Obtaining Debt Capital Venture Planning Chapter 15 Dowling Fall 2006

Sources of Debt Capital Sources of debt capital Sources of debt capital Trade credit Trade credit Commercial banks Commercial banks Finance companies Finance companies Factors Factors Leasing companies Leasing companies

Exhibit 15.1

Exhibit 15.2

Trade Credit Trade credit Trade credit percent of current liabilities of non-financial companies percent of current liabilities of non-financial companies The smaller the firm, the higher this percentage The smaller the firm, the higher this percentage Suppliers offer trade credit to attract new customers Suppliers offer trade credit to attract new customers Bad debt risk is built into prices Bad debt risk is built into prices Costs of trade credit include lost discounts for prompt payment Costs of trade credit include lost discounts for prompt payment

Commercial Banks Common types of financing involving the use of a bank: Common types of financing involving the use of a bank: Line of credit loans Line of credit loans Time-sales finance Time-sales finance Term loans Term loans Chattel mortgages and equipment loans Chattel mortgages and equipment loans Conditional sales contracts Conditional sales contracts Plant improvement loans Plant improvement loans

Commercial Bank Financing Commercial Bank Financing Commercial Bank Financing Generally more readily available to existing businesses with a track record of sales, profits, satisfied customers and a current backlog Generally more readily available to existing businesses with a track record of sales, profits, satisfied customers and a current backlog Positive cash flow and collateral Positive cash flow and collateral Great importance placed on quality of management team Great importance placed on quality of management team

Line of Credit Loans Line of credit loans Line of credit loans Agreement setting out maximum loan balance a bank will allow the borrower for a one-year period Agreement setting out maximum loan balance a bank will allow the borrower for a one-year period Used for such seasonal financings as inventory buildup and receivables financing Used for such seasonal financings as inventory buildup and receivables financing For “prime risk” (financially sound) companies, lines of credit generally available at 1 to 2 percent over Fed’s rediscount rate For “prime risk” (financially sound) companies, lines of credit generally available at 1 to 2 percent over Fed’s rediscount rate

Accounts Receivable Financing Accounts receivable financing Accounts receivable financing Short-term financing involving either pledge of receivables as collateral for a loan or the sale of receivables Short-term financing involving either pledge of receivables as collateral for a loan or the sale of receivables Made on a discounted value of the receivables pledged Made on a discounted value of the receivables pledged

Time Sales Financing Time-sales finance Time-sales finance Way of obtaining short-term financing from long- term installment accounts receivable Way of obtaining short-term financing from long- term installment accounts receivable Bank purchases installment contracts at discount rate from their full value and takes as security an assignment of the manufacturer/dealer’s interest in the conditional sales contract Bank purchases installment contracts at discount rate from their full value and takes as security an assignment of the manufacturer/dealer’s interest in the conditional sales contract

Unsecured Term Loans Unsecured term loans Unsecured term loans Provide needed growth capital to those that can’t obtain the capital from the sale of stock Provide needed growth capital to those that can’t obtain the capital from the sale of stock Substitute for a series of short-term loans made with the anticipation of renewal by both the borrower and the lender Substitute for a series of short-term loans made with the anticipation of renewal by both the borrower and the lender

Chattel Mortgages and Equipment Loans Chattel Mortgages and Equipment Loans Chattel Mortgages and Equipment Loans Chattel is any machinery, equipment, or business property that is made the collateral of a loan in the same way as a mortgage on real estate Chattel is any machinery, equipment, or business property that is made the collateral of a loan in the same way as a mortgage on real estate

Obtaining Debt Capital Conditional sales contracts Conditional sales contracts Effective rate of interest on a conditional sales contract is high, running to as high as percent if the effect of installment features is considered Effective rate of interest on a conditional sales contract is high, running to as high as percent if the effect of installment features is considered Plant improvement loans Plant improvement loans Can be intermediate- and long-term, and are generally secured by first mortgage on that part of the property that is being improved Can be intermediate- and long-term, and are generally secured by first mortgage on that part of the property that is being improved

Sources of Debt Capital Commercial finance companies Commercial finance companies Factoring Factoring Leasing companies Leasing companies

