What is a payment waterfall?
In our previous posts, we’ve discussed how high-growth companies can use debt capital to fuel growth. When a company takes on debt, it needs to pay interest and fees to the capital provider at rates outlined in the credit agreement. Making these payments is a condition for maintaining access to capital.
The payment waterfall is the order in which different creditors and vendors get paid every month or quarter. This interest and fee payment sequence is like water flowing through two buckets stacked on top of one another (hence the term waterfall). The top bucket, representing the interest expense on the loan, must be completely full before any money can overflow into the bottom bucket. This bottom bucket represents excess cash that the company can access.
For example, assume Company A takes out a loan with $10mm in yearly interest expense and generates $50mm in profit in Year 1. Once the company pays this $10mm interest expense, it will receive the remaining $40mm. In terms of our example, the top bucket can hold $10mm of money. Once this bucket is full, the bottom bucket is filled with the remaining $40mm.
Why do payment waterfalls matter in private credit?
Payment waterfalls are relevant to private credit because a growing company will often take out several loans from multiple providers, or have multiple fee types to pay at the end of each month. The payment waterfall models how capital flows between the borrower and multiple different lenders or vendors. The borrower must repay the fee and interest expense on each loan before it can access any excess capital that has completely flowed through the waterfall. In terms of our example, this can be thought of as additional buckets being added to the waterfall.
The order in which these loans are repaid is dictated by the company’s capital structure. Interest and fee payments must first be made to loans that are highest in the capital structure, such as lines of credit. Because loans at the bottom of the capital structure bear more risk that the borrower will be unable to pay them back, these loans often carry higher interest rates. In our analogy, the capital structure determines the order in which buckets are placed in the waterfall.
How do payment waterfalls affect fintechs?
As we have previously discussed in our blog post on fintech cashflows, fintechs that issue credit must often raise debt capital so they can lend to customers. As fintechs lend to customers, a receivable is created and held in the fintech’s SPV account. As customers repay their credit balances, the receivables balance in the SPV decreases and is replaced with cash. This cash then enters the payment waterfall. Interest and fee payments are made to all the fintech’s capital providers and vendors in the order outlined above, and only once this process has been completed can the fintech access the cash. It can use this cash to continue lending to its customers or make principal payments on its loans.
Fintechs that offer customers credit, such as employee benefits, card spending, or “buy now, pay later” (BNPL) services, need to maintain access to debt capital in order to grow. For this reason, a fintech must effectively manage its payment waterfall and cash flow cycle in order to continuously meet the needs of its customers. Finley’s software helps fintechs streamline this process, saving our customers time and money. If you’re interested in learning more about our product, feel free to schedule a demo. We’d love to chat!