For the best part of a decade following the global financial crisis, interest rates were artificially depressed by major central banks. Money was cheap, refinancing was assumed. Previously minor sources of financing such as Venture Capital, Private Equity and Direct Lending exploded. What didn't change much was bank lending volumes, suppressed by stricter regulations and higher capital requirements, or superseded by faster, cheaper or easier alternatives. Nevertheless, it was a good time to borrow money.
In 2021, as markets recovered from the shock of Covid, inflation returned with a vengeance. The ECB raised rates at ten consecutive meetings, taking its deposit rate from minus 0.5% to 4%. The Fed and Bank of England moved even faster.
Since then, borrowing or raising money is more difficult, and more consequential for many corporates. But the explosion of sources and types of funding remains. Choosing the right type and source of funding is a daunting prospect for many corporate treasurers.
In this series we'll examine the various types of funding available and their distinguishing features, what they are used for, where they fit in a company's lifecycle, and who provides the financing. We'll also look at pricing, hedging and some of the common covenants and conditions.
How to choose the right type of funding?
What is available to you. Very simply, not everyone has access to the same financing at the same rates. Some facilities are only available to companies at a certain stage, with certain cash flows or assets, or of a certain credit quality. If you don't meet the requirements, you may have to look at other types of funding, or other institutions. Two things change as you move along the ladder. The cost of funding generally falls (a pre-seed raise gives up more equity per dollar raised than an IPO, and a larger balance sheet can borrow at lower rates than an SME). Obligations rise: disclosure, ratings, investor relations, all costly and time-consuming endeavours required to keep a large investor base happy.
What funding is actually for. Very simply, the source of funding should match the use. Fund long-lived assets with long-dated money, and short-term swings with facilities you can draw and repay quickly. Many companies become reliant on short term funding to finance working capital, or fund large capital projects with shorter term debt.
It's not just the cheapest. Rate is a key factor, but not the only consideration. Covenants and restrictions have the potential to do more damage to your business than a slightly higher rate. Strategic flexibility is extremely valuable to corporates.
What companies get wrong
- Raising too little. Underestimating funding requirement, cash burn or runway requirement, or unexpected cost increases, with no margin for error. Emergency funding, raised at short notice, when your actuals didn't match your previous forecast will cost more and carry tighter restrictions.
- Raising too late. The best time to raise funds is on your own schedule, with plenty of notice. Some forms of financing distinguish themselves on the pace they can move at, but many still take months. You need sufficient time to talk to numerous counterparties, and allow for their credit or investment processes. As above, whether raising equity or borrowing, better to avoid doing it when you are desperate. The same goes for refinancing.
- Raising too much. For two reasons:
- Beyond a reasonable level of prudence, unnecessary debt which isn't put to use growing a company generates unnecessary interest costs and ultimately erodes value.
- Excessive leverage can put pressure on financials, and increases risk of a covenant breach or default.
- Raising all at once. Five facilities maturing in the same year adds a major cliff risk to your financing strategy. Stagger maturities.
- Using the wrong financing.
- Funding long term assets with short term debt is a common downfall for many corporates. Forces you to constantly refinance, and leaves you vulnerable to a funding downturn.
- Funding volatile cash flows with rigid term debt reduces flexibility and incurs unnecessary cost.
- Overreliance on a single funding source.
- As covered in our counterparty risk section. Diversity of funding counterparties can be as important as diversifying your cash placements.
- Diversifying funding sources can also protect you from a single source freezing or closing up temporarily (e.g. UK gilt markets in Oct 2022).
- Overly optimistic projections. Raising equity or debt based on overly optimistic projections can leave you unachievable targets to meet or covenants to maintain. Model your runway and covenant headroom conservatively.
- Understand the docs. Events of default, change-of-control clauses, cross default, material adverse change, guarantees and negative pledge, prepayment premiums and break costs, restricted payments, liquidation preference and many more. Each one has the potential to trip up a borrower or owner if not fully understood at inception.
- Floating rates, hedging and break costs. The source of numerous potential complications.
- Floating-rate debt puts your covenants at risk in a rising rate environment without any deterioration to company performance.
- Hedging adds further complication and cost, along with extra documentation. It is often a bigger step outside an inexperienced treasurer's comfort zone than the borrowing itself.
- Certain hedges incur the possibility of break costs if you decide to pay down debt early and need to exit the hedge ahead of maturity. Can quickly turn a positive step into an unexpected cost.
The same job at three sizes
Start-up. Bootstrapping and Grants initially, moving to early-stage investors: Family and friends, Angel investors, Tax-efficient investment schemes, start-up loans. … read more show less
Venture capital and Venture debt might be an option depending on your model and quality of your cash flow, but the bar has changed significantly with the advent of AI. Generally, the bigger concern here is dilution rather than interest rate, and the calculation is runway rather than repayment.
Fundraising takes longer to organise than a loan, so managing cash, forecasting requirements and initiating the fundraising process in a timely manner is essential. At other stages, if you can't access the funding you want, you fall back to a different structure or higher rate. That luxury isn't widely available for start-ups.
Established mid-market. A wide menu of bank debt is the main source of funding. … read more show less
An Overdraft for cash management, a Revolving Credit Facility for the big swings, Term Debt for investment in the business. The covenant package that arrives matters as much as the price. Diversification and competition between lenders add leverage and stability.
Depending on the company and strategy, you may also work towards a listing (raising equity, probably on an alternative index), PE (Private equity) funding, or Private credit and Direct lending (usually higher risk, but more flexible facilities, often from non-bank lenders).
Large corporate. Rated public debt issuance, syndicated facilities and a curve of bond maturities. … read more show less
Liabilities are managed as a portfolio: spreading maturities, watching spreads, managing hedges and pre-funding when markets are friendly rather than when they are forced to.