Using Debt Smartly: Nonprofit Lines of Credit and Loans
A free webchat from New York Nonprofit Press and NFF: June 12th, 2012 1-2pm EST.
Debt can be tricky to navigate for nonprofits. NFF Portfolio Manager, Barbara Libove's article in the New York Nonprofit Press offers guidance on how and when to use a line of credit appropriately and effectively. NFF has teamed up with the New York Nonprofit Press to provide an online forum for nonprofit leaders to get their questions answered. The webchat, which can be "replayed" below, offered a unique opportunity to hear both the borrower and lender perspective. Click the arrow in the window below to view the transcript. To see responses to the additional questions we weren’t able to answer during the chat, please scroll down to the ‘Follow-up Q&A’ below the transcript or click here.
- Inquire about an NFF loan
- Read answers to the questions we didn't get to in the live chat
- Take a tour of NFF's most frequently used resources
- See a webinar and powerpoint on getting ready to take on debt
Email email@example.com if you have any questions about viewing the chat.
- Obtaining a Loan or LIne of Credit (LOC)
- Terms and Circumstances of Lines of Credit
- Debt and Organizational Leadership
- Alternatives to Lines of Credit
- Paying Back Debt
- Questions on Lenders
In last month’s web chat, there were numerous questions we couldn’t get to during the live event. A small handful were beyond the scope of the chat, but the hosts of the event – Barbara Libove and Nima Krodel—went through and answered the remaining questions below. In some cases, similar questions are grouped around themes. If there are terms you’re not familiar with, you may find many of them listed in our glossary of nonprofit financial terms here. And if you’re getting ready to apply for a loan, whether from NFF or another lender, you will likely find our webinar “Preparing your organization to apply for a loan” extremely helpful.
Mo: How do small nonprofits obtain a loan? Our operating budget is $100,000 a year so far.
Mo: I am interested in how nonprofits with no credit go about obtaining a loan.
Harmon: Is it difficult for nonprofits to get unsecured debt?
Small nonprofits can contact their local bank. Most banks, regardless of past credit history will want to see your basic financial information. Getting unsecured debt depends on both your organization’s profile and the financial institution. Collateral can be in the form of lien on assets, accounts receivable and sometimes property.
Charles: What do you mean when you say a private investor? [Ed. note: A response in the live chat mentioned “private investors” as a source of capital.] And what are the potential sources of LOCs?
Lines of credit are typically provided by banks or other financial institutions. By “private investors” I mean simply a private individual, perhaps a supporter of the nonprofit.
Guest: How do nonprofits apply for loans without having assets? We do have approximately 250K in receivables each month, but we cannot get a credit line without property. Our partners provide us office space.
Guest: How is a nonprofit funded by the State with no collateral (except service provided to children) to get a bridge loan or line of credit?
Guest: We're largely government funded, and the government is often late to pay on contracts. It would be very helpful if we could have a line of credit to manage this cycle. How can I prepare my organization to look like an attractive candidate for a line of credit?
Typical lenders want to see stable financial condition (operating surpluses), stable management/board, reliable and repeatable contract revenue, and a borrower’s ability to illustrate contingency plans.
P Theatre: Are there real estate or capital loans available for nonprofits with little down payment?
In today’s marketplace, it is difficult to finance a project with no down payment. Most lenders want to see the borrower share some risk. Sometimes there are specialized programs that help finance total projects, but those are usually sector-specific. For example: I’ve seen guarantee programs for charter school financings where there is additional credit enhancement.
Jen: Do lenders typically require collateral for lines of credit? If yes, could you provide some examples?
Yes, typically a lien on accounts receivable and/or lien on all assets.
Bernadine: Would it be wise to include a graph of the cycle--or "timing”-- of your revenue streams especially if a nonprofit has multi-year funding from public sources. Does this help in getting a line of credit?
A spreadsheet detailing your cash inflows and cash outflows over a 12-month period to illustrate the timing/cycles is ideal.
Anne: What if your organization does not have a lot of deposits available to move to a bank? Are there lenders willing to provide a line of credit without a requirement that deposits are held?
This is where other forms of collateral would be helpful.
Bernadine: A 1-2 month timeline for starting the process of getting a LOC appears too close. Is this typical?
