How does DIP Financing work?

In the business world, Cash is King. Companies that do not have adequate cash cannot survive for very long. This is because of the fact that employees, vendors, tax authorities, and other creditors expect to be paid in order for the business to remain in operation.

When a company is not facing bankruptcy, it obtains funds using one of the following methods:

  • Financing from commercial banks or other lenders

  • Financing via the sale of debentures

  • Credit from vendors

  • Equity infusions by the shareholders of the company

However, when a company is facing financial duress, two things happen. Firstly, the company needs more cash to run its operations i.e., the demand for financing goes up. At the same time, all traditional lenders are no longer willing to lend to the firm. Hence, the supply of cash also goes down. This simultaneous increase in demand and reduction in the supply of cash is called a cash crunch. This is a difficult situation for a company to be in and is capable of exacerbating the bankruptcy process.

The Challenge with Insider Financing

When a company is in duress, outsiders i.e., external lenders, tend to withhold credit. This is because they do not have the visibility of the operations and the financial viability of the company. Hence, they have to make decisions in the absence of critical information, which makes it a risky bet for these companies.

However, insiders have access to this information. Sometimes, they may be confident about their ability to turn around the fortunes of their firm. Hence, they may offer to invest more money. However, it would not be prudent of them to do so without following proper procedures.

The fact of the matter is that insider loans are a subject of a lot of scrutiny in distressed companies. In many cases, loans made by insiders have later been challenged by other stakeholders. In many cases, the priority of the debt was reduced. In some other cases, the debt infusion was converted into equity, and the shareholders had to absorb the resultant losses.

Also, form a legal point of view, companies that seek Chapter 11 bankruptcy protection are supposed to get approvals from the court before they agree to any new financing arrangements.

What is Debtor in Possession (DIP) Financing?

DIP financing is an alternate way for companies that are under Chapter 11 bankruptcy to obtain finance. If the loan is given as a part of this arrangement, it is approved by the court, and hence its validity cannot be challenged by any party at a later date.

DIP financing is a boon for companies facing bankruptcy. The guarantee that this kind of financing provides attracts many potential investors. This is because the court guarantees that their interest will remain safe even if the financer is an insider or a potential acquirer.

The name DIP financing is short for Debtor in Possession financing. This is because an insolvent company is considered to be bankrupt. Hence, ideally, the debtors should no longer be in possession of the company. However, bankruptcy proceedings allow for a short period of time when they can still be in possession of the company. Hence, this state is called “Debtor in Possession” or DIP. This is the reason why the financing provided at this stage is called DIP financing.

The Procedure for Obtaining DIP Financing

In case a company wants to obtain DIP financing, it first needs to line up a lender. This means that all the details related to the loan like interest rates (which may be above market rates), fees, and repayment schedule needs to be planned. Also, the details about how the funds will be utilized, and the control plan also need to be decided. These documents are then submitted to the court for their approval.

It needs to be understood that the court will intimate all the existing creditors as well. Also, the court may consider objections raised by them, especially if the financing party is an insider or a potential acquires. After listening to both sides of the argument, the court will then decide whether or not to allow the company to obtain DIP financing.

Obtaining DIP financing is somewhat difficult. This is because the company needs to convince the court that the current position of the other creditors will not be negatively affected. Alternatively, the company can directly convince the other creditors and provide the court with written documents indicating their consent.

Many times, the existing lenders are the ones who agree to provide DIP financing. This is because, under the DIP financing laws, their interests are better protected. DIP financing carries security from an investor’s point of view. The validity of the terms and conditions of the loan granted under DIP financing is unquestionable!

The problem with DIP financing is that it takes a lot of time. Companies under the threat of bankruptcy need to reach quickly. Such long delays may not be in the best interest of all the stakeholders. The bottom line is that DIP financing is a valuable tool that needs to be used correctly. It has the potential to provide companies with critical cash flow that they need at the right time.

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