Debt Financing for IT and IP Companies- When, Why and What It Takes

Securing debt financing is a complex, time consuming and at times challenging process – particularly for IT and IP-driven companies. However, there are now many lenders with a greater understanding of non-asset based business models and, as a result, the debt markets for IT/IP driven companies have evolved considerably within the last few years. This increased sophistication among lenders has resulted in greater liquidity and competitive interest rates making bank and bond financing an attractive option for certain companies. In this CEO topic, we will explore when and why it might be appropriate to consider debt financing. We will summarize areas that require close attention and share key lessons learned from working with companies in the GA portfolio.

Over one-half of GA portfolio companies use some form of debt financing with levels ranging from $150,000 to $850 million. Our companies have accessed the debt markets for shorter-term financing, primarily lines of credit for working capital requirements, and longer-term loans for financing acquisitions and/or recapitalizations. Debt financing can be an efficient and cost effective source of capital for companies that have achieved an appropriate size and financial profile. Debt financing can accrue certain tax benefits depending upon a company’s tax status and domicile. In fact, since interest is tax deductible, the tax benefit can be one of the most interesting and compelling reasons for profitable companies to consider debt financing.

Regional banks are often the most appropriate sources of working capital or loans under the $25 million level. For larger loans, it is best to approach larger top tier commercial banks. Bond markets may be appropriate for deals in excess of $150 million. Pricing for deals under that threshold may not be as attractive as a bank debt transaction. However, bond deals have filing requirements akin to public company disclosure which may present issues for certain kind of companies.

Terms offered by banks will vary greatly and will be highly dependant on the financial profile of a company and the situation. There are a number of key considerations in securing debt financing. The amount of leverage should be considered carefully. It is essential to leave adequate room for future events such as additional acquisitions and other growth initiatives. Taking on too much debt can hinder a company’s ability to react to new opportunities and/or competitive threats. Not securing adequate financing can be similarly restrictive.

Understanding options with respect to interest rates is important. While it might be attractive in the short-term to choose a floating rate option, the risk of rising interest rates must be appropriately managed. A variety of financial products are available hedging exposure to rising rates and in many cases these protections will be required by bankers.

Close analysis of all covenants is critical. Potential lenders are likely to require strict covenants and it is management’s job to ensure that there is sufficient room for contingencies. Financial covenants are based upon a company’s financial projections so it is very important to provide a conservative plan in which management has a very high degree of confidence. EBITDA and cash flow in particular are key financial measures that will be analyzed by the lenders. The penalty for breaking covenants can be very onerous and should be well-understood. Similar care should be taken with non-financial covenants which can limit a company’s flexibility to invest for growth, pursue acquisitions, enter new business lines and engage in other strategic initiatives. Incurrence covenants, common for bond deals, are meant to ensure that covenants for bond holders are not violated in the event of incurrence of additional debt. These require careful scrutiny.

The duration of the loan and any prepayment penalties should be thoughtfully considered. In future years, it might make sense to prepay a loan but prepayment fees could make a refinancing unattractive or prohibitive. Overall cash management should be part of the analysis with respect to debt financing.

As you approach lenders, be prepared to spend both the time and resources to manage the process. The CEO and CFO must be closely involved and for the CFO in particular, this process will have to be a main priority for weeks. Once the process is complete, banks are another constituent requiring reporting and it will be important to provide the necessary information on a timely and regular basis.

The involvement of financial sponsors such as General Atlantic can facilitate the debt financing process and provide comfort to lenders regarding a company’s credit profile. GA has developed strong relationships with a number of major financial institutions and can be helpful with both introductions and the entire process. Moreover, GA has developed expertise in non-obvious debt structures involving hybrids of bond and debt markets. For additional information about debt financing, please contact your GA team.