Also known as DIP financing, debtor-in-possession financing is any type of lending or credit that is extended to a business currently under a Chapter 11 bankruptcy process. The idea behind this type of financing is typically to allow the distressed company to continue operations and eventually return to a state of profitability. In order to qualify for debtor-in-possession financing, businesses must be in full compliance with the obligations related to the bankruptcy action, as documented in the company’s court ordered reorganization process. Specific lenders may also require additional restrictions as well, depending on the overall status of the company.
With debtor-in-possession financing, potential lenders will look closely at the future prospects of the company operation. Before approving any type of loan or other financing for the distressed company, the lender must be convinced that the business is capable of recovering from its financial setbacks, and that future income levels will be sufficient to allow the debt to be repaid according to the terms and provisions outlined by the lender. In many situations, the lender will also consider the value of assets the company has which can be liquidated in order to cover the costs of the loans or lines of credit, in the event the business is ultimately unable to repay the debt. By doing so, the lender can determine if the level of risk involved with the financing is within an acceptable range, or if the application should be rejected.
One of the factors that makes debtor-in-possession financing attractive for some lenders is that this sort of debt has seniority over any other debt issued by the company. This means if the business is unable to continue operations once the financing has been arranged, the DIP lender will have priority over other creditors, and thus enjoy a better chance of receiving full payment for the outstanding amount, once the assets of the company are liquidated. This seniority can be especially important when the future prospects of the business are somewhat borderline, since it does add a small amount of security for the lender.
Not every company that encounters financial distress or files for Chapter 11 bankruptcy protection will qualify for debtor-in-possession financing. Lenders must be convinced that the applicant exhibits a reasonable level of ability to generate revenue and pay off the loan according to terms. Should the lender see any factors that indicate the company will not be able to recover, even allowing for the reorganization and the protection afforded by the court system, the application is highly likely to be denied. This initial rejection does not bar the business from seeking financing elsewhere, or submitting another application if subsequent events enhance the financial prospects for the company.