Usually it takes 4-8 weeks for NFF to underwrite a loan and then an additional 2-4 weeks to document and close. The underwriting and closing process can vary depending on how quickly the “back and forth” between borrower and lender goes and how quickly a potential borrower is able to provide follow up information.
Bernadine: How critical is the use of audit reports to getting a LOC?
At NFF, we do need to review audit reports.
Jim: Our subsidiary LLC was denied a line of credit because of a debt ratio issue. I never fully understood what the banker was looking for. Thoughts?
There are different kinds of debt ratios, so I’m not sure which one you refer to. For example DSCR (debt service coverage ratio) refers to the ability of operating cash flow to cover your annual debt service payments. There is also a Debt Ratio that is Debt divided by your Total Assets which is another type of financial ratio.
Since I’m not sure exactly which one you are referring to, I would ask the banker directly what the issue was.
Vicki: We own our building, which is approx. worth 8-10M free and clear. We are unable to get a loan as our cash flow can be irregular due to the nature of our business. We are considering a LOC and have been told that the banks want collateral other than our building, such as our investment funds. Is this a reasonable requirement?
Typically banks want additional collateral to mitigate additional risk in a worst case scenario.
Karen: Will you be discussing your typical loan terms, fees, etc?
NFF typically makes loans between $500,000-$2 million. LOCs have a 12 month term, with up to 2 annual extensions. Typically there is a “borrowing base” that reflects a % of receivables. Fees include a one-time upfront fee and a non-use fee (if the LOC is not utilized). Please contact your local office for detailed information as pricing can vary.
NFF’s typical borrowers must have a minimum budget of $500,000 (typical borrowers have budget ranging from $1-15 million). Borrowers typically have at least 3 years of operating history.
Lee: What are the costs involved in securing an LOC?
At NFF, we typically collect an application fee (that can be applied to an upfront fee if the LOC is approved), an upfront fee and legal fees if necessary.
Karen: Can you explain--what is a "clean-up provision"?
A 30 day clean up provision is a quite common LOC term and means that the borrower must keep the LOC at a zero balance for 30 days during a 12 month period.
Selma: In the past we have borrowed from a line of credit when our cash has been low due to grant payments or other receivables. We have borrowed depending on the short fall for the period. Are there better ways to determine how much we should be borrowing from a line of credit, and when? Are there any sample policies or procedures that you could direct me to?
Borrowing the amount you expect to pay back with a specific cash inflow (i.e. grant payment) is an appropriate way to determine what to borrow.
Guest: Our organization is in year 1 of a 20 year variable rate tax-exempt bond for construction of a new facility. There is a 3 -year letter of credit fee @2.75%. Current variable interest rate is .20%. With interest rates at historic lows, would you recommend using profits to (1) pay down principal or (2) invest in a "rainy day" fund?
The answer depends on your organization’s (1) appetite for debt and (2) plan for the future. Given that your debt is variable rate, there is some future risk in rates rising over the next 20 years. Depending on what your organization’s future plans are (major expansion, capital project, etc), it may be also useful to have an internal fund. Or perhaps your organization can do a little bit of both.
Brad: Our organization has an outstanding LOC and received a windfall bequest. How do we balance operating cash needs, paying down LOC and our mission desire to add to our endowment? How to balance competing needs / fiduciary [responsibility]?
Jim: Am I correct in thinking that lines of credit may or may not have pre-established repayment terms? The small line of credit that our non-profit has from a major bank does not have a maturity date - which is a nice thing.
This depends on your financial institution. Many other LOCs do have maturity dates.
Diane: Our operating line is currently collateralized by our building but the bank is requiring an appraisal every year, which is getting costly. What is the formula banks typically use to determine how big of a line they can offer when it is based on Accounts Receivable?
This depends, but it can be between 70-85% of Accounts Receivable less than 90 days.
Yulia: What is the ratio of annual budget to LOC you consider a standard in the industry? What about NFF loans? What is the average % to budget total?
Nancy: Is there a magical percentage out there that non-profits could expect a bank would finance for a capital item or project?
For capital projects, most banks do not want to finance 100% of the project. They usually look at a term called LTV (Loan to Value), which refers the amount of the loan relative to the value of the building. Banks finance anywhere from 70-85%, depending on their internal policies.
