 1% (annualized) of the outstanding loan balance.
- Backup Servicer — A backup servicer is a different company that’s responsible for all the functions of the Servicer if they are unable to perform their duties (to the satisfaction of the lender). They are chosen before the close of the facility. They stay behind the scenes and receive data daily or monthly from the Servicer. Once they are required to service the loans, they take over the portfolio and start earning servicing and other fees associated with the portfolio.
- Waterfall — defines the order of distribution of repayments received from the loan portfolio (net of defaults). A waterfall lays out who will be paid, in what order, and what happens if repayments aren’t enough to pay the lender. It’s decided as a part of closing the facility and cannot be changed. The “Servicer” follows this pre-defined waterfall when distributing repayments. Generally, all third-party fees are paid first, then servicing fee, then interest for the lender, then principal, and the startup receives their interest and principal (for the first loss position) at the end.
- Right of First Refusal (ROFR) — gives your existing lender the right (but not the obligation) to match if a new lender offers materially better terms (or better terms). So, the existing lender has the ROFR on your next debt raise. If they refuse to match the terms, you can raise from a new lender but if they match it, then you are required to continue with them.
- Credit Criteria — this is a list of credit requirements set at the closing of the deal. The lender will only buy loans that meet these credit criteria. There is little flexibility on the important terms that can impact the portfolio performance.
- Concentration Limits — Similar to credit criteria, concentration limits define the ratios and distribution of loans in your portfolio. For e.g. if you grade loans in 5 different grades — A, B, C, D, and E. The lender will put limits on the percentage of loans in each grade. These limits need to be satisfied at the time of selling the loans. The limits are put in place to control and monitor portfolio risk. A lender decides these based on their diligence of your existing portfolio.
- Representations- this is a list of claims made by your company at the close of the facility. These claims include things like compliance with the law, validity of loans, your power to authorize the transaction, etc. There are some standard terms but lenders can add more things here depending on their risk tolerance. Banks are more finicky with these requirements and have to absolutely include this.
- Covenants — these are parent company obligations that need to be met at all times until the facility is closed. Some of the common covenants include tangible net worth requirements, liens (can’t give someone else a lien on lender’s assets), indebtedness (can’t take on too much debt without lender’s consent), separateness (subsidiary should be a bankruptcy-remote entity at all times), use of proceeds (funds from the lender can only be used for funding loans), etc. Violating any of these covenants will immediately result in a default trigger. As a result, lenders will stop future funding and demand a payoff of the existing portfolio.
- Tangible Net Worth — simply means that the parent company should have minimum predetermined cash in the bank account at all times (while the facility is active). This provides comfort to lenders that the company has enough runway to meet its obligations as a Servicer (or for transfer to a backup servicer).
- Structuring Fee — A one-time fee charged by banks (commonly) at the close of the facility. Not common for alternative lenders.
- Unused Fee — An ongoing fee charged on the facility amount not used by the platform. This fee is generally much smaller than the interest rate on the facility.
- Servicing Fee — This fee is charged by the platforms to service the loans. The fee is charged as a percent of the outstanding principal balance of the portfolio.
- Legal Fee — the fee to be paid by the platform to close the facility. This is both for the platform’s and the lender’s counsel. A debt facility provider doesn’t want to pay to close the facility.
- Reporting requirements — this is a list of predetermined items (like financials) that need to be reported by the parent company on a weekly, biweekly, or monthly basis. The metrics for loan portfolios need to be reported more frequently than the parent company. It’s different from equity capital where investors mostly leave the founders alone. Debt investors monitor all key portfolio metrics like a hawk — remember their upside is limited to their interest rate.
- Monthly Commitments and allocation — most debt investors expect a minimum loan volume to be sold every month. Their goal is to deploy capital in 12–24 months in a predictable way. That’s why they may want to buy up to 100% of originated loans. In some cases, they will cap the % of originations.
- Advance Request — it’s a weekly, biweekly, or monthly request for loan originations to be sold. It’s common in warehouse facilities because the debt provider funds against these advance requests.
- Events of Default — it’s an exhaustive list of all the conditions under which a facility will stop funding new originations. A default may also trigger a faster repayment schedule or immediate payoffs. In a warehouse facility, the interest rate charged is increased when the platform defaults.
Diligence items: The lender goes through their internal due diligence list for each function of the parent company. Below are the common functions they’ll go through in detail:
- Technology — to understand the technology built to originate and manage loans. Also includes security and other tech infrastructure items.
- Credit Risk/Loan Portfolio — to understand the credit risk philosophy, individuals responsible for credit risk, their backgrounds, and how they plan to scale the portfolio.
- Operations — diving into disbursal and loan collection practices including reviewing policies, procedures, and compliance checks.
- Marketing — to determine how you plan to scale loan originations and if that is in line with their expectations (and experience). Also, make sure that marketing is complying with all the regulations under UDAAP.
- Compliance and Legal — overall review of the compliance function in the company. This is perhaps the second most important thing for banks. They are the most sensitive to potential compliance risks because it may damage their reputation with regulators.
- Finance — to understand how funds flow within the company and expected transfers after the facility is closed. The lender is primarily trying to understand the controls in place to prevent any misappropriation of funds in the company.
Audits: The lenders may ask for a third party loan portfolio audit (common in later stage facilities). This is generally done by an investment bank or an auditor who specializes in this. The lender wants to make sure that the loans were actually disbursed to real borrowers, loans were transferred to the correct accounts, repayments were applied correctly, and the balances were correctly updated.
This audit is different from a company audit which focuses on the overall financials of the parent company.
As you negotiate terms with a lender, it helps to understand these terms. There are a lot more terms to consider when you are actually closing a facility but the list above should be good enough for the most part. The more informed you are when negotiating the term sheet, the easier your life will be in the actual closing process.
Hope this is helpful in understanding a debt facility term sheet. I’ll share thoughts on negotiations in my next post.
I am always around for discussions. Feel free to follow me or send me a note on twitter @rohitdotmittal.
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