What is an advance rate?
An advance rate is how much a capital provider will lend to a corporate borrower (i.e., max advance amount), as a percentage of the borrower's total collateral. For example, if a borrower has $10 million in collateral and an advance rate of 80% with a capital provider, the capital provider will offer the borrower $8 million in credit. In the context of fintech borrowing, an advance rate typically determines how much a startup can borrow against its outstanding receivables.
For example, if you run a consumer lending startup and have a portfolio of outstanding receivables, you might want to borrow against that portfolio (in order to originate more loans to individuals). The advance rate you negotiate with a capital provider would determine how much you can borrow, relative to your portfolio size.
Advance rates vary from debt deal to debt deal and reflect a number of things, including the quality of the borrower's receivables (which are, again, used as collateral), the capital provider's risk tolerance, and the borrower's overall company creditworthiness.
Why do advance rates matter?
As Ali Hamed has pointed out, borrowers often put too much emphasis on the interest rate of their debt raise and fail to appreciate the importance of their advance rate when it comes to profitability. As Hamed notes, a 10% advance rate difference can have serious implications on a fintech's profitability, even if all other payback variables (e.g., size of loan book, repayment profile) are identical. This is because having a higher advance rate enables a borrower to fund originations without having to tie up cash on its own balance sheet. This is intuitive; being able to lend to consumers with the capital provider's funds enables a fintech company to use its own money for other purposes.
From a capital provider's perspective, an advance rate might be viewed as the amount of exposure that the capital provider has to receivable underperformance. The higher the advance rate, the more the capital provider stands to lose if a portfolio of receivables underperforms. Think of it this way—if the advance rate on a receivable-backed credit facility is 80%, a capital provider can withstand up to 20% in receivable defaults (which are borne by the credit facility borrower) before seeing any losses on principal. If the advance rate is 90%, the capital provider has only a 10% cushion.
What is an effective advance rate?
One way to think about the stated advance rate is as the percentage of every dollar (in portfolio value), that a borrower can draw against. This is also the maximum advance rate, because credit agreements often outline a number of situations in which a borrower would not get full credit for its receivables.
For example, a borrower with $1 million in current receivables and an advance rate of 80% could borrow $800,000. However, if half of those receivables were delinquent, the borrower might only be able to borrow $600,000. In that instance, its effective advance rate would be 60%. This is because the quality of the borrower's collateral has declined. It makes sense that a capital provider would not give full credit for delinquent receivables; different types of receivables should count for different amounts of credit. (In practice, the amount of credit a borrower can get for a delinquent receivable is defined in the credit agreement and negotiated between capital providers and borrowers prior to the execution of the debt raise.)
In this sense, the effective advance rate is a scorecard that tracks the quality of a borrower's portfolio of receivables, according to the guidelines/KPIs defined in the credit agreement.
How can software help borrowers optimize their effective advance rate?
As mentioned above, an effective advance rate is like a scorecard for a borrower. The closer the effective advance rate is to the stated advance rate, the better a borrower is doing when it comes to ensuring the quality of its portfolio of receivables, and the more profitably the borrower can operate.
The right software can help debt capital borrowers monitor their collateral value in near real time, centralize record-keeping on amount of capital drawn, and send alerts when an effective advance rate falls below predefined thresholds.
Without a software foundation for debt capital management, borrowers run the risk of underutilizing their debt capital and miscalculating their unit economics—even if their portfolios perform as expected.
Want to learn more?
When businesses negotiate an advance rate as part of a debt raise term sheet, they should also start planning for how they can monitor and maximize their effective advance rate, post-close. Otherwise, they may find themselves falling behind on debt capital and covenant compliance, which may lead to reduced (or blocked) access to capital. If you're interested in learning more about software that can help you optimize your effective advance rate, just request a demo of Finley here.