Flawless Financials the Financial Forecasting Online Newsletter from Minotaur Financial and David Brode September, 2004 Sent monthly to over 400 subscribers. Please pass on Flawless Financials to those in your network. To leave Flawless Financials, follow instructions at bottom. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * This month: Choosing Among Competing Lenders * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * Overview One thing I always enjoy is a juicy analytic project. I especially relish a project that has a large financial impact. Recently, one of my clients was seeking to borrow a large amount of capital. The good news was that lenders were drooling over the prospect of lending to his company, so we were faced with many options. The downside was that lenders came at us with varying term sheets. So how did we choose a deal? This newsletter summarizes our approach to analyzing the options. I. Sizing The first issue was debt sizing. How much debt did we need, and when did we need it? Initially, estimates of how much we needed varied from $50M to $300M. Once all parties (both inside and outside the company) agreed on a strategic plan, we were able to estimate the debt level for each period over the life of the loan. We also determined the period where debt reached a maximum in the base case, as well as for a series of less-than-optimal outcomes. This was a critical piece of our analysis, since the terms from the lenders varied depending on how much overall leverage we were seeking. Since we were confident we could afford the levels of debt we were seeking, we simply determined what we wanted and then asked for proposals based on that amount. Had our position been less favorable, we may have needed to pare back the request upon seeing the cost of funds. In any case, knowing the overall size of the credit facility and our exact usage of that line turned out to be a critical part of measuring its cost. II. Cost Components Our next step was to construct a debt cost sub- model. Those tricky bankers have all kinds of fees, and calculating their impact requires care. The components of debt cost are: - Origination fees. This is just like paying points on a new mortgage. If the total credit extended is $1M and you are paying one point, you owe $10K in fees (1.0%) when you close the deal. - Utilization fees. You pay these whenever you draw funds. Typically expressed in basis points (aka "bips," hundreths of a percent), so if you paid 50 bips for utilization and you drew $1,000,000 then you would owe $5,000 for the privilege of borrowing the money. This became significant to us because we had scenarios where the debt balance went up and down. Every time we drew funds we paid the utilization fee. - Non-Utilization Fees. Talk about getting you coming and going! Not only do you pay when you use the money (via the interest rate and utilization fees), but you also pay when you don't use the money. This is like an interest rate on money you haven't yet borrowed but have "reserved" to borrow. So if you have a $100M credit line and your outstanding balance is $30M, then you owe non- utilization fees on $70M. At 50 bips per year, that's $350,000 per year in non- utilization fees. - Interest Rate. This one term people most focused on, simply the annual interest rate paid on the outstanding loan balance. While clearly important, it can be outweighed by significant fees. III. Analyzing Deals and Presenting Results Given the cost components, we were able to describe the costs for any deal with a handful of inputs. We then created a model that showed the expenses incurred in each period for each component, given the projected debt balance over time. The next step was to figure out how to summarize the dozens of numbers into one single measure for each deal. I think the most analytically rigorous way would be to figure out the payment streams for all the costs and then do an NPV on the total costs, but I have found that people often have a hard time processing NPV results. So the next simpler way was to just add up all the costs over the term of the loan. The downside of this method is that it doesn't penalize a lender with higher upfront costs as much as it should, but if all lenders are roughly comparable in the timing of their costs then it won't matter much. In the end, we did a variant of this and expressed all costs in terms of a net effective interest rate. People could really understand this, and it was a very powerful presentation tool. What was the impact of this? We decisively rejected one deal that had a very low interest rate but huge fees for the other components, resulting in a massive effective interest rate. We were also able to rank the remaining lenders and continue negotiations knowing which terms mattered most to us. IV. Non-Quantitative Factors Even in a financial transaction there are non- quantitative factors that are not to be under- estimated. We had to gauge how much money and effort it would take to actually draw on the credit line, given the detailed contractual terms. We questioned how well the lender's vision of the business aligned with our own view, given that we would have a deep working relationship and would likely be looking to modify terms over time. These factors can make or break a deal, so it's not just the numbers, of course, or all lending could be automated. Nonetheless, it's clear that you can get a much better deal if you enter the negotiations being armed with full quantitative tools. Until next month, all the best, David Brode -- Minotaur Financial Removing Financial Issues as a Deal Roadblock * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * NEWSLETTER ARCHIVE AVAILABLE Make sure to visit the Minotaur Financial website for the Newsletter Archive at http://www.brode.net/resources/ * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * http://www.brode.net mailto:David@Brode.net 1919 14th Street, Suite 510 Boulder, CO 80302 (303) 444-3300 * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * ABOUT DAVID BRODE I’m a financial modeling specialist. Over the last fifteen years I’ve completed dozens of models and certainly thousands of versions to support corporate development, M&A, strategic planning, and debt and equity transactions. These models have raised over $1B in debt and $100M in venture capital and private equity. Over time I’ve consistently revised software tools and work processes to get the job done quickly and well. If you have a financial forecasting issue, I’d love to help. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * (c) 2004 Minotaur Financial, All rights reserved. You are free to use material from the Flawless Financials newsletter in whole or in part, as long as you include complete attribution, including a live web site link. Please also notify me where the material will appear. The attribution should read: "By David Brode of Minotaur Financial. More articles on financial forecasting can be found at http://www.brode.net " * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * Are you struggling to convince others to do a deal which you think is a no-brainer? To discuss how you can take numbers off the table as a deal roadblock, call (303) 444-3300. I'm very accessible and glad to help. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * DO YOU LIKE THIS NEWSLETTER? You are welcome to share this email with colleagues who would benefit from better numbers. Your feedback is always welcome and appreciated. Write in to mailto:feedback@brode.net. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * PRIVACY POLICY: I never rent, trade, or sell my email list to anyone for any reason whatsoever. You'll never get an unsolicited email from a stranger as a result of joining this list. To SUBSCRIBE FREE to this newsletter, send an email to mailto:subscribe@brode.net. And you'll get Minotaur's Financial Forecasting White Paper in the deal. To be REMOVED from this list, send an email to mailto:remove@brode.net. (Please note that this message needs to come from the email address that originally subscribed. If you need help determining this, please email mailto:David@Brode.net.)