We see so many borrowers think more about the Interest Rate of the loan they are receiving without giving enough consideration to the Advance Rate they are receiving.
This is just bad math.
A 15% interest rate at a 100% advance rate is much better for most all companies than a 14% facility at a 90% advance rate.
Last night I was on the phone with the CFO of one of our portfolio companies (who is smart, and so is thinking through this carefully), and we were trying to determine how to calculate the trade-offs of a higher interest rate versus a less attractive Advance Rate.
Here is the framework we came up with:
First, Definitions:
Interest Rate: This is the amount of money a lender charges for putting capital at risk… pretty simple.
Advance Rate: The amount of money a lender is willing to contribute as a percentage of the value of the underlying collateral.
· Example: If I make a loan to a company that originates home loans, and I lend at a 90% advance rate, for every $100 of loans they make. I’ll lend them $90, with the originator’s $10 being the first capital at risk.
Secondly, The Math:
· First, you should figure out what your gross yield net of defaults is for the underlying loan book
· Then, you should consider the two rates you are being offered
· You should also factor in the amount of income generated by using your own balance sheet to originate loans (at a 100% advance rate, you are only earning net interest margin (money on top of the rate you are being charged), at anything less than 100% you are earning net interest margin + gross yield net of defaults on your own cash
· And finally, and this is the most important part, subtract the opportunity cost of having cash locked up. If you have $4M of your cash locked up, you can’t use that to acquire customers, pay for marketing, etc. (so what is your ROI and what is your opportunity cost of trapped cash?).
See below for a screen shot — and [HERE] for a link to a google sheet to play around with the assumptions.
Other Variables:
Usually, a 100% advance rate may come with lower default rate triggers, or a tighter loan box, etc. So these are overly simplified assumptions.
But it’s a good framework that we believe more founders should use.
