If you have made it this far into the world of corporate law, there’s not much I should need to tell you about how debt works. But perhaps it's useful to link some familiar concepts to our handy new framework for thinking about the funding puzzles you will encounter.
Many discussions of debt delve into the time value of money, interest rates and yield. That’s not what we will do here. In this post we are interested in the “flavour ”of debt, compared to the flavour of other sources of funding.
Overview of the basic mechanics of debt
First, a quick review so that we are all on the same page.
I’m using a very broad, imperfect and idiosyncratic definition of debt. When I say "debt" I’m talking about when a lender gives cash to a business now, and the business has to give back cash later. That cash can be worth more or less than the original amount, and it can be paid back in one go or in a series of instalments. It can be paid back with interest or without.
What's important is that the lender is parting with his or her money for an amount of time, and needs to be compensated for a) the time value of the money, and b) the risk that it will not be repaid.
For our purposes, I’m going to abstract the entire world of debt along two axes:
- The number, size and timing of the payments that the business has to make, in order to clear the debt;
- The other obligations that the business incurs as a result of taking on the debt.
Each of these axes contain choices for designing a debt instrument that provides adequate protection for the lender and sufficient flexibility for the business, at a price that both parties can afford.
Axis 1: Designing the stream of cash flows
You probably know (and perhaps dread) this diagram:
It is your best friend for thinking about debt. Any time you encounter a debt, draw this out and populate it with the incoming cash at t = 0, and the outgoing repayments over time. This simple chart can tell the story of pretty much any debt instrument. There are of course fancy variants that are not so easily captured but this trusty diagramme will do the job most of the time.
So what do you as a lawyer need to understand about these different debt structures? Two things:
- Each structure delivers a combination of risk and return to the lender, and a combination of flexibility and affordability to the borrower.
- Often, an increase in one attribute will come at the expense of another.
Let ’s give some brief examples:
- a debt which is repaid all at once, far in the future is probably more risky for a lender than receiving a stream of payments over the term of the loan. But it offers more operational flexibility to the businessm because the business doesn’t have to worry about allocating cash to interest payments during the term.
- a debt which requires a smaller repayments at first and larger repayments later will typically be easier to manage for the borrower, but riskier for the lender.
- having a variable interest rate (and hence, variable sizes of payments over the term of the loan) rather than payments of a fixed size might benefit the borrower or the lender, depending on the circumstances, including macroeconomic factors.
Note that all these structures are designed in the shadow of the interest rate. If a particular structure of payments favours one side, the interest rate can be tweaked to compensate the other side.
What’s a useful takeaway from this discussion? That businesses normally like to pay as little as possible for as long as possible, while lenders want to guard against default by collecting at least some money in the short and medium term.
But - and this is important - if a bank collects all its money too soon, the bank might not actually get the return it wanted. In other words, when the bank makes a loan, it rents out cash. In order to earn its rental fee, the bank’s cash has to be out in the market, generating interest!
One more related aside: lenders who are in the business of making loans think in terms of loan portfolios. They need to make sure that on average the loans they make work as intended. Banks and other lenders design loans as products which can handle a certain rate of failure. Next time you see a news story about default rates in a certain sector or industry, this is what they are talking about.
Axis 2: the obligations that are wrapped around the cash flows
We just covered the design of the cash payments that are embodied in the loan. The is how the loan is supposed to work.
But the best laid schemes of mice and men and highly paid investment bankers gang aft a-gley: various things can happen to put the stream of repayments at risk of not being paid.
Risk 1 is that the business doesn’t generate enough cash to fund operations and have money left over to pay the lender according to the agreed schedule. Risk 2 is that the business does generate cash, but that someone else has a higher claim on it.
What are the protections that lawyers put in place for lenders to mitigate Risk 1? There are preventive protections, such as making sure the borrower provides ongoing disclosures, as well as financial and operational guardrails to make sure that the business doesn't spend on certain things or go above or below specific thresholds. Then there are remedial protections, such as forfeiture of collateral or acceleration of payments.