Tara: If LOC terms are usually 1 year, do you need to show the bank a cash flow projection that will including paying off any draws from the line? And, is it a good idea to take out a LOC if you do not know if you'll have the funds for repayment within that short of a time frame?
Yes, if there is no source of repayment, the LOC is being used for cash, and not cash flow. This is not an appropriate use. So, answering the second question, no, if you do not have a source of repayment, it would be difficult to obtain a LOC.
Marilou: We are seeking a CA grant to help pay for new engines for our ship - but the grant is only paid after the installation. Would an LOC be given for this type of need?
This would be a bridge loan. NFF has frequently done these types of bridge loans for capital grants.
Lita: We will undergo a A-133 audit for this FY ending June 2012. We still have an outstanding balance from a LOC. Should we close off the loan?
Not necessarily, showing a balance on your LOC on your audit is only one point in time. If June 2012 is typically a month that you need to draw and you pay back your line the next month, it is still being used for cash flow. Some borrowers don’t “like” to show a balance on their audits, but as long as the LOC is being used appropriately, it is not an issue.
Selma: One of our contracts gives us the option of requesting an advance. Do you have any guidelines as to the amount we should request? Would it be the same as a LOC, under 90 days of receivables? If we chose to have both a LOC and request an advance should we look at having under 90 days of receivables between the both of them as the amount of credit to have available?
Selma, the reasoning you apply here is sound. It is reasonable to use “under 90 days of receivables” as a benchmark for how much credit you should have available. With regard to the advance, you should be thoughtful about how much capital is needed to fund the “up front” costs of the contract. This will ensure that you have enough cash on hand to do the initial work. You may increase the amount requested to also include a provision for future work, depending on the timing of future inflows. When applying for the line, you should be clear about the seasonality of your cash flows so that the lender knows how much your peak usage will be and when it will occur.
Karen: One problem with taking on a line of credit is who do you get to pay the interest payments? Government contracts won't do that.
Excellent question, your organization will need to have a small operating surplus every year to cover the interest payments. This is something that lenders will look for. Also, occasionally for facility-related debt (not operating LOCs), I have seen government pay for debt service, but it really depends on the type of nonprofit.
Dawn: Would a line of credit also based on the personal credit of the Executive Director? Our Director has assumed personal debt to keep the organization going and it has not been favorable to his own credit.
It depends on the bank/financial institution. A personal guarantee is another form of collateral. Another form of collateral for a LOC would be a lien on all assets or a lien on accounts receivable.
Hans: Would taking a loan from a Board member violate fiduciary responsibility?
P Theatre: Do banks require personal guarantees of board members?
Before taking a loan from a Board Member, the organization should make sure that this is not expressly prohibited in its articles of incorporation or bylaws. Furthermore, if an organization takes a loan from a Board member, it should be well documented and disclosed in the notes to its audited financial statements.
Charles: Barbara - To the question of board involvement. Do you typically require a board officer to approve draw downs? As a board member and treasurer of an organization I helped the rest of the board be comfortable by committing to them that I would require a repayment plan before I approved drawing down on the line, and we had a resolution that required my approval before the line was used by the CFO.
No, NFF does not require a board officer to approve draw downs, though individual organizations may have their own internal policies. Check the bylaws for this information. In the loan documents, there is typically a designated person who is required by the lender to sign off on draw requests (may be ED or CFO).
Dawn: We operate a non-profit social enterprise. While we do earn some revenue from the social enterprise, it is not enough to fully fund operations. How do we help our Board to understand that even with the social enterprise, assumption of some debt for operations is necessary?
This is a tricky question, while often social enterprises (or start-ups) do not have enough revenue to fully fund operations, debt as a tool to fund operations on an ongoing basis is not a long-term solution. If revenues never fully fund operations, this can be a dangerous financial situation. I would advise using grants as a better tool to fund operations as your social enterprise heads toward generating surpluses.
Stefanie: Is it appropriate to use a Line of Credit instead of having a reserve fund? If the interest on the Line of Credit is good, and having a reserve fund is not feasible, why have a reserve fund?
