Risk

The High Price of Cheap Debt

How can a CFO make the best decisions about debt for the business?
Scott BergquistMay 14, 2012

Leverage can be a powerful tool, but optimizing its application requires some calculus of cost versus benefit. The traditional reference to debt as “leverage” is certainly appealing. Much like a simple tool can help a person lift twice as much weight, adding term debt or a revolving credit facility can lift a transaction size or working-capital liquidity beyond what precious equity capital can achieve alone.

Finding that perfect, simple leverage tool is critical to a company’s growth and future success. So, how can a CFO make the best decisions about debt for the business?

Borrowers often forget that cost is what you pay, and value is what you get. Interest rates and fees tend to be overweighted in the decision-making process.  At the risk of sounding self-serving as a 25-year senior and mezzanine debt provider,  is prime plus 1% really better than prime plus 2%, if the loan structure limits operating flexibility or provides less availability? No way.  If the leverage provided facilitates scaling your business or boosts investor return, the 1% implied cost difference is de minimis in context.  

The emotional reaction that “prime plus 2 is way more expensive” should be balanced by the translation to absolute dollars and put in context. The 1% actually represents less than $10,000 per year on $1 million borrowed, because a term loan amortizes, and average borrowings on a revolving credit facility will be below the commitment amount. I encourage management teams, and bankers, to invest a disproportionate amount of time and analysis marrying the proposed structure to the strategic objective.  Only when that analysis is complete should they then consider cost.

Structural elements of a borrowing proposal like covenant types and level, commitment amount, tenure, advance formulas, amortization, and tranching must be quantified against the strategic plan, and, importantly, considered against management’s confidence in its pro forma financial forecasts. Innovative companies can and do experience material variance in actual-to-plan performance as they scale. Accordingly, for them, greater flexibility is often seen as the greatest value.  Conversely, if a company has 90% or more confidence in the plan, the  value proposition of higher flexibility may not warrant the associated premium. Thus, confidence will be the part of the decision calculus of whether to go with lower direct cost and tighter structure or higher direct cost and looser structure.

The borrower also has to understand how bankers look at those dynamics. They view the balance between cost and structure as risk versus return. The easiest way to understand how the banker is weighing flexibility (or risk to the bank) versus price (or return to the bank) is to request two term sheets that alternately emphasize price and flexibility.

A One-Transaction Relationship?
The cost-versus-value conversation can take place within a lending relationship that is more vendorlike or one that is more long term and multifaceted. For example, if it is a single-product provider, a vendor will approach the creditor-debtor association as a pure transaction.  Assuming the transaction performs within the agreement, all should work well for both parties.  In fact, the CFO may not even communicate with the lender except at reporting intervals and the instrument’s maturity date. 

A relationship-based partnership, on the other hand, can go beyond that. The borrower can expect intangibles like subject-matter expertise and network leverage, as well as very tangible considerations like off-plan patience (the lender’s willingness to make adjustments when a forecast is off) and bundled pricing.  It is important for both parties to be conscious of the kind of association they are pursuing, or expectations will not be met.

There is future opportunity cost associated with failing to think beyond the current transaction. That means considering things like the scalability of the current partner to accommodate growing operating and credit needs.  Will the company need to manage two relationships or need to switch providers as it grows? For example, many creditors focus and excel at growth capital term debt or asset-based working-capital solutions, but not both.  So, in a revenue ramp scenario, one consideration is whether the senior-secured term debt provider would allow a collateral carve-out to a second lender for a needed working-capital solution.

Another governor on the scalability provided by the lender is maximum targeted hold levels for any one borrower relationship. If the bank is not signaling or managing expectations, the CFO has to quiz it on comfort and appetite above a certain lending commitment amount. Likewise, as the company grows, nondebt banking needs also change, demanding more sophisticated treasury and cash-management solutions, so the CFO has to stay informed on the entirety of the bank’s platform.

It may be an oversimplification, but finding the best loan term sheet is no different than buying a new flat-screen TV. When looking for real value, shop features and fit first, before price. 

Scott Bergquist is the central U.S. division manager for Silicon Valley Bank, overseeing business development and client relationship activities with 2,000 companies and managing more than $1 billion in committed capital. He specializes in financing solutions for high-growth technology and life-science companies.