Three Ways Out - How Banks Think about Debt Repayment

Due to its low risk – low return model, most commercial lending is done on a senior secured basis.

That means the lender has priority to the liquidation proceeds in the event of a forced liquidation, and can use those funds to repay what the business borrower owes.

In addition to that, banks typically seek to have two other repayment sources at their disposal, for what is often called a “three-ways-out” repayment structure.

Here’s how each of the three ways plays out:

1.The first repayment source for a lender is cash flow from ongoing operations.

Selling assets to repay debt (investing cash flows) or getting external capital into the business to repay debt (financing cash flows) are both considered short term, temporary cash flow generating solutions.

For long-term sustainable debt financing companies need to show they can generate sufficient positive cash flow from operations.

2. The second repayment source for a lender is asset collateral security values.

In the event future business operating cash flows were no longer satisfy debt repayment obligations, the lender wants to be able to rely on the value of the various assets pledged by the business borrower as security and have them sold to repay outstanding debt.

Both current assets of the business, like accounts receivable and inventory, as well as fixed assets like real estate can be used as collateral security for commercial loans.

3. The third repayment source for a lender is recourse against a guarantor.

In the event the cash flows of the business and the pledged collateral security asset values are insufficient to repay the outstanding debt, a lender can enforce a third party guarantee to source the balance of the funds it is owed. Note that the guarantee could be a personal guarantee, or a corporate guarantee.

Here’s an example of the "three ways out" model at work:

Imagine you have a corporation which took out a $1 million line of credit from its bank. The business is profitable and it has annual revenues of $5 million. Also, let's assume your business is seasonal, so there are times during the year when it has sufficient value in its accounts receivable and inventory balances to secure the line, and times when it doesn’t.

Your bank may think of your line of credit repayment sources like this:

1st way out – operating cash flows

2nd way out –1st ranking general security agreement providing first claim on all business assets and tracking to the average value of accounts receivable and inventory balances throughout the year

3rd way out – full/partial personal guarantee from owner operators

The trouble with personal guarantees is that often times aren’t really feasible (not enough personal assets or too many corporate shareholders) or necessary (strong company balance sheet).

In that case, when the circumstances call for an external 3rd way out, a lender could still use the personal guarantee to ensure cooperation from owner-operators, but it could also seek out more tangible 3rd ways out for its repayment, such as:

3rd way out – third party guarantee from a crown corporation like Export Development Canada (EDC)

This could be useful when accounts receivable and inventory balances throughout the year are not deemed sufficient to provide repayment security for the entire limit of the line of credit.

OR

3rd way out –corporate guarantee from a related real estate holding company

This could be useful (and quite cost effective) when real estate holdings are easily available to pledge as additional security and increase the value of the business borrower’s pledged assets.

About Financiario:

Financiario helps small and medium sized businesses with revenues of $50 million or less plan, negotiate and manage their access to financing. We support CEOs and Boards of Directors by complementing and expanding the capacity of their Controllers, VPs of Finance and CFOs.

We help you understand your requirements, source the capital you need, and use it to grow your business.

We also help you track your performance results to your plan, and when that fails we help you go back to the financing drawing board to design a better one.

Visit www.financiario.com to learn more and see how we help companies like yours achieve their growth objectives.