The Founder's Guide to Raising a Warehouse Facility in 2024

Given you’re reading this guide, we’re going to assume that you’re either a fintech startup looking to raise a warehouse facility to provide capital to other startups, or you’re researching embedded lending and want to add a financing component to your product. In either case, we’re happy you’ve made it here! In this guide, we break down warehouse facilities and share tips from raising our own $150M credit facility.

What warehouse facility financing is (and isn’t)

A warehouse facility is a form of credit facility issued by a lender to a third party that intends to provide some percentage of the capital to a non-related party. Like a credit facility, the startup approved for the credit draws down the available balance as it issues credit to other parties. Typically the startup issuing the credit is responsible for underwriting the deal and collecting the outstanding monthly payment, so they can repay the initial lender.

The term originates from the mortgage industry, where mortgage loans were temporarily stored in a hypothetical "warehouse" for several weeks before being sold on the secondary market. In essence, lenders required short-term financing to finalize the mortgage loans for investors who were purchasing bundles of homes.

How warehouse facility financing works

Warehouse facilities are fairly straightforward debt instruments. There are typically three parties involved: 

• The lender - this is the entity that provides the credit to the intermediary,
• The intermediary - this is the entity that receives access to the credit pool and extends some portion of it to a borrower.
• The borrower - this is the entity on the backend of the transaction that receives the financing.

Essentially the borrower approaches the intermediary with a request for credit. The intermediary underwrites the deal and determines whether or not the borrower is qualified. If they determine the borrower is qualified, they draw a portion of the facility from the lender and facilitate its transfer to the borrower. The intermediary makes money by accessing funds at a fixed rate, say 10%, and providing the capital to other startups at 15-16%. The difference between what they pay for the credit and what they “sell” it for is their margin.

Why lenders issue warehouse facilities

Intermediaries exist because the underlying lenders either don’t have access to the proprietary deal flow or aren’t equipped to underwrite the deals. It’s also possible that direct lending isn’t a part of their core business model and they aren’t willing to take the underlying risk of default. In most scenarios, it’s a combination of the above factors that makes issuing a warehouse facility an attractive option for a family office or non-bank credit funds.

The intermediary does all of the upfront work of sourcing, qualifying, and facilitating the deals. The lender simply writes a check and collects a guaranteed interest rate from the intermediary when funds are issued. In some deal structures, they may even collect an “access fee” for providing access to credit even if it is not issued.

Why Fintechs like warehouse facility financing vs funding deals on balance sheet

Most Fintechs prefer to utilize a warehouse facility to fund deals because they don’t have to tie up a majority of their capital and they can access additional financing to fund more deals without giving up equity in their business. Also, asset-lite businesses are typically viewed more favorably by investors compared to asset-heavy businesses.

The flow of funds in warehouse facility financing

The flow of funds for warehouse facility financing is fairly straightforward. The lender approves the intermediary for a pool of credit. When the intermediary identifies a strong credit applicant, they reserve a portion of their facility and extend the credit to the application. If the borrower agrees to the terms of the deal, then one of two things happens. 

• 1) The intermediary draws down the facility, the funds hit their bank account, and they transfer the funds to the end borrower. 
• 2) The intermediary draws down the facility and the funds go directly to the borrower.

Scenario two is more common nowadays. However, in some situations, the entire sum given to the borrower doesn’t come exclusively from the lender. In those instances, the intermediary is required to fund some portion of the deal, say 10%, from its balance sheet so they have “skin in the game.”

What happens in a default event

As they say, the difficult part about credit is not extending it, it’s getting paid back. In the case of a default event with the end borrower, several things can happen based on the terms and structure of the original warehouse facility. For example, the intermediary may be held liable for the outstanding credit and be required to pay it back to the lender on behalf of the borrower. Alternatively, the intermediary may not be held responsible, but their access to the facility may get shut off.

In a not entirely unheard of scenario, the intermediary may be asked to recall all of the outstanding deals it facilitated (even those not in default) prematurely. That’s why it's so important to understand the terms of the warehouse facility before you agree to them and to plan for the unfortunate possibility of the downside scenario: defaults.

When warehouse facility financing works well (and when it doesn’t)

Warehouse facility financing works well in low-interest-rate environments when venture capital dollars are freely flowing. This is because the end borrowers (startups) continue to raise additional funding and thus can continue to service their debt. The perfect example of this, was 2014-2021 when dozens of fintech startups sprouted up with the idea of acting as an intermediary to other startups. When the VC bubble popped and interest rates rose in late 2022, the music stopped.

Delinquency rates rose quickly with end borrowers (startups) being unable to repay their debt. This was because they could no longer raise more capital from VCs, sales slowed as the economy slowed, and their subsequent revenue couldn't keep pace with the required debt repayments. Rising interest rates also drove up the cost of debt from the lender. Instead of tapping the capital at say 10%, the intermediaries were forced to pull it at 12-14% and pass through the subsequent hike to the end borrowers. That made repaying even harder and eliminated an already narrow lending margin.

