Short term working capital financing is most commonly facilitated with an asset-based line of credit. As its name suggests, the loan is secured by an asset in the business – usually accounts receivable. If you ever consider using this type of a vehicle in your business, here are the 5 most critical terms you should understand and know how to negotiate.
What is the asset that will be securing the line? These loans are normally tied to current assets like accounts receivable and inventory, but they can also be secured by equipment and even intangible assets like intellectual property and goodwill.
If we default on our payment of the obligation, the lender will have the right to seize ownership of the asset. Banks and lenders do not want to have to do this and they will be the first to admit that they are not structured or equipped to effectively liquidate such assets. These assets are usually very valuable to the business which makes payments on the line of credit a top priority for most businesses.
BORROWING BASE REQUIREMENTS
Assuming the asset is the accounts receivable of the business, the lender usually sets limits and conditions on the amount of the receivables that can be included in the borrowing base. The two most commonly used limitations are past due accounts and customer over-concentration.
The lender will often only allow current receivables in the borrowing base. This is often set as all receivables less than 60 days old or only receivables less than 60 days past due. Lenders will often limit the percentage of the total receivables that one customer can hold. This is usually set at no more than 20% of the total eligible borrowing base. For example, if we have total receivables of $1,000,000 and they are all current (very unlikely in this economy), no single customer can account for more than $200,000 of the total receivables. If they do, then all amounts over $200,000 are excluded from the borrowing base.
Once the total borrowing base is established, the lender will then often only allow a certain percentage of those assets as the final base. On accounts receivable, this percentage usually ranges from 60-80%. As an additional note, borrowers are usually required to report on the status of the borrowing base on a monthly or more frequent basis.
So, how does all of this work. Here is a basic example: let's assume the lender allows us to borrow a maximum of $100,000 against 75% of our eligible receivables. The lender excludes all receivables over 90 days old and has no limit on customer concentration. Our total accounts receivable is $150,000, but $50,000 is over 90 days past due and we are about to write it off as bad debt. This means our eligible AR is $100,000, which means our borrowing base is actually only $75,000 ($100k AR times 75% of eligible AR).
This is very simply the maximum amount the lender is willing to lend on the line of credit, regardless of the value of your borrowing base. Most lenders set this amount by looking at their secondary sources of repayment, which are usually the financial strength of the owner(s) and/or the equity in un-related assets (like their home). These are often secured with a personal guarantee.
Each bank structures its fees a little differently, and it is important to understand these so that we can make an “apples-to-apples” comparison on costs. Most lenders assess an origination fee of between .5-1.5%. In addition, they will often charge document and other fees. We have also seen banks require borrowers to pay an independent third-party to verify and validate the assets in to be secured. We recommend receiving proposals from more than one bank and then comparing the total cost proposal from each potential lender to understand which may present the best deal for you.
INTEREST RATE & FLOOR
When you establish your borrowing base and you draw on the line, interest will begin to accrue. Most banks are setting the interest rate on these lines at prime plus 1.5-2.0%. Prime is currently at 3.25%, so that would equate to an interest rate of 4.75-5.25%. Because these rates have dropped so low, most banks have instituted a floor, or a rate below which they will not drop. Interestingly, those floors are being set at 6.5-7.0% in this market.
Asset-based lines of credit are an affordable and effective way to finance the peaks and valley in working capital. As a word of caution, most require a personal guarantee from all owners of 20% or more of the business. We recommend you seek legal counsel before agreeing to personally guarantee the debt, especially if the guarantee is unlimited – which means each partner can be held responsible for 100% of the obligation personally.