When a company takes on debt financing, such as a revolving credit facility, there is typically a set period of time in which the company can draw down and repay the debt – this is known as the revolving period.
However, at some point, the ability to continue drawing on the facility ends, and the debt transitions into an amortizing term loan that must be repaid over a set schedule. This post will provide an in-depth explanation of amortization requirements, the mechanics of amortization after revolving period termination, different amortization methodologies, as well as key considerations and sample terms related to this important aspect of debt facilities.
What is Amortization?
Amortization refers to the repayment process of gradually paying off a debt obligation over time through periodic installments. In the context of a credit facility, amortization begins after the conclusion of the revolving period, when the company no longer has flexibility to draw down and repay debt on a revolving basis. At that point, the facility transitions to a term loan that must be repaid pursuant to an amortization schedule.
The goals of amortization are to:
- Repay the outstanding principal balance of the debt obligation over a set period of time
- Pay interest expense owed to lenders
- Build mechanisms to pay down debt faster if cash flow permits
The amortization structure is typically negotiated upfront when executing a credit facility and documented in the loan agreement. It contractually obligates the borrower to make mandatory repayments of principal after the revolving period ends. Companies agree to amortization terms as a condition required by lenders for providing financing.
Mechanics of Amortization
Once the revolving period ends, also referred to as revolving period termination, outstanding balances can no longer be repaid and redrawn. At this point, the debt converts to a term loan to be repaid pursuant to the negotiated amortization schedule.
The mechanics involve allocating a percentage or fixed amount of outstanding principal to be paid each payment period. This continues applying the amortization requirement each period until the debt is fully repaid by the contractual maturity date.
In addition to mandatory amortization payments, term loans also require ongoing interest payments based on outstanding principal balances. Together, amortization and interest make up periodic debt service obligations owed post-revolving period.
Key Components of Amortization Terms
- Amortization Commencement Date – The date after the end of the revolving period when amortization requirements kick in. This transitions the debt into a term loan.
- Amortization Schedule – Details the exact amounts or percentages and timing of periodic amortization payments. This outlines the contractual repayment obligations.
- Amortization Period – Defines the total length of time given to fully repay the amortized term loan. Typically aligns with the final maturity date of the facility.
- Repayment Frequency – The interval at which amortization payments are due, such as quarterly or monthly installments. Should match frequency of interest payments.
- Principal Repayment Amounts / Rates – The fixed dollar amounts or percentage rates contractually owed each amortization period.
The specifics of these terms are negotiated and tailored for each transaction based on factors such as the type of borrower, credit risk profile, nature of the loan, and lender requirements.
Types of Amortization Schedules
There are a variety of types of amortization schedules that allocate repayment amounts over different curves. The most common methodologies include:
1. Straight-Line Amortization
Involves equal principal repayments each amortization period. This method results in the same dollar amount owed for each scheduled installment over the amortization term until the debt is fully repaid.
2. Interest-Only Period with Bullet Payment
An interest-only period requires no amortization payment for the initial periods of the amortization term, just interest expense is due. This postpones principal reductions. After the interest-only timeframe, the remaining balance must be repaid in a single large “bullet” payment at final maturity.
3. Declining Balances Amortization
With this structure, the same percentage rate is applied to the outstanding principal balance every amortization period. So as the balance declines over time from ongoing amortization, the fixed percentage results in lower actual repayment amounts also declining each period.
Each methodology has unique cash flow repayment profiles resulting in different economics, durations, and risks. We will explore the mechanics, pros and cons of various structures more deeply.
1. Straight-Line Amortization
Straight-line, or fixed principal repayment scheduling involves equal periodic installment amounts over the full amortization term until the debt is fully extinguished. For example, a term loan with $10 million outstanding and 5 year amortization term would have $2 million, or 20%, due each year.
The calculation is based on taking total principal owing divided by the number of payment intervals in the amortization period. This determines the fixed repayment amount contractually mandated each period.
The advantages of straight-line amortization include:
- Simplicity and predictability of equal annual installments. This allows for easier cash flow planning and liquidity management.
- Discipline of gradual reduction of debt over time without flexibility to defer principal repayments.