In general, NFF recommends that an organization create and maintain one or more reserve accounts to support operating and capital needs, including contract delays, construction, expansion, or maintenance needs. Although it can be a daunting task, it is still important for an organization to work towards building reserves, whether it is through generating surpluses or approaching funders with a well thought-out plan for how to manage the reserves and what they would be used for.
That being said, building a reserve takes time. In the interim, an organization may want to consider obtaining a line of credit that it uses judiciously and responsibly. This can help meet their operational cash flow needs while allowing them time to make the case for raising restricted reserve funds.
Yulia: We had an operational budget deficit last year (which was covered in Full by cash reserves), and when we applied for Credit Line increase, the request was denied citing the deficit as a reason. What are our other alternatives? We have large cash in and out gaps?
Yulia – it sounds like your lender was not ready to increase its exposure to your organization. Are there any other funders, or even board members, who may be willing to provide capital to meet your funding needs? It would be crucial to demonstrate to them (1) why you incurred a deficit last year, (2) steps you are taking to right-size the budget and generate a surplus this year, and (3) the underlying cause of the gaps between cash inflows and outflows. Be prepared to explain how your organization will cope with a downside case – i.e., staff reductions, furloughs, other cost-cutting measures. Until funding becomes available, are there any area organizations with whom you can partner to deliver on programs at a reduced administrative cost?
Theresa: If an organization does not have the financial capacity to take on debt, what are other sources of financing recommended?
Your question is an important one, Theresa, since not all organizations can or should take on the burden of debt. For nonprofits, alternative sources of financing include unrestricted grants (able to be used for general operating purposes) or restricted grants that are restricted based on time or programs.
Lee: How do grants figure into the picture?
In order to fund operations, an organization that takes on debt will also need to ensure that it generates sufficient cash flow to (1) cover its expenses, (2) provide cushion in the event of an unforeseen downturn, and (3) enable the organization to service its debt and repay at maturity. Depending on the organization, this cash flow may be a combination of earned and contributed revenue, and that is where the grant funding comes in.
Ingrid: What kind of reporting do you need to do for a grantor to be able to pay back an LOC with their funds?
This will vary by grantor. Management should have an open conversation with a grantor if it intends to use their grant to repay a line of credit. It is important to be transparent about this since, if a grantor intends for their funds to be used in a specific manner, and the organization does not follow the restrictions, it can lead to a break in the relationship.
Kathi: I am with a small organization that needs to refinance a small credit card debt. We get grants and donations and have been able to service the debt and do the work without taking on any more debt, but the high interest rate of a credit card eats up extra working funds. What steps should we take?
Kathi: I'm on the Board of a small organization. When the organization began a few years ago, it acquired credit card debt with a high interest rate. The interest rate has caused the debt to snowball. We asked the bank to re-finance at a lower interest rate and they won't. Now where do we go? It is a small organization (under $500,000 per year) with a $50,000 debt. No one I've contacted seems interested in a small debt.
It sounds like you have made attempts to reduce your future debt burden, but to no avail. Does your organization currently track and report on the impact of its programs? Prepare multi-year forward-looking cash flow projections? If you can clearly demonstrate the results of your work, per dollar spent, you can make the case to a funder that, if they were to step in and refinance the debt for you at a better rate, possibly even forgive a portion of it, they would earn “return” based on the funds your organization is able to allocate to programs as opposed to a punishingly high interest rate. The projections would help you show how you are able to repay the debt over time.
Alexis: What if you have existing debt from prior year deficits; can you plan to pay down over time?
If an organization has built up debt with various creditors, it should negotiate a payment plan with each of those parties. The organization should be forthcoming with information so that the creditors can understand the full magnitude of the situation. The organization should not consider a line of credit or other forms of debt while it is playing catch-up on past debts.
Laura: If an organization not only has a LOC, but also a capital reserve or other limited term "endowment," can the lender require repayment of the LOC from those funds if insufficient operating income? Would the lender expect those funds as collateral?