And how about Risk 2? A lot of debt structuring is about establishing priority between various creditors and building legal protections to make sure that this priority remains intact. Negative covenants can be used to forbid taking on new debt, to prevent any additional assets from being collateralised, and so on.
Lawyers are trained to think carefully and deeply about Risk 2. They are great at writing debt covenants that defend a lender’s priority, and making sure that in case of a bankruptcy, their client’s claims are not trumped by a competing claim. I find that lawyers don’t instinctively think enough about Risk 1 - the risk that the business doesn’t generate the necessary cash. The discussion below will focus a little more on the consequences of debt for a living, breathing business that is not at immediate risk of default.
The accounting story
A quick detour into the accounting story:
When the cash from the loan is achieved, the debt shows up on the balance sheet as a liability, either long-term or short-term.
As interest payments are made, these show up on the income statement below the gross income line, and as they do, the cash on the balance sheet decreases and the outstanding liability may change.
Important: there are a number of financial ratios based on the accounting statements that are key metrics used by lenders both to monitor the health of the business, and as a trigger for certain mechanisms.
Debt is blind, clunky and “one-shot”
A defining feature of the borrower-lender relationship is the information asymmetry between the lender and the borrower.
Let’s think back to our discussion of trade credit. In that discussion, we covered the fact that suppliers are in a great position to understand the business that they are lending to, that they have access to up-to-date information from the market, and they can tweak the terms of trade from one transaction to the next in to reflect new information, or growing/shrinking confidence in the business they are lending to.
On each of these counts, banks have it tougher. Let’s play this through.
- Understanding the business: Banks and other lenders are not directly engaged in the industry they lend to. They are in the business of making loans, not producing widgets, or selling consulting hours or whatever. Some lenders try hard to think like borrowers (they may even hire people from the industry) but many do not.
- Access to up-to-date information: As mentioned, suppliers are in the chain of commerce. Banks and lenders are not. When a business hits a snag or gets a new order, suppliers will start to feel the effects of that change in the next order that the business places with them. On the other hand banks and lenders need to actively seek this information out or put borrowers under a contractual obligation to furnish it.
- Being able to integrate new information into the dealings: Suppliers can tweak the terms of trade on a nearly continuous basis. Compare this with a loan: A lot of effort goes into designing and executing a loan agreement up front. But once the agreement is in place, there is generally little scope to modify it.
In other words: lenders are lending to a business as it exists at t = zero, based on all the information they have been able to acquire up front. But this information is already becoming stale by the time the documents have been signed. And looking ahead, the business itself will surely evolve over time in response to the market. The living, breathing business that has borrowed the money will naturally over time start to look different from the one the lenders did their due diligence on, and lent money to.
Real world business consequences at an operational level
But the real action is on the cash management side. There are many expenses that a business can delay paying, but interest payments are typically not among them. By introducing debt financing into a company, the company takes on a burden of making sure that it can set aside a certain amount of cash every period to service that debt. That ’s a constraint that may feel trivial in good times, but it can be crippling in tough times.
What clients care about (sometimes)
If you are representing a lender, your main job will be to make sure that they are protected from the risk of not getting paid. But you should understand that not every loan needs to work perfectly every time. A lender builds a certain default rate into the design of their loan portfolio. If they don’t take enough risk, they may not be making best use of their capital.
If you are representing a business who is borrowing, your job is to:
- Preserve flexibility in future funding arrangements
- Preserve operational freedom
- Keep monitoring/compliance costs to a minimum
The takeaway from this post should be to understand that your business client isn’t necessarily thinking: “How can I subordinate this loan to the interests of the next lender I talk to when I run out of money?” Rather, they are worried about the need to set aside cash for interest payments. They are irritated at the addition of a new expense line on their P &L. They are worried about the market’s perception of a change in their debt-to-equity ratio. And they might be very worried about the fact that yet another stakeholder can tell them how to run their business. Finally, they may also be irritated at having to report a bunch of new metrics, and deal with the distraction of attending bondholder meetings, and so on.
Keep these concerns in mind and you’ll find yourself able to empathise with and better serve your clients.