- Shows consistent deleveraging progress to lenders.
The downsides of fixed repayments involve:
- Pressure on near term cash flows with no relief period.
- Inability to pay down faster in periods of strong cash generation.
- heightened risk of default if operating performance declines since committed amounts cannot be reduced.
Overall this approach is simple, disciplined, and preferred by more conservative lenders looking to minimize risk through gradual deleveraging.
2. Interest-Only Period with Bullet Payment
Another approach is to have an initial interest-only period followed by a large bullet principal repayment. For example, a $10 million term loan could allow 2 years of interest-only payments, repaying no actual principal during that timeframe. After that, the full $10 million balance would need to be repaid as a single final “bullet” payment at maturity.
This schedule delays amortization to provide cash flow flexibility and operating margin relief in the near-term. However, it leaves risk of a large pending repayment amount still owed.
The benefits include:
- Preserves capital resources and increases liquidity during the interest-only term by postponing principal reductions
- Can boost income statement performance and cash flow available for reinvestment activities near term
- If the business ramps up faster than expected during the interest only period, the larger bullet payment may be easier to manage with improved results down the road
There are also notable downsides to be aware of:
- Significant risk of a large bullet payment still due while business performance remains uncertain years into the future
- Likelihood that external refinancing from new lenders may be needed to manage the pending balloon payment
- Tougher to obtain further financing from existing lenders if operating trends do not materialize as hoped
As a result, interest-only periods are favored by borrowers but seen as riskier by lenders. Bullet repayment structures usually require borrowers to exhibit stronger credit profiles and require higher costs of financing.
3. Declining Balances Amortization
This approach uses a fixed percentage or rate applied to outstanding principal every amortization period. For example, a $10 million balance could amortize at a 10% repayment rate annually. So year 1 would require repaying $1 million of principal, year 2 would be $900,000 (10% of the $9 million still outstanding), year 3 repays $810,000, etc. Until the debt is fully paid.
Since the ongoing percentage payment is applied to a declining base principal amount each period, the actual repayment sums themselves decline over time. Although counterintuitive, this structure has unique advantages:
- Front loads amortization to pay down more aggressively early in the term when cash flows may be stronger
- Allows residual principal balances owed later in the term to be lower, providing flexibility
- Dynamic alignment to cash flow cycles, repaying more principal when possible, and less when cash is tighter
There are also potential disadvantages namely:
- Less predictable amortization amounts decreasing yearly makes liquidity planning tougher
- Requires careful monitoring of ongoing percentage rates tied to balances
Declining balances can optimize repayment timing with business cycles when properly structured. It requires discipline to not let later lower absolute repayments extend durations.
Layered Amortization Approach
Another methodology gaining favor is a layered approach combining structures. For instance, 20% straight-line amortization per year could cover baseline mandatory repayments. Additional declining balance payments could be required if excess cash flow thresholds are achieved.
This blend allows both predictable fixed repayment amounts as a base component, supplemented with adaptable declining percentages tied to financial results.
Tailoring Amortization to Business Dynamics
There is no one-size-fits all amortization schedule appropriate for every company. The ideal structure aligns repayment obligations with reasonable expectations of future cash generation capability and inherent business cycles.
For example, early stage startups may prefer interest-only periods to preserve growth investment capacity, while stable enterprises favor straight-line amortization for consistency.
The best outcome entails designing amortization terms tailored to both adequately reward risk-adjusted lender yield requirements and also mirror the borrower’s earnings power trajectory. That mutually beneficial alignment sets up the optimal risk profile ensuring successful repayment execution.
Sample Amortization Term Sheet Provisions
To make the amortization methodologies more concrete, below displays sample terms for a $50 million secured revolving credit facility. The language excerpted from an actual loan agreement represents the negotiated amortization provisions between a commercial finance lender and a private equity-backed software company.
