1. Chapter 14 Understanding Financial Contracts

2. 2 Introduction Chapter focuses on financial contracts between lenders and borrowers Chapter focuses on financial contracts between lenders and borrowers Non-traded financial contracts are tailor- made to fit the characteristics of the borrower Non-traded financial contracts are tailor- made to fit the characteristics of the borrower In business financing, the differences in contracting can be great, both in terms of how financial instruments are originated and in the characteristics of the terms of contract In business financing, the differences in contracting can be great, both in terms of how financial instruments are originated and in the characteristics of the terms of contract

3. 3 Asymmetric Information Problems associated with the availability of information about the borrowers who seek funding. Problems associated with the availability of information about the borrowers who seek funding.

4. 4 How Business Obtains Financing Businesses need funds for a variety of reasons Businesses need funds for a variety of reasons Finance permanent assets such as plant and equipment Finance permanent assets such as plant and equipment Finance the acquisition of another business Finance the acquisition of another business Finance working capital—inventory or accounts receivable Finance working capital—inventory or accounts receivable

5. 5 Financing Small Businesses Small firms—assets less than $10 million Small firms—assets less than $10 million Vast majority are privately owned with ownership concentrated in a single family Vast majority are privately owned with ownership concentrated in a single family Generally do not need external financing beyond trade credit—delayed payment offered by suppliers Generally do not need external financing beyond trade credit—delayed payment offered by suppliers Profitable firms may have sufficient capital to be self-financing Profitable firms may have sufficient capital to be self-financing Banks are most likely source of external financing Banks are most likely source of external financing

6. 6 Banks Provide Funds Short-term loan—negotiated contract with short maturity Short-term loan—negotiated contract with short maturity Line of Credit Line of Credit Bank extends a credit for specified period of time Bank extends a credit for specified period of time The borrowing firm can draw down funds against L/C The borrowing firm can draw down funds against L/C Credit Rationing—insures borrower has access to funds even if bank would prefer to curtail new loans Credit Rationing—insures borrower has access to funds even if bank would prefer to curtail new loans When financing capital assets the maturity of the loan is typically less than life span of the asset When financing capital assets the maturity of the loan is typically less than life span of the asset

7. 7 Bank Loan Origination Locate a bank that meets your needs, usually through a referral Locate a bank that meets your needs, usually through a referral The bank’s loan officer conducts a complete credit analysis The bank’s loan officer conducts a complete credit analysis Review borrower’s financial statements Review borrower’s financial statements Visit the place of business Visit the place of business Assesses the managerial strengths/weaknesses of borrower Assesses the managerial strengths/weaknesses of borrower Provides an opportunity to develop a one-on- one relationship Provides an opportunity to develop a one-on- one relationship

8. 8 Bank Loan Origination

9. 9 Obtain additional information about the firm Obtain additional information about the firm Obtain credit report on the firm and borrower Obtain credit report on the firm and borrower Address any concerns with the borrower Address any concerns with the borrower Loan is approved by the bank Loan is approved by the bank Small loan approved by a loan officer Small loan approved by a loan officer Larger loans are approved by more senior officers Larger loans are approved by more senior officers Above a certain amount must get approval from loan committee Above a certain amount must get approval from loan committee Borrower and bank negotiate terms of the loan Borrower and bank negotiate terms of the loan Maturity of small business loans rarely exceeds 5 years Maturity of small business loans rarely exceeds 5 years

10. 10 Features of a Small Business Loan During application period and after the loan is granted, develop a relationship between bank and borrower During application period and after the loan is granted, develop a relationship between bank and borrower Loans are often collateralized Loans are often collateralized Pledging of assets against the loan Pledging of assets against the loan Secured lender—bank has the right to petition the bankruptcy court to sell the asset pledged as collateral to satisfy the loan Secured lender—bank has the right to petition the bankruptcy court to sell the asset pledged as collateral to satisfy the loan Unsecured lender—have right to proceeds from sale of assets after secured lenders have been paid Unsecured lender—have right to proceeds from sale of assets after secured lenders have been paid Owner may pledge personal assets as collateral Owner may pledge personal assets as collateral

11. 11 Features of a Small Business Loan Loan can be guaranteed by the owner Loan can be guaranteed by the owner Borrower is personally liable for any unpaid balance Borrower is personally liable for any unpaid balance Lender may require a personal financial statement of the borrower Lender may require a personal financial statement of the borrower With very small firms, often loan is strictly dependent on creditworthiness of the individual not the small business With very small firms, often loan is strictly dependent on creditworthiness of the individual not the small business

