Debt Capital, Debt Facility, and Term Sheets

In recent years, there has been a significant increase in the number of fintech startups emerging. These startups and their founders aim to revolutionize financial services for both businesses and consumers.

Among the various types of fintech startups, “lending products” are quite common. These startups provide credit by leveraging alternative data, improved risk-scoring models, or utilizing unique acquisition channels.

Although these startups aspire to grow rapidly, expanding a credit business necessitates acquiring debt capital. Unfortunately, there is a scarcity of resources available to assist founders in comprehending the process of raising debt capital. As a result, many founders are left bewildered, particularly when it comes to understanding debt term sheets. The following sections will examine the essential and sometimes perplexing terminology found in debt capital term sheets.

Understanding Debt Capital

Entrepreneurs are accustomed to soliciting equity capital from venture investors, which is subsequently utilized to finance various aspects of company operations, such as marketing, salaries, and product development. However, as a credit company, entrepreneurs must also secure funding for the “loans” they offer.

Since most equity investors prefer not to allocate expensive equity capital towards funding loans, entrepreneurs must obtain debt capital from a distinct group of investors – debt investors. These investors typically comprise alternative lenders, hedge funds, and banks.

Debt capital is usually restricted to funding “loans” and cannot be employed for operational expenses such as salaries or marketing. Typically, this debt capital is a substantial amount and carries a lower cost than equity capital.

What is a Debt Facility?

A debt facility is a financial arrangement between a borrower and a lender in which the lender provides a certain amount of debt capital to the borrower for a specified period. This debt capital may come in the form of a loan, a line of credit, or a bond issue. The terms of a debt facility are established in a legally binding contract, which outlines the amount of the loan, interest rates, repayment schedules, and any other covenants or restrictions. A debt facility may be secured or unsecured, and the interest rate may be fixed or variable. The purpose of a debt facility is to provide the borrower with access to capital to fund various business operations or projects.

Types of Debt Facilities

Debt facilities, generally, come in two forms: 

• Forward Flow Facilities
• Warehouse Facilities

Below, we’ll take a closer look at both types of facilities and explore examples. 

Forward Flow Debt Facilities

A forward flow facility is an agreement between a lender and a borrower in which the lender agrees to purchase a specific type of financial asset(s), such as a loan or mortgage, from the borrower on a regular basis, usually monthly or quarterly. The financial asset must meet specific criteria set by the lender, such as a minimum credit rating or specific loan-to-value ratios. The lender may pay the borrower a fee for originating the asset and then either hold it in their portfolio or sell it to other investors.

As an example, a fintech startup that offers personal loans enters into a forward flow facility agreement with a large hedge fund. The agreement specifies that the hedge fund will purchase $100 million worth of the startup’s newly originated personal loans on a monthly basis for a period of one year. The hedge fund has specific criteria for the loans, including a minimum credit score and a maximum debt-to-income ratio. The agreement also outlines the purchase price for the loans, which is based on a formula that takes into account the outstanding principal balance and the interest rate on the loans.

Warehouse Debt Facility

A warehouse facility is a line of credit provided to a financial institution, such as a mortgage lender, that enables them to originate loans for a short period of time before selling them on to a larger investor, such as a mortgage-backed securities issuer. This allows the financial institution to continue generating revenue from loan origination while minimizing its exposure to risk by not holding onto the loans for an extended period of time. Warehouse facilities may also require that the loans meet specific criteria in order to be eligible for financing.

As an example, A fintech startup that offers small business loans secures a warehouse facility with a large investment bank. The facility provides the startup with a $100 million line of credit that can be used to originate new small business loans. The startup can draw on the line of credit to fund the loans and then sell the loans to investors to repay the line of credit. The warehouse facility has specific requirements for the loans, such as a minimum business credit score and a maximum loan amount. The facility also specifies the interest rate charged on the line of credit, which is typically based on a spread over the prevailing LIBOR rate. The warehouse facility has a term of one year and may be renewed subject to certain conditions.

Both forward flow and warehouse facilities are important financing options for financial institutions that specialize in originating loans, as they provide access to the necessary capital to fund loan origination while minimizing risk. They are also commonly used in securitization transactions, in which financial assets are pooled together and sold off to investors as securities.

Debt Term Sheets

A debt term sheet is a summary of the proposed terms and conditions of a debt financing agreement between a borrower and a lender. It outlines the key economic and legal terms of the proposed loan, such as the amount of the loan, the interest rate, the repayment schedule, any fees or charges associated with the loan, any security or collateral required for the loan, and any covenants or restrictions placed on the borrower.

A debt term sheet is not a legally binding agreement, but rather a preliminary document that outlines the general terms of the loan. It serves as a basis for negotiation and discussion between the borrower and lender, allowing both parties to better understand each other’s expectations and reach a mutually acceptable agreement.

Once the borrower and lender have agreed upon the terms outlined in the debt term sheet, a more comprehensive loan agreement will be prepared, which will incorporate the terms from the term sheet along with other detailed provisions and legal language. This loan agreement will be a legally binding document that governs the terms of the loan and the obligations of the borrower and lender.

Final Thoughts on Debt Facility 

In conclusion, as fintech startups continue to grow and innovate, the need for debt capital to finance their lending products becomes increasingly crucial. 

Debt facilities enable startups to access the necessary capital to fund loan origination while minimizing risk. Debt term sheets are critical documents that outline the key terms and conditions of a debt financing agreement and serve as a basis for negotiation and discussion between borrowers and lenders. 

As the fintech industry continues to evolve, understanding debt capital and its associated terminology will be essential for startups to succeed in the highly competitive financial services landscape.

Frank Gogol

A seasoned SEO expert, Frank has a long history of working with and for startups. Starting in mid-2018, Frank served as the SEO Strategist for Stilt, a fintech startup that provided fair loans for immigrants in the US and other underserved markets. While with the company, he scaled site traffic from zero to more than 1.5 million unique visits per month, driving the bulk of the company’s lead generation until it was acquired by J.G. Wentworth in December 2022. As employee #5 at Stilt, Frank was witness to, and part of, the successful building and sale of a fintech company, uniquely positioning him to create content for founders about all things startups.

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