The usual way an owner-run business borrows is simple. The house bank, which has held the business's accounts for years, offers a facility. It is sized at a multiple of last year's EBITDA, it matures on a single date, and it comes with covenants written in the bank's standard language. The owner signs it, because the rate looks fair and the relationship is good, and reads the covenants for the first time in the quarter one of them is tested.
Each part of that carries a risk. The size was set by a multiple of a good year, with no regard to what the business can carry in a bad one. The single maturity means the whole facility has to be refinanced at once, on whatever terms the market offers that year. And the covenants, whose definitions decide whether a soft quarter is a nuisance or a default, were never compared with anyone else's.
Facility Sizing replaces that process. It moves debt capacity from a computed ratio to a term sheet: a facility sized to the downside case, structured so that no maturity crowds another, and tested in the market with more than one lender. Done well, it leaves the business knowing what it could borrow, choosing to borrow less, and holding term sheets from competing lenders whose covenants it has compared along with their rates.
Where Facility Sizing sits
Three drivers set how much debt the cash flow should carry. This essay covers the second.
Cash flow available for debt service
- Levered ForecastShows how much debt the cash flow carries in a downside set before anyone knows the answer
- Facility SizingThis essayTurns the computed ratio into a term sheet sized to the downside, tested with more than one lender
- Growth CapacityMakes capacity the largest debt the cash flow carries while still funding its own growth
Debt capacity
Sized to the downside
The proposed facility has to keep debt service coverage at or above the floor in the downside case, keep total funded debt plus debt-like items under the leverage ceiling, and leave real headroom to every proposed financial covenant.
The facility is sized from the downside. Downside cash flow available for debt service, divided by the coverage floor, gives the debt service the business can afford in a bad year, and from that the debt it supports. The result is checked against the leverage ceiling, and the smaller answer wins. A multiple of EBITDA appears only as that ceiling, never as the starting point.
The repayment profile is then shaped to the cash flow. Debt that finances equipment is repaid over the equipment's life. A business whose cash is strongest in the autumn repays more in the autumn. The lender's standard schedule is built for an average business, and this one is built for the business that has to pay it.
The headroom requirement needs its own explanation. A facility that only just meets its covenants in the downside will breach them in a slightly worse downside, and downsides are rarely exactly as forecast. Headroom to every covenant, in the downside, is what lets a bad quarter stay a bad quarter. With the debt as large as the cash flow supports and no larger, the equity is not discounted for being overleveraged.
Why borrow less than you are offered
Owners often find this part of the driver hard to accept. If a lender is willing to lend $4 million, why take $2.8 million? The extra money could fund growth, pay the owner a dividend or sit in the bank as a cushion.
The lender's offer and the business's capacity answer different questions. The offer reflects what the lender is prepared to risk, given its security, its fees and its view of the market. The capacity is what the business's cash flow can carry in a bad year without breaching. When the two differ, the gap is risk the business would be taking on that the lender has priced and the owners have not.
The cushion is the argument owners find most persuasive, and it holds up least well. Cash borrowed and held as a cushion costs interest every year, and it sits under a covenant sized for a larger facility. A better cushion is the undrawn line that Growth Capacity sizes to the downside gap, which is committed in advance, costs a commitment fee where drawn debt costs full interest, and is drawn only when needed.
More than one lender, compared on more than price
The facility is tested with more than one lender, and the term sheets or written indications are compared on their covenant definitions, headroom, security, guarantees and prepayment terms as well as on price.
The process is prepared once. A lender information pack brings together the lender packs, the levered forecast, the capital structure file and the evidence from the earlier bridges' checkpoints, and is shared under confidentiality. Several lenders are approached, at least one of them not a bank, each given the same pack and the same deadline, and the comparison is written on one page.
Most of the value of competition lies in that comparison, and rarely in the rate. Two facilities a quarter point apart in price can differ far more in what they allow. One defines EBITDA for its covenant test with the add-backs the business uses, and the other does not, so the same business has less headroom under it. One requires the owner's personal guarantee, and the other takes security over the company's assets only. One charges a heavy fee to repay early, and the other does not. A business that compares only rates is choosing on the least important term.
