Calculating the true cost of a debt facility

As you scale a credit startup, raising a debt facility is one of the functions for the founders. It is still untractable for most. Learning it early in your startup will influence many decisions.

A quick note on democratizing the hidden pieces in fintech:
I write primarily for the founders, builders, and creators. The ones building something to improve the financial system for hundreds of millions around the world. My goal is to share learnings on the required but unsexy parts of fintech. Investors don’t really know this stuff and are not able to provide any support either. I’ve seen founders struggle and in many cases make incorrect decisions that jeopardize the company.

You don’t have to start from scratch. We figured out this stuff over the years. Stand on our shoulders and build a successful company. Godspeed.

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Raising debt facility is complex. It is also expensive. Among other things, the investors and the costs of a large facility stay with you for years. They may also impact your company’s trajectory. A measured and thoughtful approach helps you prevent mistakes.

Most founders don’t understand the true cost of capital when negotiating a term sheet. A debt facility has a lot of moving pieces including the rate you are paying, the initial setup costs, ongoing costs of compliance, etc. This results in a web of expenses, some of which are incurred before you can even use the facility. Remember that you pay for almost all the costs and before the facility is closed.

As you are negotiating or weighing multiple debt term sheets, you’ll need to compare all the costs - both short and long-term. I made quick spreadsheets with obvious and non-obvious costs to calculate the true interest rate you can expect to pay based on the most common debt terms.

If you want to understand the list of terms, please read my previous post.

Here is a link to a sample cost comparison spreadsheet: https://docs.google.com/spreadsheets/d/1W4Xc1p5hzcROoeB5f9QBs1IR05iVQUW2jzyA3kziqlo/edit?usp=sharing

You can make a copy and change the numbers to get an approximate “true cost of capital” of a debt facility. I have all added some reasonable numbers to start with. Each debt facility is unique and costs can vary significantly. Keep an eye out for all the sneaky or unclear terms in a term sheet.

The takeaway is that the actual running cost of a debt facility can be 8% even the interest rate is 5%. This extra 3% expense directly reduces your bottom line. As you grow your capital markets function, lowering the cost of capital will be one of the drivers of positive unit economics.

This spreadsheet is an approximation but not far from what it will be. For e.g. unused fee is charged daily and the outstanding balance may also change every day. So, we have to approximate calculations over the revolving period.

Here’s a dictionary of the terms that impact interest rate:

Initial Committed Amount: When you raise a facility, a part of the overall facility is committed. It means that the lender will fund at least the committed chunk of the facility. e.g. In a $50M total facility, the initial committed amount can be $10M. It’s possible that the facility is discontinued after this - if the loans don’t perform. So, when calculating the overall have an expectation of how much do you expect to use.

Structuring Fee: It’s common for banks to charge an upfront fee at the close of the transaction. It is a percentage of the “committed amount”, not the overall facility amount. At later stages, when the next tranche is committed, they’ll charge a fee on the additional committed amount.

Benchmark Floor: Interest rates are set using LIBOR or a similar base rate. But if the LIBOR is too low (as it is in 2020), banks want to set a floor rate. It is usually 25 bps or higher.

Interest Spread: It is the interest rate added on top of a benchmark floor rate. Benchmark Rate + Interest Spread = Interest Rate - charged on the outstanding balance.

Default Margin: If your company goes into “default” under the “events of default” condition, lenders charge an additional rate on top of interest rate. This rate generally varies from 1%-3%. Again, you won’t pay this additional rate during normal course of operation, it only applies when there’s an “event of default”.

LIBOR: The standard 30-day LIBOR.

Unused Fee: A fee charged on the committed amount not deployed. It applies on day 1 after the facility starts. You will continue to pay unused fee until the facility is fully deployed. It starts at 0.25% (of the amount not deployed).

Agent Fee: A lender may assign an agent who works on their behalf. They charge a monthly fee to manage a small part of operations for the lender (irrespective of deployed amount).

Ongoing Diligence Fee: After you raise a facility, expect annual due diligence. This includes financial audits, loan audits, compliance reviews, and other similar items. You will have to pay for this every year. In some cases, lenders ask for a biannual review - which is painful and costs more money.

Facility Set Up Costs: This is the big daddy of all upfront costs. It includes lawyer fees (both yours and lender’s), audit fees, initial compliance review fee, loan audit fee, background checks, travel expenses for on-site visits by the lender’s team, and many other things. You’ll see flight ticket prices you’ve never seen before like a domestic return flight for $5k. Yeah, all these expenses add up and you have to pay for this.

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Hope this is helpful in understanding the true cost of a debt facility. I’ll share thoughts on negotiating a debt term sheet soon.

Feel free to follow me or send me a note on twitter @rohitdotmittal. I am always around for discussions.

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