What Happens After a Debt Deal?

So you’ve successfully found a debt investor and signed a debt deal. Now what? For founders, getting a debt deal is only part of the equations for success. Just as important, if not more important, is understanding how the debt deal will play out after it’s signed. 

In our previous blog about navigating debt term sheets, we outlined seven groups that encompass debt term sheet vocabulary. In that post, we focused on the terms that determine how a debt deal develops (qualitative, risk, fees, and diligence).

Here, we’ll discuss the terms that affect the deal after it takes effect and explore how that impacts the parties involved, including: 

• Structural and Operational
• Legal Obligations
• Future Growth

Below, we’ll delve into the terms that impact the deal after it takes effect, exploring how they affect the parties involved. Structural and operational terms, legal obligations, and future growth clauses all play a crucial role in debt financing agreements. By the end of this post, you should have a better understanding of the key terms founders need to know when developing and executing a debt deal.

Structural and Operational

Once a facility is in place, certain structures need to be defined to ensure its smooth operation.

There are myriad factors that affect how a debt facility will operate once the deal is complete. One critical aspect of this process is understanding the Waterfall, which outlines the order of repayment distribution received from the loan portfolio. Additionally, startups must be aware of the importance of a Bankruptcy Remote Entity, the role of a Servicer, and the various reporting requirements, monthly commitments, allocations, and advance requests that are often included in debt term sheets. 

In this section, we will provide a comprehensive overview of these key components of debt financing.

Waterfall

The Waterfall defines the order of repayment distribution received from the loan portfolio (net of defaults). A Waterfall sets out who will be paid, in what order, and what will happen if repayments aren’t enough to pay the debt investor. It is decided during facility closing and cannot be changed. The “Servicer” follows this pre-defined Waterfall when distributing repayments. Third-party fees are generally paid first, followed by the Servicing Fee, interest for the lender, principal, and (finally) the startup receives their interest and principal (for the First Loss Position) at the end.

Bankruptcy Remote Entity

Sometimes referred to as a Special Purpose Vehicle (SPV), this entity is created by the debt investor to manage the facility. The Bankruptcy Remote Entity purchases the loans originated by the startup with the funds from the debt investor’s facility. It also has separate bank accounts where the debt investor deposits the money for funded loans and collects repayments. This reduces the risk of the loans getting impacted if the startup isn’t around or encounters any existential problems. A debt investor’s primary goal is to protect their assets (loans). Every debt facility provider will either create their own SPV or ask the startup to create one.

Servicer 

A Servicer manages the loans for the debt investor, which includes collecting payments from the borrowers and disbursing funds to the startup. The Servicer also keeps track of loan balances for borrowers and facility balances for the debt investor. Servicing is typically performed by the startup, which earns a fee, usually 1% (annualized), of the outstanding loan balance.

Reporting Requirements

Reporting Requirements consist of predetermined items, such as financials, that must be reported by the startup on a weekly, biweekly, or monthly basis. Debt investors closely monitor all key portfolio metrics because their upside is limited to their interest rate.

Monthly Commitments

Monthly Commitments are the minimum loan volumes the startup is required to sell every month.

Allocations

Allocations refer to the percentage of originated loans the debt investor will buy each month to deploy capital predictably over 12-24 months. Therefore, a debt investor may choose to purchase 100% of originated loans. In some cases, they will cap the % of originations.

Advance Request

The Advance Request is a weekly, biweekly, or monthly request from the debt investor requesting that the startup sells a certain amount of loan originations. Advance Requests are common in Warehouse facilities because the debt investor funds against these Advance Requests.

Legal Obligations

To ensure compliance with the facility agreement, the startup must adhere to certain standards and obligations to avoid defaulting on the facility.

When a startup enters into a debt financing agreement with a lender, there are certain legal obligations and requirements that must be met, including:

• Representations
• Covenants
• Eevents of default

Representations are the claims made by the startup regarding compliance with the law and other factors, while covenants are the obligations that must be met until the facility is closed. Events of default, on the other hand, are the conditions that could lead to the debt investor stopping new originations or demanding an immediate payoff. 

Below, we’ll discuss each of these topics in detail, exploring what they mean for startups and how they can impact a debt financing agreement.

Representations

At the closing of the facility, the startup makes claims regarding compliance with the law, the validity of loans, their power to authorize the transaction, and other standard Representations. Additional items may be added by the debt investors depending on their risk tolerance, especially bank partners who are highly risk-averse.

Covenants

Obligations and standards that the startup must maintain until the facility is closed are called Covenants. Tangible net worth requirements, liens, indebtedness, separateness, and use of proceeds are common Covenants. Violating any of these covenants will result in an immediate default trigger, leading to a halt in future funding and demanding a payoff of the existing portfolio from the debt investors.

Events of Default 

A list of exhaustive conditions under which the debt investor stops funding new originations for the facility is known as Events of Default. In case of default by the startup, a more aggressive repayment schedule, or even an immediate payoff, may be triggered. In a Warehouse facility, the interest rate charged is increased as a result of default.

Future Growth

In the world of debt financing, it is common for startups to work with multiple debt investors over time. However, when a startup is considering working with a new debt investor, the existing investor may include a Right of First Refusal (ROFR) clause in the debt agreement. This clause gives the current debt investor the right to match the terms of any new debt investor offering better terms for the facility. 

In this section, we’ll take a closer look at the ROFR clause and its implications for startups and debt investors.

The Right of First Refusal

The Right of First Refusal is a clause included in a debt facility agreement that gives the current debt investor the right to match the terms of a new debt investor offering better terms for the facility. Essentially, it provides the existing debt investor with the option to retain their investment by matching or bettering the offer made by the new debt investor. Although the current investor is not obligated to exercise their ROFR, if they choose to match the offer, the startup is required to continue working with them. This clause helps to ensure that the current debt investor has the opportunity to maintain their investment and continue their relationship with the startup.

Final Thoughts

Understanding the key terms of a debt financing agreement is crucial to building a successful company through a debt facility. From the Waterfall to Representations, Covenants, and the Right of First Refusal, every term has a significant impact on the operation and future of your business. With the knowledge above, founders will be better equipped to negotiate and execute debt deals. And with that knowledge, you can secure the funding you need to grow your business, all while protecting you interests and building strong relationships with debt investors.

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.

See author's posts