Navigating Debt Capital Term Sheets

When it comes to debt capital, debt term sheets are a critical component of any startup’s funding journey. They provide a framework for the proposed loan agreement between the borrower and lender, outlining key terms and conditions that both parties must agree on before moving forward. While not legally binding, a debt term sheet sets the stage for negotiations and helps ensure that both parties are on the same page. In this blog, we’ll provide a brief overview of debt term sheets and take a closer look at some of the key terms and categories found in these documents.

Brief Overview of 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 serves as a preliminary document that outlines the key economic and legal terms of the proposed loan, allowing both parties to better understand each other’s expectations and negotiate the final agreement.

The key terms included in a debt term sheet may include 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.

While a debt term sheet is not a legally binding agreement, it provides a starting point for negotiations and helps ensure that both parties have a clear understanding of the proposed terms. 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.

Debt Facility Vocabulary

Debt term sheets contain a variety of terms, which can be grouped into the following categories:

• Quantitative
• Risk
• Fees
• Diligences
• Structural and Operational
• Legal Obligations
• Future Growth

While there are no official groupings for these terms, organizing them into these categories can be helpful in understanding the key aspects of a debt term sheet. In the following sections, we will discuss the first four groups, which comprise (roughly) the terms that go into the development of a debt deal. 

Quantitative

Let’s start by examining the quantitative aspects of a debt term sheet. These are the numerical values and percentages that determine the broad strokes of a debt facility.

One of the most important aspects of debt facilities is the interest rate, which determines the cost of the debt to the startup. Other critical terms include the advance rate, first loss position, commitment amount, warrants, and servicing fee. 

In this section, we’ll look at six of the key quantitive debt sheet terms founders need to know:

• Interest rate
• Advance rate
• First loss position
• Commitment amount
• Warrants
• Servicing fee

Below, we will explore these key terms in detail.

Interest Rate

This is the most crucial term in the facility, as it determines the rate at which the startup will pay interest on the outstanding principal balance. Interest is calculated daily (either on a 360-day or 365-day basis) and paid weekly, bi-weekly, or monthly, depending on the Waterfall (explained below).

Advance Rate

This refers to the percentage of the outstanding loan balance that the debt investor will fund. For example, if the advance rate is 75%, the debt investor will cover $75 for every $100 of outstanding loans. The remaining $25 is the responsibility of the startup. The advance rate also determines the expected equity funding (see First Loss Position) that the startup will need to cover. For instance, a $100M facility at full deployment will necessitate $25M in supporting equity.

First Loss Position

This is the percentage of loan volume that is not funded by the debt investor, which is 100% minus the “Advance Rate.” The First Loss Position functions similarly to a mortgage down payment. If a debt investor does not receive their expected interest or principal, the First Loss Position capital is utilized to repay them. Startups must raise substantial equity rounds to cover the First Loss Position. It is also essential to note that the debt investor does not receive a return on the First Loss Position.

Commitment Amount

Once the facility is closed, the Commitment determines how the facility will be disbursed to the startup. For example, a $100M facility may have a commitment of $25M at the close, with incremental disbursements of $25M as long as the loan portfolio performance holds and other conditions are satisfied.

Warrants

In addition to the Interest Rate, most debt investors will request a percentage of the startup. This helps them align their interests and earn a higher return if the company performs well. They want to be compensated because their debt aided the company. The size of these Warrants is dependent on the stage of the company and the size of the facility.

Servicing Fee

This is the fee charged by the startup to service the loans for the Bankruptcy Remote Entity. The fee is charged as a percentage of the outstanding principal balance of the portfolio.

Risk

Every debt term sheet contains specific collateral requirements that a startup must meet or maintain.

Before receiving this funding, startups must meet certain credit criteria and adhere to strict concentration limits to ensure portfolio performance. Debt investors may also require startups to set aside a portion of repayments in a reserve account as an additional safety net. Furthermore, to mitigate startup risk, term sheets often require a minimum tangible net worth and a backup servicer in case the primary servicer is unable to perform their duties. 

Below, we’ll delve deeper into risk-related debt sheet terms, including:

• Credit Criteria
• Concentration Limits
• Reserve Requirement
• Tangible Net Worth
• Backup Servicer

Read on to learn more about these terms. 

Credit Criteria

This is a list of credit requirements for loans that is established at the closing of the deal. The debt investor will only purchase loans that meet these criteria, and there is little flexibility in the important terms that can impact portfolio performance.

