Demystifying 1st Lien Term Loans: A Guide for Small Businesses and Startups

Raising capital is crucial for any small business or startup to grow and scale. Beyond bootstrapping or bringing on investors, debt financing through business loans offers an alternative way to fund operations and expansion.

One type of loan commonly used is a 1st lien term loan But what exactly does this entail and is it a good financing option for your company? This guide breaks down key details on 1st lien term loans so you can evaluate if they align with your capital needs and risk tolerance,

What is a 1st Lien Term Loan?

A 1st lien term loan is a secured loan issued by a bank or institutional lender, with the borrower’s assets used as collateral It gets its name because the lender has a “first lien” claim on those pledged assets in case of a default

Some key features include:

• Loan term – Medium-term loans, typically 3-7 years
• Interest rate – Usually a variable rate tied to a benchmark like LIBOR or Prime
• Amortization – May fully amortize or have a balloon payment due at maturity
• Security – Secured by a first claim on the borrower’s assets
• Size – Can range from under $1 million to over $100 million

1st lien term loans are a type of commercial financing used by businesses of all sizes, from small private companies to large corporations, to fund growth and operations.

Comparing 1st Lien Term Loans to Other Financing Options

It helps to understand where 1st lien term loans fit compared to other common small business lending options:

• Bank lines of credit – Revolving credit lines that can be tapped as needed. Typically variable rates and lower limits. Unsecured.

• Equipment financing – Funding to purchase specific equipment like machinery or vehicles. Secured only by that equipment.

• SBA 7(a) loans – Government-backed loans with long terms and fixed rates. Partially guaranteed, so lower risk for lenders.

• Revenue-based financing – Funding provided in exchange for a % of future revenue rather than fixed payments. Unsecured.

• Merchant cash advances – Lump sum in exchange for a cut of future credit card sales. Very high effective rates. Unsecured.

• Venture debt – Specialty financing for startups and growth companies backed by VC/PE investors. May be secured or unsecured.

1st lien term loans differ by providing medium-term secured financing at variable market rates. Lenders can fund larger amounts since the loan is collateralized.

Pros and Cons of 1st Lien Term Loans

Potential Benefits

• Larger loan amounts – Can access more capital since secured by business assets.

• Longer terms – Gives more time to repay than short-term loans like credit lines.

• Clear repayment structure – Set monthly principal and interest payments. Easier to budget vs. lump sums.

• Variable rates – Interest rate can decrease if benchmark rates fall.

• Tax deductible interest – Interest expenses can reduce taxable income.

Potential Downsides

• Collateral required – Must pledge specific business assets which lender could seize in worst case.

• Prepayment penalties – May face fees if paying loan off early.

• Rising interest costs – Variable rates could increase payments if underlying rates go up.

• Reporting requirements – More financial reporting than unsecured loans.

• Upfront costs – Lender, legal, appraisal fees can be expensive.

• Restrictive terms – Tighter limits on additional debt, distributions, transactions.

The right fit depends on your specific situation and needs. For some companies, the benefits outweigh the drawbacks.

What Do Lenders Look for When Underwriting 1st Lien Term Loans?

Lenders thoroughly analyze the following areas when deciding to issue a 1st lien term loan:

• Business viability – Proven concept, strong financials, experienced management.

• Cash flow – Consistent positive cash flow to make payments. Debt service coverage ratio > 1.2x.

• Collateral coverage – Assets to secure the loan worth more than loan value.

• Credit profile – Good business and personal credit history.

• Term loan purpose – Proceeds used for logical business purposes like growth.

• Industry dynamics – Competitive advantages and sector stability.

Meeting typical commercial lending standards is crucial given the larger loan sizes and secured nature. Don’t let this deter you from exploring your options though.

What Types of Businesses Use 1st Lien Term Loans?

Since needs and risks vary by industry, 1st lien term loan uses include:

• Equipment-heavy businesses – Manufacturers, processing plants, heavy machinery companies often use term loans instead of equipment leases or loans. Assets like equipment and real estate provide collateral.

• Real estate-related businesses – Commercial real estate investors, developers, REITs use term loans for property purchases and construction projects. The real estate secures the debt.