What the comparison is really about
Illustrative. Two term sheets, a quarter point apart on price. Guess which differences matter more than the rate, then select each to see why.
Select each item to see the verdict.
The same business has less headroom under the narrower definition, and headroom decides whether a soft quarter is a default.
A guarantee puts the owner's own assets behind the company's debt and will have to be released before a sale.
It makes refinancing or selling the business expensive, and both are likely within the facility's life.
Real money, but on $2.8 million it is about $7,000 a year, and it is a price effect rather than value.
A single-quarter test turns one seasonal dip into a breach that a trailing test would absorb.
It does not change what the business may do under the agreement.
Competition also sets the cost of debt, and therefore the cash left for the owners.
A maturity ladder
The maturity ladder is designed before signing, so that no twelve-month window carries too large a share of the total debt.
The tenors are staggered across tranches and lenders, so that term debt, equipment finance and any revolving facility mature in different years. A business with one maturity date has one refinancing on which everything depends. If that year's credit market is hostile, or the business has had a poor year, the owners may be forced to take whatever terms are offered, or to sell. A business with a ladder refinances a portion at a time, and no single refinancing can put the equity at risk.
A maturity ladder
Illustrative. A $2.8 million structure split across four facilities, by the year each matures. No year carries too large a share of the total, so no single refinancing puts the owners at risk.
Debt maturing
The revolving line matures in year two, equipment finance in year three, and two term loans in years four and six. The largest year is $900,000, about 32 percent of the total. With a single term loan, all $2.8 million would mature at once.
Show the numbers
| Year | Debt maturing |
|---|---|
| 1 | $0k |
| 2 | $400k |
| 3 | $600k |
| 4 | $900k |
| 5 | $0k |
| 6 | $900k |
| 7 | $0k |
What it does to value
Facility Sizing ranks third on the bridge, and it is where the bridge's most certain value is counted. The tax shield, the tax saved on the interest of the facility actually obtained in each year of its amortization, is counted here, once, for the whole bridge. From it is taken the expected cost of a breach at the headroom the facility leaves.
The shield the facility earns
Illustrative, for a facility repaid in equal instalments, so interest falls each year as the balance does. Interest is deductible, so every dollar of it saves tax at the entity's rate. The total over the life is shown before discounting; the valuation discounts each year at the weighted cost of capital and deducts the expected cost of a breach, so the shield counted is smaller than that total.
In the illustration, the $2.8 million facility at 8 percent saves $56,000 of tax in its first year at a 25 percent rate, and $224,000 over seven years before any discounting.
The same logic explains why the driver pays nothing for a larger facility. More debt earns a larger shield, but it raises the probability of a breach, which another driver, Covenant Management, is paid to keep low. So the finance lead is paid in full for a facility of the size the downside supports and nothing extra for one beyond it.
The basis points a second term sheet takes off the margin are recorded as price. A margin shaved by competition changes what the debt costs this borrower and leaves the business's cash flows worth what they were. The second lender's willingness, which deepens the pool of lenders, is price for the same reason.
What has to be in place first
The sizing depends on three earlier drivers. It needs the levered forecast and its downside case from Levered Forecast, because sizing without the downside means sizing to the base case. It needs the schedule from Capital Structure File, because lenders size on total obligations and a debt-like item found after the term sheet reopens it. And it needs a solid record of on-time lender packs from Lender Reporting, because lenders price history: a business with three months of packs is offered terms for a business with three months of history.
Knowing that it works
The size of the facility rests on debt capacity in the downside case, in dollars, recomputed each quarter. Beside it sit the term sheets or written indications received, each with its date, and the headroom to each proposed covenant in the downside, as a percentage.
An owner who sized the facility can explain in a sentence why it is smaller than the largest offer, naming the downside number that set its size. Reading every covenant definition in the preferred term sheet, the same owner should find the one with the least headroom before counsel does.
Why it slips, and what holds it
Leverage creeps past capacity, one equipment loan or overdraft extension at a time. And a maturity arrives without a committed refinancing, because nobody started early enough.
The first is held by a written leverage ceiling set below every covenant, so that new borrowing hits the company's own policy before it hits the lender's limit. The second is held by starting every refinancing well before its maturity, on a date fixed when the facility is signed.