What if a company wants to buy equipment, fund operations or make an acquisition? These longer term assets aren’t a great fit for the revolving line of credit we discussed earlier. There is a mismatch in the life of the asset and maturity of the debt which causes two potential problems:
- the company has to pay back a short term loan quickly, before the asset is fully used
- buying longer term assets with the line of credit robs the company of future liquidity; there won’t be any credit room to fund growth in working capital
The downsides of this mismatch are important to bear in mind because a bank line of credit is often the cheapest form of debt available so it’s tempting to use it to fund longer term assets.
Build a spreadsheet to optimize your cost of capital and it will immediately max out the line of credit. Spreadsheets don’t have to live with the consequences, though ;)
In its simplest form a term loan works like a house mortgage or car loan. The company borrows, say, £1mm today and pays a combination of principal and interest over the term of the loan with the full amount being repaid by maturity.
A term loan has a number of levers which determine the size and frequency of payments and maturity date. Let’s walk through some examples.
First, take a £1mm term loan with an 11% interest rate with equal monthly principal payments and maturity in 36 months:
Principal payments will be £27,778 each month for 36 months;
Interest payments will be higher at the start getting smaller each month as the principal is repaid;
The total of all payments will be £1,169,583.
Some companies prefer to make the same payment each month. In that case the monthly payment will be £32,739 each month for 36 months. However, the principal and interest components of that payment will change each month. In early months more of the payment will pay interest and less will pay down principal. The total of all payments for this structure will be £1,178,594.
(You will notice that the difference of the sum of all payments payments is less than £10,000 whether the loan is structured as equal monthly principal payments or equal monthly principal plus interest payments. This difference would be greater with a longer amortising period).
Most term loans for venture-backed companies will have a maturity of about 36 months which results in a larger monthly principal payment than interest payment. Pushing out the maturity date will lower the principal payments. Stretching the £1mm loan from 36 to 48 months will reduce principal payments from £27,778 to £20,833.
Companies that want to delay principal payments should look for longer term maturities. Some may even want a bullet structure where most or all of the principal repayment is deferred to the maturity date. Because these loans are riskier for the lender they are typically offered to larger companies with fairly stable revenues and will contain some form of financial covenants (which we will discuss in a later post).
- Longer term assets should be financed with longer term liabilities such as a term loan;
- Term loans provide a lump sum of cash today and are paid down (amortised) over time;
- Extending the maturity date or structuring a bullet repayment will reduce principal payments in the earlier years of a loan. These structures are riskier for the lender so often come with financial covenants and are offered to larger companies with stable cash flows.