• Service businesses – Service companies with recurring revenue streams use term loans to fuel expansion. Accounts receivable, IP, or other assets provide security.

• Tech and biotech firms – Pre-revenue startups use later stage venture debt. When generating revenue, term loans fund growth before eventual IPO. IP and equity pledges provide collateral.

• Consumer product companies – Term loans allow scaling manufacturing. Inventory, receivables, and wholesale contracts get pledged as collateral.

1st lien term loans offer capital to match long-term growth strategies in many industries. Their secured structure makes them viable for asset-intensive businesses.

What Interest Rates and Fees Are Typical?

Since 1st lien term loans carry lower default risk than unsecured debts, interest rates are generally reasonable. Here are typical costs:

• Interest rates – Variable rates ranging from Prime + 2.0% to Prime + 6.0% are common, depending on risk, collateral, size, term, and overall conditions. Rates currently start around 7-10%.

• Upfront fees – Upfront fees of 2-3% of the loan amount help offset origination costs. Legal/appraisal fees may also apply.

• Prepayment penalties – Loans may have prepayment fees during the first 2-3 years if refinanced or repaid early.

• Repayment terms – Interest-only with a balloon payment, or fully amortizing terms up to 7 years are typical.

Always model out the full cost of capital across different term lengths and fee structures when comparing lenders. An extra half percent on the rate or year of prepayment penalties makes a notable difference.

Tips for Securing a 1st Lien Term Loan

Follow these tips when seeking a 1st lien term loan to ensure a smooth process:

• Have a clear business case – Demonstrate market opportunity, financials, management team, and growth prospects.

• Target reasonable loan amounts – Don’t apply for more than reasonably supported by collateral, cash flow, and use of funds.

• Accurately appraise and evaluate assets to pledge – Assets must be unencumbered and able to cover loan amount.

• Gather required financial documents – Tax returns, financial statements, accounts receivable/payable, inventory, etc.

• Create realistic projections – Forecasts for financials, growth, expenses should be achievable.

• Check business and personal credit – Know your scores and address any reporting errors in advance.

• Explore multiple lenders – Compare options from banks, credit unions, specialty finance firms, and peer-to-peer lenders.

• Negotiate the best rates/terms – Fight for lower rates, longer grace periods, flexible prepayment terms.

With proper preparation and persistence, securing a 1st lien term loan on reasonable terms is doable for many small and mid-sized firms.

Alternatives If You Don’t Qualify for a 1st Lien Term Loan

Don’t get discouraged if you apply and don’t get approved for a 1st lien term loan right now. Consider these alternative debt financing options:

• SBA loans – Government guaranteed loans like SBA 7(a) or SBA 504 loans have lower borrower requirements.

• Revenue-based financing – Funding repaid through a percentage of monthly revenue rather than fixed payments.

• Lines of credit – Tap revolving credit as needed instead of a lump sum term loan.

• Accounts receivable financing – Borrow against unpaid customer invoices to generate immediate funding.

• Equipment leasing – Lease production equipment to preserve capital and cash flow.

• Asset-based loans – Specialty financing using accounts receivable, inventory, machinery, or real estate as collateral.

• Microlenders – Smaller loans from non-profit lenders focused on underserved businesses.

• Peer-to-peer lending – Borrow from a pool of investors rather than a bank.

For companies that don’t qualify for a bank-issued 1st lien term loan, these options provide viable alternatives to secure financing.

The Bottom Line

1st lien term loans provide medium-term working capital, funding for equipment purchases, real estate acquisitions, or other growth needs. Their structured payments, variable rates, larger sizes, and collateralization make them useful for many small and mid-sized businesses.

While you give up some flexibility and control compared to unsecured financing options, the benefits may outweigh the drawbacks. Ensure you understand all costs and terms before committing. And realize approval hinges on strong management, finances, projections, and pledged collateral.

With the right preparation and persistence, a 1st lien term loan can provide the injected capital your business needs to take it to the next level. Just approach the process strategically, creatively pursue alternative options if you encounter obstacles, and partner with lenders who best understand your industry and potential.