Concentration Limits

Similar to Credit Criteria, Concentration Limits define the ratios and distribution of loans in the portfolio. For example, loans may be classified as A, B, C, D, and E, and the debt investor will place limits on the percentage of loans that can fall into each grade bucket. The debt investor will determine the percentages based on their diligence of your existing portfolio to monitor and control portfolio risk. These terms must be satisfied at the time of selling the loans.

Reserve Requirement

In some cases, debt investors require startups to set aside a percentage of repayments to act as a “reserve” that provides an additional safety net. This amount accrues from the extra interest from loan repayments. If the portfolio performance falls below expectations, the debt investor will receive additional payments from the reserve account to make up for the shortfall. Sometimes, debt investors may request reserve accounts ranging from 2.5% to 5% of the outstanding portfolio balance. The higher the quality of the loan portfolio, the smaller the reserve account.

Additionally, every term sheet includes language outlining the mitigation of startup risk. Investors want to ensure that the startup has sufficient funding to continue loan origination and servicing.

Tangible Net Worth

This is the minimum cash that the startup must have in the bank at all times while the facility is active. This figure is predetermined and agreed upon before the facility is finalized and distributed. Tangible Net Worth provides the debt investor with an additional layer of security because the startup has extra runway to meet its obligations as a Servicer (or for transfer to a backup servicer).

Backup Servicer

In the event that the Servicer is unable to perform their duties (to the satisfaction of the lender), those responsibilities will be transferred to the Backup Servicer. The Backup Servicer is chosen before the close of the facility. They stay behind the scenes and receive data daily or monthly from the Servicer. Once they are required to service the loans, they take over the portfolio and start earning servicing and other fees associated with the portfolio.

Fees

A debt facility will typically include certain fees outlined in the term sheet.

Understanding the various fees associated with a facility is essential for startups to effectively manage their finances and make informed decisions about their funding. 

In this section, we’ll look at three critical fees that startups should be aware of when negotiating debt facilities: 

• structuring fee
• unused fee
• legal fee

Below, we’ll explain what these fees are and how they are calculated. 

Structuring Fee

This is a one-time fee charged at the close of the facility. Typically, bank partners require a Structuring Fee, but it is less common when working with debt investors. The amount of the structuring fee is typically a percentage of the total facility amount and can range from 0.5% to 1% of the facility size.

Unused Fee

This is an ongoing fee charged on the amount of the facility that is not utilized by the startup. Generally, this fee is very small compared to the interest rate of the facility, often around 0.25% per annum.

Legal Fee

Legal fees associated with a debt facility are the costs associated with legal representation for both the startup and the lender during the facility process. The startup is responsible for paying for its own legal representation, as well as the legal fees incurred by the lender. In general, legal fees for a debt facility are usually a percentage of the total facility size, typically ranging from 0.5% to 1%.

Diligences

Diligences refer to the debt investor’s list of required due diligence for each function of the startup.

When a startup seeks debt capital, it must prove to debt investors that they are equipped to manage and scale its operations responsibly. This requires a solid foundation in: 

• technology
• credit risk management
• compliance
• marketing
• finance
• operations

By understanding these critical components and ensuring that their business meets the necessary requirements, startups can increase their chances of securing the funding they need to grow their lending business.

Technology

The technology built by the startup to originate and manage loans, including security and other tech infrastructure items, must be robust.

Credit Risk/Loan Portfolio

The startup’s Credit Risk philosophy must be clear. It should be clear who is responsible for Credit Risk and scaling the portfolio.

Operations

The startup’s loan disbursal and collection practices, including reviewing policies, procedures, and compliance checks, must be sound.

Marketing

The startup’s understanding of how to scale loan originations must be aligned with the debt investor’s experience and must comply with all UDAAP regulations.

Compliance and Legal

The startup’s Compliance function must be sound. Bank partners, in particular, are sensitive to potential compliance risks because it may damage their reputation with regulators.

Finance

The startup must understand how funds flow within the company and the expected transfers after the facility is closed. The debt investor needs to comprehend the controls in place to prevent any misappropriation of funds in the company.

Final Thoughts

Understanding the key terms and categories found in a debt term sheet is essential for any startup seeking debt capital. From interest rates and advance rates to credit criteria and compliance, every aspect of the agreement must be carefully considered and negotiated to ensure a successful outcome. While a term sheet is only the beginning of the process, it sets the stage for a comprehensive loan agreement that will guide the borrower and lender through the terms of the loan and their respective obligations. By carefully considering the terms and categories outlined in a debt term sheet, startups can position themselves for success in securing the funding they need to grow and thrive.

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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