Sample Credit Agreement Amortization Excerpt
Revolving Line Termination Date:
The date that is thirty-six (36) months after the Effective Date (the “Revolving Line Termination Date”)
Conversion to Term Loan:
If on the Revolving Line Termination Date there are any outstanding principal amounts owing, such outstanding principal amounts shall convert automatically to a term loan (the “Term Loan”). Borrower must repay the Term Loan by making quarterly payments of principal, plus accrued and unpaid interest, commencing on the first day of the next fiscal quarter after the Revolving Line Termination Date, and continuing on the first day of each fiscal quarter thereafter. The principal amount of each quarterly installment of the Term Loan shall be the Quarterly Amortization Amount (as defined below), or, if different, the amount determined pursuant to Section 2.1.1(d). Once repaid, the Term Loan (or any portion thereof) may not be reborrowed.
Quarterly Amortization Amount:
(a) Commencing on the first day of the fourth full fiscal quarter after the Revolving Line Termination Date and on the first day of each fiscal quarter thereafter, Borrower shall repay the aggregate outstanding Obligations on the Revolving Line Termination Date divided by twenty (20) installments (the “Quarterly Amortization Amount”).
(b) Notwithstanding the foregoing, on an annual basis at the end of each fiscal year, the Quarterly Amortization Amount shall be recalculated based upon the then outstanding principal amount owing and the number of fiscal quarters then remaining until the Term Loan Maturity Date. The new Quarterly Amortization Amount shall be due and payable commencing on the first day of the next fiscal quarter after the end of such fiscal year and continuing on the first day of each fiscal quarter thereafter.
(c) In addition to the foregoing quarterly payments, (i) beginning on January 1 of the year immediately after the Revolving Line Termination Date and continuing on January 1 of each year thereafter, Borrower shall repay the Term Loan in an amount equal to five percent (5%) per annum of the original outstanding Obligations owing on the Revolving Line Termination Date, and (ii) within fifteen (15) days of receipt by the Loan Parties, collectively, of net cash proceeds in excess of $5,000,000 from any sale of equity securities in a single transaction or series of related transactions, Borrower shall repay the Term Loan in an amount equal to twenty-five percent (25%) of such net cash proceeds.
(d) Notwithstanding anything herein to the contrary, all outstanding principal and accrued and unpaid interest with respect to the Term Loan is due and payable in full on the Term Loan Maturity Date. Once repaid, the Term Loan may not be reborrowed
Term Loan Maturity Date:
The date that is seventy-two (72) months from the Effective Date
Let’s walk through some key elements:
Revolving Line Termination Date
“Revolving Line Termination Date” is defined as 36 months from closing of the facility. This establishes the conclusion of the 3 year revolving period when amortization will begin.
Conversion to Term Loan
After the termination date, the section “Conversion to Term Loan” specifies that outstanding revolving balances will convert to a term loan. This contractually obligates repayment under the prescribed amortization schedule.
Amortization Schedule
The negotiated structure here provides for an interest-only period followed by a declining balance amortization percentage. For the first year, only interest payments are due. After that, 5% of outstanding principal becomes repayable quarterly.
Note that a benchmark floor is established, requiring minimum amortization of $3 million per annum is set even if the 5% rate would calculate below that level. And additional excess cash flow payments bring optional acceleration when possible.
Repayment Frequency
Amortization installments and interest are to be made quarterly once the revolving period stops. This matches the Company’s quarterly financial reporting periods for simplicity.
Maturity Date
The maturity date when all obligations must be satisfied is set at 72 months from closing. After revolving line termination at 36 months, there are 36 months remaining to complete repayments.
These provisions represent a balanced approach allowing 12 months of interest-only deferral at the beginning of amortization to preserve operating flexibility and investment capacity. But declining balance rates thereafter require increasing degrees of principal reduction.
Key Takeaways
Modeling out repayment schedules under different amortization structures is advisable in credit negotiations to fully examine the cash flow and risk implications. This will ensure business performance can support the scheduled principal and interest obligations beyond the interest-free revolving period once amortization kicks in.
The selected terms should match up to forecasts and allow adequate flexibility to endure market fluctuations. At the same time, amortization serves the critical function of imposing fiscal restraint on management teams to gradually deleverage. Well constructed amortization aligns all parties to realize successful outcomes repaying lenders on schedule while enabling borrowers operating flexibility to execute business plans.