What is DIP Financing or Debtor in Possession Financing?
A debtor in possession financing or DIP financing provides funding for a business. DIP Financing will allow the business time to reorganize its business affairs under the umbrella of protection offered by US bankruptcy statues. It is only available to companies once they have filed for protection under the bankruptcy laws.
The first step then is for a business owner to determine whether to seek shelter under these provisions. If so, then ownership will need to weigh alternatives carefully. This requires developing an orderly plan for fixing the company or taking the necessary steps to promote a sale of the business or liquidation of assets. Regardless of the pathway or chosen strategy, financing is a critical consideration in keeping an enterprise alive and functioning; especially during any bankruptcy. For this reason, every small business owner should know the rudiments of this borrowing technique—just in case.
How a business can exit Chapter 11 Bankruptcy with Debtor in Possession (DIP) Financing
All businesses, large and small alike, experience setbacks. Production difficulties, service disruptions, lost customers, you name it. There are as many things that can go wrong in business as there are businesses themselves. When problems escalate, financial pressure often follows, creating stress for the business and business owners. If left unchecked, difficulties can threaten the continuation of the enterprise itself. But not always. Debtor in possession (DIP) financing is a tool that you can use to great advantage to save the business value. Also, this will help to preserve jobs and allow companies time and the means to get back on track.
How Debtor in Possession Financing Works?
Financing a company while it’s under bankruptcy protection is a unique form of financing. However, in many ways, it is among the most straightforward. Simply put— a lender provides funding against the business’ working capital. In return gets a first-priority lien on the assets of the business as protection. Meaning, the lender is first in line to receive payment upon successful refinance of the company. Such can also be possible upon a sale or liquidation of assets. The loan is “margined” against the assets of the business. Meaning the lender estimates the realizable value of the various asset classes (accounts receivable, inventory, fixed assets, and intangible assets) in arriving at a loan amount and structure, allowing for a buffer of safety.
A business typically undertakes DIP financing at the start of a bankruptcy filing. The court approves the financing plan as part of the protection granted to the company, and administration of the loan by the lender is subject to court authority as well. Once in place, the business owner now has the liquidity needed to continue to run the business. At the same time, thoughtfully developing an exit strategy and tactics.
How can I Choose a Debtor in Possession (DIP) Lender?
Choosing the right DIP lending partner is as important as deciding whether to seek bankruptcy protection in the first place. In this short DIP financing primer, there are generally three high-level considerations to thoughtfully weigh:
Lender capability (Less evident than it seems)
Not every lender is equipped to work closely with a borrower during the bankruptcy period, nor prepared to take the time required to understand and adequately assess the owner’s restructuring plan. Other lenders and capital providers though make it a point to specialize in this type of financing. Also, they make it a priority to work closely with companies when they need help the most. The debtor in possession financing is not like conventional lending—businesses should align with a DIP specialist.
Existing lender relationship
Assuming the current lender has DIP capability, a business owner should next ask, “can I still work with my existing lender, or is our relationship past the point of no return?” At times, stresses giving rise to a bankruptcy filing produce an irreversible and unreconcilable difference between borrower and lender. Other times, matters get unavoidably personal, making starting fresh a reasonable, practical, and often necessary alternative.
Help going forward
Often a new source can provide more than just required funding. Additionally, a relationship that may prove helpful for the business once debtor in possession financing is retired. Ease of doing business during the DIP period is often a key determinant and a proxy for how well a relationship will work going forward.
What Areas of Expertise to look for in a DIP Funder?
- an online application process
- streamlined information requests
- helpful, timely dialogue with knowledgeable professionals
- straightforward documentation
- transparent, easy to understand rates and fees
- ease of reporting
- quality and timeliness of lender reporting
- ancillary services available beyond lending
An Example of DIP Financing
John ran a successful import business for many years in Miami. He does this by buying flowers from farms in Central America and selling to major retailers in the US. Relations with suppliers were excellent, and customers paid on time. John was cautious about expanding too quickly. Currently, the warehouse and redistribution facility he rented was a manageable size, and his payroll modest. One winter, unusually cold weather settled over the mountains in Colombia. As a result, John’s supply of flowers was disrupted for a time. Unable to have their orders filled, customers soon looked elsewhere.
Others slow or short paid as John struggled with quality control in the aftermath of his supplier problems. Debt service on equipment leases and rents brought the company quickly to a decision point.
After consulting with his attorney, John elected to seek relief for the business under Chapter 11 of the US bankruptcy code. He then cemented his plan by seeking out debtor in possession financing. Financing that allows him to operate the business profitably while giving him time to work out a restructuring with creditors.
None of John’s existing lenders provided DIP financing, so attention was quickly turned elsewhere. After careful online research, John turned to a factoring company for a practical solution. Within days he was able to arrange for his invoices to sell to the factor in return for immediate cash. After recognizing the need for additional liquidity, John’s existing term lenders were content for the factor to take a first lien position on the business assets. Once he commenced selling invoices, acceleration of cash flow helped John rebuild his cash position. As a result, allowing him to work out payment plans with his creditors and rebuild relationships with customers.
John’s new lender also took pressure off the company’s back office by taking over the credit and collection functions. New customers undergo screening and are already pre-approved. Thankfully, the balance sheet was restored, and John was able to exit Chapter 11 on a firm footing. He kept the factoring relationship in place afterward, as a permanent means of managing cash flow, credit adjudication, and collection functions.
A debtor in possession financing gave John the liquidity and time he needed to restructure and relaunch his business. Suppliers maintained an outlet for their product. To take care of customers – to the preservation of KJobs. Lastly, to protect the business value.
Setting DIP Lender Expectations
While debtor in possession financing has unique benefits, there are also critical practical considerations:
- Fees and expenses for a debtor in possession financing are generally higher than “regular” working capital borrowing arrangements.
- Small business owners should expect to be asked for a personal guarantee to back up the debtor in possession loan.
This may seem redundant or like overkill. However, lenders take this as a vital sign that the owner is committed to working in good faith and have the DIP perform correctly.
- The court approves chapter 11 proceedings, and a judge’s oversight extends to the borrower’s compliance under the DIP loan, making it essential that the business adheres to the terms and conditions of the loan agreement.
- Having debtor possession financing in place is not a guarantee of solvency or ultimate survival of the business. While it represents an invaluable tool for operating during a restructuring, the business owner must still address the systemic difficulties facing the enterprise. DIP provides breathing room necessary.
DIP Financing Summary
Debtor in Possession (DIP) financing can sound complicated, but it does not have to be. At its core is a straightforward arrangement: the lender provides maximum possible liquidity to business while it is under bankruptcy protection. We give protection to the lender through the priority lien on business assets. Likewise, the lender provides a personal guarantee from the owner confirming his or her commitment to the program.
The Borrower receives operating capital to keep the business running during the restructuring period. Borrower and lender operate under a credit agreement that has the approval of the bankruptcy court, with the court maintain some oversight on the subsequent trajectory of the lending relationship.
Choosing the right DIP lender is an important consideration. Not only does the capital provider need to offer this lending specialty as table stakes, but the business owner should also reflect carefully on the state of the company’s existing borrowing relationships, and the potential value of lining up a more suitable partner.
Ease of doing business, straightforward documentation, transparent pricing, helpful reporting capability, and professional personal interaction are all good indicators of a successful debtor in possession financing. Moreover, perhaps an improved, more beneficial lending relationship post-restructuring. In this way, one should now approach DIP financing from BusinessCash.com with apprehension, rather as a chance to start fresh—and prosper in the process.