News | September 5, 2000

The benefits of good loan structuring

Through proper planning, you can avoid trouble

By Cameron McRae, Vice President, Acacia Federal Savings Bank

Table of contents
The loan must satisfy its purpose
Be sure you get the tight amount
Collateral and the type of loan are important
Recognize the risks and possible means of mitigation
Pricing is important
Financial covenants

Your company needs a loan? That sounds simple enough, but you should think about how the loan should be structured to best serve your company. A properly structured loan can save money as well as time, energy and, possibly, trouble in the future.

Perhaps a treatment on the subject of loan structuring should begin with two basic definitions: loan structuring and risk. Loan structuring is simply designing the loan to fulfill the financing requirements of the borrower while simultaneously attempting to protect the lender against loss resulting from the failure of the borrower to repay the debt and the interest and fees thereon. Risk can be defined as the perception of a potential adverse event occurring in the future. Perception is the key word in this definition because once such an event occurs; there is no longer the risk of the event. There is then the reality of the event.

Loan structuring involves several elements, including: purpose, amount, collateral and type of loan, risk recognition and mitigation, pricing, and financial covenants. All of these elements must work for both the borrower and the lender within the two definitions above.

The loan must satisfy its purpose (Back to top)
The borrower's requirements are fulfilled only if the loan enables him/her to accomplish the intended purpose, i.e.: obtaining working capital to meet payroll, pay rent, taxes, and vendors; buy new or repair existing equipment; acquire another company; expand markets; develop a new product line, etc. For different borrowers, in different industries, in different circumstances, the loan that enables the borrower to accomplish any of those purposes may require different structuring. Any improperly structured loan may prove to be a deterring, rather than an enabling, factor in the borrower's accomplishment of its purpose.

Be sure you get the tight amount (Back to top)
The amount of the loan is a critically important element of good loan structuring. For the achievement of any of the borrower's purposes, the amount of the loan must be at least adequate (with a bit of "wiggle room" in some cases, perhaps) but never excessive. Lending too little obviously jeopardizes the borrower's ability to accomplish its purpose, but may also endanger its ability to repay the loan because the purpose was not fulfilled. Lending too much could create a repayment problem for the borrower because cash flow may be inadequate. Consequently, the lender must assure itself that the borrower has – or, where appropriate, will have – sufficient cash flow to service a loan for the correct amount.

Collateral and the type of loan are important (Back to top)
Loans to government contractors are generally either revolving lines of credit for working capital support of term loans for acquisitions, expansion, or equipment purchases. Occasionally, a contractor will acquire real estate and require a mortgage loan, but that is a category of lending beyond the scope of this article. Revolving lines of credit usually supplement short-term working capital. They are generally secured by current assets such as accounts receivable, and sometimes inventory. Since these assets are volatile by nature – ebbing and flowing with increasing and decreasing revenues – they should be financed with short-term loans (one year or less). However, no periodic payout should be required because the continuing business generates continuing assets and needs continuing support. Rates of loan advances against these assets should be adequate to meet the borrower's need and still provide an adequate cushion of protection for the lender against reasonable dilution in the collateral. The orderly conversion of those assets represents the primary source of repayment and should be sufficient.

Term loans are properly made to finance generally non-recurring requirements of longer duration and necessitating extended time for repayment. The activities are not of such nature as to generate cash for repayment within one year. Thus, the collateral is usually tangible assets with current and projected value to secure the loan. In structuring term loans, the lender should not only consider the value of the collateral, but must pay close attention to the adequacy of the historical and projected cash flow as the primary source of repayment, and should satisfy itself of the likelihood and adequacy of that flow. Net profit is often the principal component of the cash flow available for the repayment of term loans.

Recognize the risks and possible means of mitigation (Back to top)
One of the principal functions of the lender is to recognize risks and be able to mitigate those risks in such a way as to protect itself against loss while fulfilling the borrower's requirements. By structuring the loan well, the lender can achieve both objectives, thereby benefiting both parties. With effective risk recognition and mitigation effectively performed, the lender can price the loan to provide an acceptable yield and a benefit to the borrower.

Pricing is important (Back to top)
Loans that are well structured can also be priced in beneficial ways for the borrower. Pricing can, for example, include lower interest rates, as well as the application of fees for administration and/or other services. Such fees may qualify as allowable costs for the borrower, which would be a benefit.

Financial covenants (Back to top)
Financial covenants are frequently included in the agreement between the lender and the borrower. They represent what should be the mutually acceptable standards of financial performance and condition the borrower will meet during the life of the loan(s). The number and nature of the covenants may vary from borrower to borrower. Ideally, financial covenants should be set at such levels as to protect the lender in the event the borrower's financial performance and/or condition deteriorates materially. Conversely, they should not be so restrictive as to be subject to frequent violations resulting from materially insignificant or periodic financial reverses, more or less in the normal course of business. Not only do well-structured financial covenants serve as a protection for the lender, but they may also buffer the borrower against capricious adverse action by the lender.

Government contractors are better served by lenders that understand the industry well enough to be able to structure loans effectively for their mutual benefit. Good loan structuring is a win-win situation for both parties.

About the author (Back to top)
Cameron McRae has been in banking 38 years. For 25 of those years, he has specialized in financing government contractors and technology firms. He has spoken on financing and cash flow management issues at numerous seminars for government contractors and has authored several published articles on those topics. He has participated in training a number of banks in government contractor financing and was VP, Finance & Administration, in a government contracting firm for over three years. Mr. McRae is a graduate of Duke University and a member of the National Contract Management Association and the Northern Virginia Technology Council. For more information on this topic, contact Mr. McRae by telephone at 703-506-8116, by fax at 703-506-8160, or by e-mail at