Laura – very good questions. In response to the first question: if an organization is in default of its loan agreement, be it a line of credit or some other loan, its lender can pursue its rights and remedies under the terms of that loan agreement. If there is collateral associated with that loan, the lender may begin a proceeding to take possession of that collateral, which may or may not include the endowment or capital reserve. While a lender cannot specifically direct the borrower to take certain action, such as liquidating a reserve, it can take certain measures such as putting the loan in default or eventually filing a lawsuit in its pursuit of repayment. In response to the second question - depending on the restrictions associated with the endowment or reserve funds, your organization may not be allowed to pledge them as collateral to a lender. If that is the case, the lender may try and secure the loan with a lien on accounts receivable, or with a lien on all assets, but carve out the endowment or otherwise restricted funds.
Matt: Are there any resources you can recommend for finding lenders who have nonprofit experience in our area?
I would recommend consulting the Community Development Financial Institution (CDFI) website. For some background, CDFIs include regulated institutions such as community development banks and credit unions, and non-regulated institutions such as loan and venture capital funds. Follow the below link. About halfway down the page is a link to a spreadsheet containing Certified CDFIs and Native CDFIs, and it is sortable by geography. http://www.cdfifund.gov/what_we_do/programs_id.asp?programid=9
Tina: I sent a comment about Board education a couple of minutes ago (sorry if it pops up suddenly) but I found having bankers on the Board helps NPOs with LOCs, etc.; however, traditional banks can be difficult. Isn't this a good time to use alternative lenders like yourselves? We have only a few in Canada but it’s a good alternative.
Desmond: How can NFF assist non-profits whose main source of funding is City, State and Federal funding?
Michelle: Does NFF offer lines of credit? We have had a hard time acquiring one through banks in our area. We finally got one through a mortgage refinance, but it is only for one month. We may be looking at more than that in CA this year...
Harmon: What is the difference between seeking a loan from NFF versus a traditional bank?
Great question. NFF has 30+ years of experience in working with nonprofits. As a nonprofit ourselves, we understand the obstacles that nonprofits face, and tailor our debt products (term loans, construction loans, lines of credit) to meet their needs. We take the time to understand the complexities of an organization’s funding streams (government and private), while many commercial banks do not. For more concrete examples of how clients have benefited from NFF’s lending and advisory services, please see some our client stories.
Charles: Barbara, is there a rule of thumb lenders like yourself use about the size of AR vs. the amount of an LOC granted?
We size the LOC based on the peak level of a borrower’s accounts receivable, but also take into account the size of the organization, its ability to manage an LOC, and the available collateral. It is important to note that a borrower will only be able to draw between 70-80% of its eligible accounts receivable (invoiced, uncollected, and under 90 days outstanding).
David: Will a lender consider a loan to an org with some history of operating deficit? How many years back are important in their consideration? How has the economic slowdown impacted how lenders look at an org's finances?
Lenders typically look at 3-5 years of operating history and will certainly consider what the market conditions were during those years. If the organization has experienced deficits, it should be able to explain (a) why the deficits occurred and (b) the steps they have taken to right-size the organization and generate surpluses in future periods.
If your organization has experienced deficits, due to the economic slowdown or otherwise, be prepared to share with a prospective lender your plan to address future downside conditions. When preparing your annual budget, also prepare a “low-case” budget that shows the loss of certain contract or grant funding and the accompanying expense reductions you would make in response.
Patricia: What are red flags when assessing a lender offering a line of credit?
Be wary of a lender that is not up front about the specifics of the loan, including fees, required paydown periods, interest rates, and the length of the term. You do not want any surprises. How much lead time do they need to process your draw requests? Does the interest rate change over time? Is the line subject to annual renewals, and if so, are there fees associated with each renewal?
Ahmed: As a lender, what is the top issue or problem that you have with nonprofit borrowers? Is there a common problem that comes up consistently?
One of the most common mistakes that borrowers make is, when things do not go as planned (grant payments are delayed, a contract got revoked), they put off the uncomfortable conversation instead of being forthcoming with information. It is always in a borrower’s best interest to maintain honesty with the lender. Trust is not easy to rebuild once it is lost.
Jossi: There is a contract that we want to bid on that represents a major growth opportunity, but we know we’ll need an LOC to use as working capital to float for the difference between A/P and A/R. Here’s our problem: LOC are granted based on past A/R figures. We know that, if we were to win the contract, our future A/R would be sufficient to necessitate a substantially greater LOC, but we can’t get that LOC increased until we win, and we can’t in good faith bid on the contract without already having that LOC in place. Any advice on how to have this conversation with our bank or others so that we don’t walk into a situation and have to scramble?