Thus, warehouse facility financing does not work well in rising interest rate environments.

Advantages of warehouse facility financing

• Scalable: Typically warehouse facilities can scale indefinitely based on positive loan-book performance. Startups without a warehouse facility that extends credit to other entities, need to raise more equity financing and thus incur dilution.
• Non-Dilutive: As mentioned in the prior bullet, typically warehouse facilities do not result in dilution to either the intermediary or the end borrower. 
• Flexible: With warehouse financing, startup intermediaries can operate more flexibly. They can adapt to changes in demand, and respond quickly to market trends without being constrained by immediate capital limitations.
• Risk Mitigation: Typically most intermediaries only need to fund a portion of the deals they approve (5-20%) as such they have a much lower capital risk in the event of default.

Disadvantages of warehouse facility financing

• High Cost of Capital: Compared to bank debt, warehouse financing often comes at a much higher cost of capital which can be challenging for intermediaries to “sell” and the end borrowers to satisfy monthly payments. 
• Financial Obligation: Intermediaries need to make monthly payments to their lenders regardless of whether or not they are paid by the borrower. This can strain cash flow, particularly if the underlying portfolio experiences unexpected challenges.
• Market Dependency: Intermediaries' cost of capital is typically pegged to the underlying rates in the market. As rates rise, so does their cost of capital. 
• Default Risk: In some cases, if an intermediary breaks the covenants of its warehouse facility it may lose access to the facility or even be forced to prematurely pay off the rest of its outstanding balances.

Tips for your first warehouse facility financing

Raising and negotiating your first warehouse facility may seem like a daunting task, but don’t fret — the process is fairly straightforward should you prepare ahead of time. You’ll want to come prepared with a solid plan for how you intend to attract, qualify, and process credit applications. You’ll also want to create robust projections for how much loan volume you intend to process.

Step 1: Set clear objectives and priorities

Before you kick off the raise process, you’ll want to have a clear understanding of how much credit you are looking for. You’ll also want to understand how you intend to structure your terms to the end borrower and what cost of capital you are looking for. These should be based on your loan tape projections over the next 12-24 months and your level of confidence in said projections.

Step: 2: Identify lending partners

The reality is that not all lenders who will float your first warehouse facility are going to be a good fit for what you wish to accomplish. Start with a list of your top 25 potential partners and narrow it down based on feedback from other Fintech CEOs who have worked with them and ideally your investors.

Step 3: Establish your non-negotiables 

Come up with a list of terms that you would not be comfortable agreeing to. These can be limits on the highest interest rate you’d accept, limits on the shortest payback period you’d accept, or limits on the covenants you’d be prepared to accept. Once you’ve come up with the list, then bucket them into three categories: 1) non-starters, the things that you would not accept no matter what the other terms were; 2) semi-negotiables, the items that you would not be happy with accepting, but could stomach them; 3) nice-to-haves, these are the terms that you would like to see, but are willing to give them up for something better.

Step 4: Heatmap the key terms 

Once you’ve received the term sheets, it’s time to pull out your spreadsheet and go line by line. First note the basics. Then get into the nitty gritty and note how the lender defines a default event: what triggers a default, and what happens following a default. Then break down the required covenants, the associated clauses that trigger during a default, and the associated provisions.

Step 5: Reference the results of steps 3 & 4 and enter the negotiation

It's time to put your negotiation skills to the test, remember the more information you have the better. Start with the basics, amount, interest rate, and structure, and then work your way down to the more complex items. At some point (ideally the beginning) of the process you’ll want to bring your legal counsel into the mix. Remember: the goal of the negotiation process shouldn’t be to get everything you’re looking for, just the items that are most important to you.

Step 6: Ink the deal

You’re at the one-yard line, don’t fumble the ball with a last-minute request. If you’re happy (and comfortable) with the terms of the warehouse facility, then it's time to sign on the dotted line. You can always revisit the terms of the deal a bit further down the road when you have some wins under your belt.

Wrap up - raising a warehouse facility in 2024

Congrats! If you’ve made it this far, you’re well on your way to raising your first warehouse facility! Warehouse facilities are great for Fintechs that want to explore credit, but don’t want to get their lending license and for startups that want to add an embedded financing component into their product. They’re fairly scalable and flexible, they’re non-dilutive and they can help mitigate the risk associated with fully-funding a loan. However, they also come with a higher cost of capital, which can make “selling” credit difficult and if your portfolio is not properly managed, it can “blow up” at any time.

If you’d like additional tips on raising your first warehouse facility or if you’d like introductions to lenders get in touch with us.