Debtor-in-Possession (DIP) Financing: Definition, Operation, and Real-World Examples

Debtor-in-possession (DIP) financing is a specialized form of funding designed for companies navigating the complex waters of bankruptcy, specifically under Chapter 11. It serves as a financial instrument that enables these companies, referred to as debtors-in-possession, to secure capital essential for sustaining their operations while the bankruptcy proceedings unfold. What sets DIP financing apart is its priority status, often superseding existing debt, equity, and other claims.

Chapter 11 bankruptcy places a strong emphasis on corporate reorganization rather than liquidation. Seeking bankruptcy protection can be a crucial lifeline for distressed companies in dire need of financial support. In the case of debtor-in-possession (DIP) financing, the court must approve the financing plan, ensuring it aligns with the protection granted to the business. The lender’s oversight of the loan is also subject to the court’s scrutiny and approval. If the financing is sanctioned, the business gains the necessary liquidity to continue its operations.

Securing DIP financing sends a clear message to vendors, suppliers, and customers that the debtor company will remain in business, fulfill its service obligations, and make payments for goods and services during the reorganization process. When a lender determines that the company is creditworthy after a thorough financial evaluation, it’s likely that the marketplace will reach a similar conclusion.

Notably, during the Great Recession, two prominent U.S. automakers, General Motors and Chrysler, availed themselves of debtor-in-possession (DIP) financing to steer through their financial crises successfully.

DIP financing typically comes into play at the outset of the bankruptcy filing process. However, many struggling companies that could benefit from the protective measures of the court may delay filing due to an unwillingness to acknowledge their predicament. Such hesitation and procrastination can consume valuable time, as the DIP financing process often proves to be lengthy.

Once a company enters Chapter 11 bankruptcy and identifies a willing lender, it must secure approval from the bankruptcy court. Lending under bankruptcy law provides a lender with a level of comfort when extending financial support to a financially distressed company. DIP financing lenders enjoy the first claim on the company’s assets in case of liquidation, an approved budget, a market or premium interest rate, and any additional protective measures deemed necessary by the court or lender. Existing lenders often have to agree to these terms, especially regarding their position relative to the lien on assets.

The approved budget is a critical component of DIP financing. The “DIP budget” incorporates a forecast of the company’s income, expenses, net cash flow, and outflows for specific periods. It must also account for the timing of payments to vendors, professional fees, seasonal variations in receipts, and capital expenditures. Once the DIP budget is mutually agreed upon, both parties will determine the size and structure of the credit facility or loan. This negotiation and planning process is essential for securing DIP financing effectively.

DIP financing is often provided in the form of term loans. Term loans are fully funded throughout the bankruptcy process, leading to higher interest costs for the borrower. Historically, revolving credit facilities were more commonly used, allowing borrowers to draw down the loan and repay it as needed, similar to a credit card. This offered more flexibility and lower interest costs, as borrowers could actively manage the borrowed amount.

Not all companies are eligible for DIP financing. It is primarily available to companies that have filed for bankruptcy protection under Chapter 11. The court must approve the financing plan.

DIP financing signals to vendors, suppliers, and customers that the debtor company can continue its operations, ensuring the provision of services and payments for goods during the reorganization process.

While term loans have become more prevalent, historically, revolving credit facilities were also used for DIP financing. The choice between term and revolving loans depends on the specific needs of the debtor company.