12. 12 Restrictive Covenants Loan may contain restrictive covenants Loan may contain restrictive covenants Covenant—promises that the company makes to the bank regarding their future actions and strategies Covenant—promises that the company makes to the bank regarding their future actions and strategies The bank may require an audited financial statement to verify the convents have not been broken The bank may require an audited financial statement to verify the convents have not been broken More restrictive covenants are linked to actions indicating the company has become riskier More restrictive covenants are linked to actions indicating the company has become riskier

13. 13 Financing Midsize Businesses Assets between $10 million and $150 million Assets between $10 million and $150 million Large enough to no longer be bank-dependent for external debt financing, but not large enough to issue traded debt in the public bond market Large enough to no longer be bank-dependent for external debt financing, but not large enough to issue traded debt in the public bond market Some are likely to be publicly owned—issue equity traded in the over-the-counter market Some are likely to be publicly owned—issue equity traded in the over-the-counter market Can either be owner managed or managed by someone other than the owner Can either be owner managed or managed by someone other than the owner

14. 14 Financing Midsize Businesses For short-term debt, principally rely on commercial banks For short-term debt, principally rely on commercial banks Depending on size of debt and bank, can use either local or non-local banks Depending on size of debt and bank, can use either local or non-local banks Typically have covenants placed on the loan and may pledge collateral Typically have covenants placed on the loan and may pledge collateral Revolving Line of Credit--access to longer-term debt financing through their commercial bank that combines an L/C with intermediate-term loan Revolving Line of Credit--access to longer-term debt financing through their commercial bank that combines an L/C with intermediate-term loan

15. 15 Financing Midsize Businesses Long-term debt financing is often provided by non-bank institutions Long-term debt financing is often provided by non-bank institutions Mezzanine debt funds provide loans to smaller midsize companies Mezzanine debt funds provide loans to smaller midsize companies Private Placement Market (Figure 14.2) Private Placement Market (Figure 14.2) Generally a bond issue in excess of $10 million Generally a bond issue in excess of $10 million Bonds do not have to be registered with the SEC Bonds do not have to be registered with the SEC Avoids public disclosure of information Avoids public disclosure of information Sold only to financial institutions and high net worth investors Sold only to financial institutions and high net worth investors

16. 16 Private Placement Origination

17. 17 Financing Large Businesses Firms with assets in excess of $150 million Firms with assets in excess of $150 million Becomes cost effective to enter the public bond market Becomes cost effective to enter the public bond market These bond issues are liquid assets that are traded in the secondary market These bond issues are liquid assets that are traded in the secondary market Therefore, can be issued at a lower yield than a nontraded instrument Therefore, can be issued at a lower yield than a nontraded instrument

18. 18 Financing Large Businesses Large businesses can afford the high distribution and underwriting costs of a public issue Large businesses can afford the high distribution and underwriting costs of a public issue Additional costs to sell to a wider range of investors Additional costs to sell to a wider range of investors Substantial costs associated with registering the bond with the SEC Substantial costs associated with registering the bond with the SEC Securities Underwriting (Figure 14.3) Securities Underwriting (Figure 14.3) Issuer selects an underwriter, generally an investment bank, to assist in issuing and marketing the bond Issuer selects an underwriter, generally an investment bank, to assist in issuing and marketing the bond Underwriters actively market their services to companies large enough to issue in the public market Underwriters actively market their services to companies large enough to issue in the public market

19. 19 Securities Underwriting

20. 20 Shelf Registration Permits the issuer of a public bond to register a dollar capacity with the SEC Permits the issuer of a public bond to register a dollar capacity with the SEC Draw down on this capacity at any time Draw down on this capacity at any time This avoids additional registration requirements This avoids additional registration requirements Permits issuers to respond instantaneously to changing market conditions Permits issuers to respond instantaneously to changing market conditions

21. 21 Financing Large Businesses Large companies with good credit ratings tend to rely on the commercial paper market for short-term financing Large companies with good credit ratings tend to rely on the commercial paper market for short-term financing Some very large businesses also issue medium- term notes, which are like commercial paper, except maturities range from one year to five years Some very large businesses also issue medium- term notes, which are like commercial paper, except maturities range from one year to five years Also issue equities, through underwriters, which is another form of external long-term financing Also issue equities, through underwriters, which is another form of external long-term financing