What it means
When a company files for protection from its creditors, its normal sources of cash tend to disappear overnight. Suppliers demand payment up front, customers slow their orders, and the existing bank facility is frozen, so the business can run out of money long before a rescue plan is agreed.
Bankruptcy financing solves that gap by letting the court grant the new lender a better position than everyone already owed money. That priority, often called a super-priority claim, means the new loan gets repaid first from whatever the company sells or earns, which is the only reason a lender will accept the risk.
Existing creditors usually accept the arrangement because a business that keeps trading is worth far more than one liquidated in a hurry. In practice the facility is small, short and tightly controlled.
It is typically sized to cover a rolling thirteen-week cash forecast rather than the full balance sheet, and it comes with conditions such as weekly cash reporting, spending limits and hard deadlines for filing a reorganisation plan. Miss one of those milestones and the lender can withdraw support, which in effect forces a sale or a wind-up.
Pricing reflects both the risk and the borrower's lack of alternatives, so interest rates sit well above ordinary corporate borrowing and are stacked with arrangement, commitment and exit fees. Managers should therefore judge these facilities on total cost rather than the headline rate, and remember that the cheapest offer is not always the one with the most workable conditions.
In practice
Real-world examples.
Example
A regional airline enters administration after a fuel price spike drains its cash. A court-approved facility of $40,000,000 lets it keep flying its most profitable routes through the peak summer season while it negotiates new aircraft leases, preserving a business that would have been worth almost nothing grounded.
Example
A furniture retailer with 60 stores files during a downturn and secures a $25,000,000 facility from its existing lender. The money funds stock for the Christmas trading period and severance for staff at 14 stores being closed, and the lender attaches a covenant requiring the closure list to be finalised within eight weeks.
Example
A software company in a formal restructuring needs cash to keep its data centres running because switching them off would destroy the customer contracts that make up most of its value. A specialist fund provides a $6,000,000 facility priced at 14%, on the condition that the founders hand over two board seats.
Formula
Calculation
Total cost of a bankruptcy facility = (principal x annual interest rate x term in years) + arrangement fee. Effective annualised cost = (total cost / principal) x (12 / months drawn).
A regional food distributor files for protection and obtains a court-approved facility of $12,000,000 at 11% a year, expected to be drawn for 9 months, with a 2% arrangement fee payable up front.
Interest: $12,000,000 x 11% x 0.75 years = $990,000.
Arrangement fee: $12,000,000 x 2% = $240,000.
Total cost: $990,000 + $240,000 = $1,230,000.
Cost as a share of principal: $1,230,000 / $12,000,000 = 10.25% over 9 months.
Effective annualised cost: 10.25% x (12 / 9) = 13.67%.
So the true cost of the facility is roughly 13.67% a year, not the 11% quoted, and that gap is exactly what the finance team should present to the board.Case study
Seen in the real world.
Northvale Ceramics is an illustrative, fictional tile manufacturer that entered a formal insolvency process after a long dispute with its largest customer left it $9,000,000 short of the cash it needed to cover payroll and kiln fuel. Its ordinary bank facility was frozen the day it filed, and its clay supplier moved it to cash on delivery, so the business had roughly four weeks of liquidity left.
The finance director built a thirteen-week cash forecast showing a peak funding need of $7,500,000 and used it to negotiate a court-approved facility of $8,000,000 at 12% with a 2.5% fee, drawn for an expected six months. The total cost worked out at $8,000,000 x 12% x 0.5 = $480,000 of interest plus $200,000 of fees, or $680,000, which is 8.5% of the principal over six months and about 17% annualised.
The board initially baulked at the price until the finance director showed that an immediate liquidation was expected to return only about 30 cents in the dollar to unsecured creditors, while trading on through the reorganisation was projected to return around 65 cents. In this fictional example the expensive money was still the cheap option, which is the judgement most boards in this position actually face.
Watch out
Common mistakes.
- Assuming bankruptcy financing is a rescue in itself. It buys time to execute a plan; without a credible plan it simply adds a senior creditor to the queue and speeds up the end.
- Comparing offers on the interest rate alone. Arrangement, commitment, monitoring and exit fees frequently add several percentage points to the true annualised cost.
- Treating the covenants as paperwork. Missing a milestone such as a plan filing date can trigger an immediate default, and that clause is usually the lender's real control mechanism.
Questions
People also ask.
Who actually approves the loan?
The insolvency court does, after hearing from existing creditors, because the new lender is being given a claim that ranks ahead of theirs.
Does it dilute shareholders?
Not directly, since it is debt rather than equity, but it consumes value that would otherwise reach shareholders and is often paired with warrants or board seats that do dilute control.
Can the existing lender provide it?
Yes, and it often does, partly to protect the value of its earlier loan and partly because it already understands the borrower's cash cycle.
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