Senior Secured Debt Terms Explained: A Simple Guide

Understand the key terms and concepts you’ll encounter when exploring senior secured debt financing for your business.

When you start exploring senior secured debt financing, you’ll encounter various terms and concepts that might seem confusing at first. Don’t worry – while the language can sound complicated, the concepts are actually quite straightforward once you understand what they mean. This guide will explain the key terms you need to know in simple, easy-to-understand language.

Breaking Down “Senior Secured Debt”

Let’s start with the name itself. “Senior” means this debt gets paid back first if your business runs into financial trouble. Think of it like a line at the bank – senior debt is at the front of the line, while other debts have to wait their turn.

“Secured” means the loan is backed by something valuable that the lender can take if you can’t repay the loan. This is called collateral. It’s like when you buy a car with a loan – the car itself is the collateral, and the bank can repossess it if you stop making payments.

“Debt” simply means money that you’ve borrowed and need to pay back, usually with interest. So senior secured debt is borrowed money that’s backed by collateral and gets paid back before other debts.

Understanding Collateral and Security

Collateral is anything valuable that you pledge to the lender as security for the loan. If you can’t repay the loan, the lender has the right to take and sell your collateral to recover their money. Common types of business collateral include equipment, inventory, accounts receivable (money customers owe you), and real estate.

A security interest is the legal right that gives the lender claim to your collateral. When you sign a loan agreement, you’re giving the lender a security interest in specific assets. This is usually documented through legal filings that make the lender’s claim public record.

A first lien means the lender has the primary claim on your collateral. If you have multiple loans secured by the same assets, the first lien holder gets paid first if the assets are sold. This is why first lien loans typically offer better interest rates – the lender has less risk.

Key Financial Terms

The advance rate is the percentage of your collateral’s value that the lender is willing to lend you. For example, if you have $100,000 worth of equipment and the lender offers an 80% advance rate, you could borrow up to $80,000 against that equipment. Different types of collateral have different advance rates based on how easy they are to sell.

Your borrowing base is the total amount you can borrow based on all your eligible collateral. If you have equipment worth $100,000 (80% advance rate = $80,000) and inventory worth $50,000 (60% advance rate = $30,000), your borrowing base would be $110,000.

Availability refers to how much of your borrowing base you haven’t used yet. If your borrowing base is $110,000 and you’ve already borrowed $70,000, your availability is $40,000. This is important because it tells you how much additional money you can access without getting a new loan.

Interest Rates and Pricing

Most business loans use a base rate plus a spread to determine your interest rate. The base rate is usually tied to a benchmark like the prime rate or SOFR (Secured Overnight Financing Rate). The spread is the additional percentage points the lender adds based on their assessment of your business’s risk.

For example, if the prime rate is 5% and your spread is 3%, your total interest rate would be 8%. As the base rate changes, your interest rate will change too, unless you have a fixed-rate loan.

Loan Covenants Explained

Covenants are promises you make to the lender about how you’ll run your business. Think of them as rules you agree to follow while you have the loan. There are different types of covenants, and understanding them is important because breaking a covenant can trigger default on your loan.

Affirmative covenants are things you promise to do, like maintaining insurance on your assets, providing regular financial reports to the lender, and keeping your business licenses current. These are usually straightforward and easy to comply with.

Negative covenants are things you promise not to do without the lender’s permission, like taking on additional debt, selling major assets, or making large distributions to owners. These protect the lender by preventing you from taking actions that might hurt your ability to repay the loan.

Financial covenants require you to maintain certain financial metrics, like keeping a minimum amount of cash or maintaining certain ratios between debt and income. These help ensure your business stays financially healthy throughout the loan term.

Important Loan Documents

The credit agreement is the main document that outlines all the terms of your loan, including how much you can borrow, what interest rate you’ll pay, when you need to make payments, and what covenants you need to follow. This is the most important document to understand thoroughly.

The security agreement gives the lender legal rights to your collateral. It describes exactly what assets are securing the loan and what the lender can do if you default. This document is usually filed with government agencies to make the lender’s claim public record.

If other people or entities are guaranteeing your loan, there will be guarantee agreements that make them responsible for repaying the loan if your business can’t. Personal guarantees from business owners are common, especially for smaller companies.

Default and What It Means

Default occurs when you break the terms of your loan agreement. This could mean missing payments, violating covenants, or failing to maintain required insurance. Understanding what constitutes default is crucial because it gives the lender the right to demand immediate repayment of the entire loan.

Cross-default provisions mean that defaulting on one loan can trigger default on other loans, even if you’re current on those other loans. This is why it’s important to understand all your loan agreements and how they interact with each other.

If you do default, the lender has several options. They might work with you to cure the default, they might demand immediate repayment, or they might begin the process of taking your collateral. Most lenders prefer to work with borrowers to resolve problems rather than seize assets, but understanding their rights is important.