Present your situation to the lender, sharing as many details as you can about the nature of the prospective contract. Be clear that your request is contingent upon you receiving the contract. Your lender may then be willing to prepare a term sheet or commitment letter which clearly spells out that the line would only be available if you win the contract.
Pam: In cases where the loan is not due to cyclical fluctuations in payments received vs. expenses incurred, isn't it a good idea to use the loan funds to expand a program or another activity that increases future revenues so as not to be forever dependent on the LOC?
Pam – this is a great question. For some borrowers, an LOC is a temporary fix. They may have cumbersome contracts and a small staff, thus making it difficult to properly invoice for and receive agency payments. The LOC may be the right answer to avoid a cash flow crunch during the delay. Ideally, the organization will be able to reduce the delay over time to the point where an LOC is no longer necessary.
However, for some organizations, the timing delay does not improve or go away over time. It may be out of their control and instead driven by the funder or government agency. As such, some organization mays always need a line of credit. You make an excellent point about how a loan may be used to fund growth and program expansion. Such loans are structured quite differently from lines of credit. Depending on where the organization is in its growth trajectory and the nature of its revenue base, both a line of credit and a growth loan, or either one on its own, may be the right answer.
Joe: Nima – can you elaborate on additional information requirement for the capital related loans?
Jenny: I'd like to learn more about facility related loans - and some clarification - how do loans differ from LOCs?
Stanley: As far as facilities-related debt, what additional upfront work should an organization be prepared to do? Are there differences from a normal LOC to bear in mind?
Good questions. Let’s consider the differences between a line of credit and a facility-related loan, such as a construction loan. The due diligence process for a facility loan will encompass everything that the LOC underwriting does – financial analysis, assessment of programs, management and board, stability of revenue sources – but will add on a thorough review of the project for which the facility loan will be used. If construction or renovation, the lender will analyze all aspects of the project – general contractor, project management, project budget, timeline, and the potential risks.
The structure of the two loans is also quite different. A line of credit is disbursed based on periodic requests that are substantiated by a borrowing base of receivables. The term is generally one year and the borrower can draw and repay as needed. Interest is only charged on the outstanding balance, typically at a variable rate. A non-use fee may be charged on the undrawn portion. On the other hand, a facility loan will be disbursed based on construction draw requests and accompanying invoices. Such loans are typically interest-only at a fixed rate until construction is complete.
Guest: What are some of the common causes for operating deficits? Are they due to faulty budgeting? Tips please.
We often see organizations take on grants to operate programs without examining whether the program itself operates at a deficit or a surplus. It is key for management to be thoughtful in taking on restricted grants and additional contracts since added revenue does not necessarily lead to improved financial condition and in a worse-case scenario, can be detrimental to the organization.
Jamie: As a lender, what would you tell organizations that are experiencing a combination of cash flow problems and poor financial health? However, they need to continue programs in order to receive contract/grant funds (e.g. they cannot necessarily downsize)?
Take a close look at what is causing the underlying problem of poor financial health. This may involve performing a profitability analysis of each program. If a program runs at a deficit, is there sufficient grant funding with which to subsidize it? Sufficient surplus from other programs to supplement it? This will give you a much clearer picture of what contracts are bolstering the health of your organization and which ones are not.
Michael: What would be an example of a low risk bridge loan? High risk?
A low-risk bridge loan may be bridging grant funds that are backed by a firm commitment from the funder. The less certain the commitment for the funds that the bridge loan is bridging, the more risky it is. In order to mitigate risk, a lender may seek collateral that is unrelated to the actual funds the loan is bridging, such as a building or other asset owned by the borrower.
Read About Our EXPERT PANELISTS
- Barbara Libove, Portfolio Manager, NFF, performs credit and financial analysis, manages risk, and negotiates loan restructurings.
- Sandra Reeve, Director of Finance,The Classical Academies, a tuition-free public charter school that uses a revolving line of credit to manage their cash flow needs.
- Nima Krodel, Associate Director and Lender, NFF, is responsible for the underwriting, closing and monitoring of loans to clients.
- Moderator: Fred Scaglione, Editor-in-Chief, New York Nonprofit Press