The Different Types of Debt (#345)
/The Line of Credit
The line of credit is the most essential form of debt for a business. It’s intended for the funding of cash shortfalls caused by periodic changes in your cash flows. So, a seasonal business might draw down cash from a line of credit in order to buy inventory for its peak selling season. Once the inventory has been sold, the company has the cash to pay off the line of credit. The intent here is to completely pay off the line of credit at least once a year, if not more frequently. If you can’t do that, then the lender has granted you too large a line of credit, and will probably scale back the amount to a figure that you can reasonably expect to pay off each year.
A line of credit is designed to be fairly low-risk for the lender, who takes the company’s accounts receivable as collateral, and maybe a bunch of other assets, too.
The Term Loan
Another type of debt is the term loan, which you’re supposed to gradually pay down over a number of years. This loan is designed to fund capital projects. It has a sufficiently long duration so that you can use the cash generated by the funded project to pay off the loan – so the loan duration could be anywhere from three to 10 years, and maybe longer. This arrangement is riskier for the lender, so expect it to charge a higher interest rate, and it might demand personal guarantees from the owners, too.
The Construction Loan
A more specialized loan is the construction loan. This is a short-term loan that’s used to pay for the cost of developing land and constructing buildings. The land and buildings are used as collateral for the loan. This loan is not usually paid out all at once. Instead, payments are made as needed through the construction process, so the cash is dribbled out only to meet immediate needs. Once the property has been completed, the property developer pays off the construction loan with the proceeds from a longer-term financing arrangement.
The Bridge Loan
Which brings us to the next loan, which is the bridge loan. This is a short-term debt that covers the time period between the conclusion of a prior loan and the commencement of another loan. So, the recipient is committing to obtain longer-term financing in the near future that will pay off the bridge loan.
This loan is pretty common when you’re trying to replace a construction loan with a long-term loan that you can pay down over a lot of years. The lender usually wants to use the underlying facilities as collateral, and will charge a pretty high interest rate on the loan.
Subordinated Debt
For a larger business, a good option is subordinated debt. This is a debt obligation that has a lower payment priority than more senior debt – which means that the claims of more senior debt holders must be paid off before the holders of subordinated debt can be paid. If you don’t have the cash to pay off your lenders, then those holding the subordinated debt will be at a greater risk of not being paid. Given the higher risk for these lenders, subordinated debt has a higher interest rate than more senior debt, which compensates them for the higher risk of default. This type of debt is preferred by larger corporations that are financially secure, since lenders are willing to grant them fairly low interest rates. On the other hand, a smaller business with questionable cash flows might not be able to take on any subordinated debt at all.
Convertible Debt
And then we have convertible debt. This is a loan that can be converted into the common stock of the issuer. In essence, it’s a loan with a built-in stock option. The conversion to stock only happens if the lender decides to do so, and it takes place at a predetermined conversion ratio, such as $10 of debt equals one share of common stock. Generally speaking, a business only agrees to convertible debt when it has no other options, because the lender could potentially take a large ownership stake in the business – which you may not want. The duration of convertible debt can be all over the place, and it may or may not involve collateral; that all depends on your level of desperation.
The Demand Loan
Another option is the demand loan. Under this arrangement, the lender can call the loan on short notice, like a few weeks from now. Because of the risk of having to pay back the loan really soon, this is a bad choice for anything but an extremely short-term cash need, such as having to cover a liability for a month or so. Beyond that, this loan is highly not recommended.
Mezzanine Financing
And finally, we have mezzanine financing. This is a form of funding that’s partway between debt and equity financing. So, it might be structured as a convertible loan, or maybe as preferred stock that earns a dividend. In essence, the lender wants to participate in the upside of the business, which means having some access to your equity. There can be all sorts of uses for this type of funding, such as a management buyout, or maybe to provide funding for more growth. You usually have to go to a lender that specializes in mezzanine financing, since traditional lenders don’t handle these arrangements.
So in short, it usually makes sense for a business to get a line of credit first, and then a term loan to finance specific capital projects. If the business grows into something significant, then a good option is subordinated debt. Beyond that, there are all sorts of specialized loan arrangements. It just depends on your specific financial situation.