Commercial Finance Companies Frequently lend money to companies that do not have positive cash flow Frequently lend money to companies that do not have positive cash flow Will not make loans to companies unless they consider them viable risks; usually more accepting of risk than are banks Will not make loans to companies unless they consider them viable risks; usually more accepting of risk than are banks

Factoring Factoring—a form of accounts receivable financing where the receivables are sold, at a discounted value, to a factor Factoring—a form of accounts receivable financing where the receivables are sold, at a discounted value, to a factor The factor buys the client’s receivables outright, without recourse, as soon as the client creates them, by shipment of goods to customers The factor buys the client’s receivables outright, without recourse, as soon as the client creates them, by shipment of goods to customers Cash is made available to the client as soon as proof is provided (old-line factoring) or on the average due date of the invoices (maturity factoring) Cash is made available to the client as soon as proof is provided (old-line factoring) or on the average due date of the invoices (maturity factoring)

Leasing Companies Leasing companies—leases common and readily resalable items such as automobiles, trucks, computer equipment, and office furniture to both new and existing businesses: Leasing companies—leases common and readily resalable items such as automobiles, trucks, computer equipment, and office furniture to both new and existing businesses: Up front payment required of about 150 percent of the value of the item being leased Up front payment required of about 150 percent of the value of the item being leased Interest may be more or less than other forms of financing, depending on the equipment leased, the credit of the lessee, and the time of year Interest may be more or less than other forms of financing, depending on the equipment leased, the credit of the lessee, and the time of year

What to Look for in a Bank Knowledge Knowledge Sense of urgency Sense of urgency Teaching talent Teaching talent Industry knowledge Industry knowledge Financial stability Financial stability Manager (Loan Officer) with backbone Manager (Loan Officer) with backbone

Exhibit 15.3

Managing the Banking Relationship Managing and orchestrating the banking relationship Managing and orchestrating the banking relationship The lending decision: The lending decision: Need more today than a good relationship with a loan officer to secure funding. Need more today than a good relationship with a loan officer to secure funding. Analysis and documentation are generally required. Analysis and documentation are generally required.

Managing the Banking Relationship The TLC of a banker or other lender: The TLC of a banker or other lender: Your banker is your partner, not a difficult minority shareholder Your banker is your partner, not a difficult minority shareholder Be honest and straightforward in sharing info Be honest and straightforward in sharing info Invite the banker to see your business in operation Invite the banker to see your business in operation Always avoid overdrafts, late payments and late financial statements Always avoid overdrafts, late payments and late financial statements Answer questions frankly and honestly. Tell the truth. Lying is illegal and undoubtedly violates covenants. Answer questions frankly and honestly. Tell the truth. Lying is illegal and undoubtedly violates covenants.

Bank Lending Criteria Lending criteria: Lending criteria: Quality and track record of management team Quality and track record of management team Historical financial statements show 3-5 years of profitability Historical financial statements show 3-5 years of profitability Well-developed business plan Well-developed business plan Analysis of debt capacity Analysis of debt capacity Ability of company to repay both principal and interest on time Ability of company to repay both principal and interest on time

Bank Loans After the loan decision: After the loan decision: Loan restrictions Loan restrictions Negative covenants Negative covenants Positive covenants Positive covenants

Personal Loan Guarantees Personal guarantees and the loan Personal guarantees and the loan When to expect them: When to expect them: You’re under-collateralized You’re under-collateralized You’ve had poor or erratic performance You’ve had poor or erratic performance You’ve had management problems You’ve had management problems Your relationship with your banker is strained Your relationship with your banker is strained You have a new loan officer You have a new loan officer There is turbulence in credit markets There is turbulence in credit markets Wave of bad loans made by lending institutions Wave of bad loans made by lending institutions

Personal Loan Guarantees Personal guarantees and the loan Personal guarantees and the loan How to avoid them: How to avoid them: Good to spectacular performance Good to spectacular performance Conservative financial management Conservative financial management Adequate collateral Adequate collateral Careful management of the balance sheet Careful management of the balance sheet

Obtaining Debt Capital Beware of leverage: the ROE mirage Beware of leverage: the ROE mirage Leverage creates an unforgiving capital structure and the potential additional ROI often is not worth the risk Leverage creates an unforgiving capital structure and the potential additional ROI often is not worth the risk

Exhibit 15.4

Exhibit 15.5

Exhibit 15.6

Exhibit 15.8