Chapter 14

1. Chapter 14 Understanding Financial Contracts

2. Introduction • Chapter focuses on financial contracts between lenders and borrowers • 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

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

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

5. Financing Small Businesses • Small firms—assets less than $10 million • 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 • Profitable firms may have sufficient capital to be self-financing • Banks are most likely source of external financing

6. Banks Provide Funds • Short-term loan—negotiated contract with short maturity • Line of Credit • Bank extends a credit for specified period of time • 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 • When financing capital assets the maturity of the loan is typically less than life span of the asset

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

8. Bank Loan Origination

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

10. Features of a Small Business Loan • During application period and after the loan is granted, develop a relationship between bank and borrower • Loans are often collateralized • 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 • Unsecured lender—have right to proceeds from sale of assets after secured lenders have been paid • Owner may pledge personal assets as collateral

11. Features of a Small Business Loan • Loan can be guaranteed by the owner • Borrower is personally liable for any unpaid balance • 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

12. Restrictive Covenants • Loan may contain restrictive covenants • 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 • More restrictive covenants are linked to actions indicating the company has become riskier

13. Financing Midsize Businesses • 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 • 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

14. Financing Midsize Businesses • For short-term debt, principally rely on commercial 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 • Revolving Line of Credit--access to longer-term debt financing through their commercial bank that combines an L/C with intermediate-term loan

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

16. Private Placement Origination

17. Financing Large Businesses • Firms with assets in excess of $150 million • Becomes cost effective to enter the public bond 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

18. Financing Large Businesses • Large businesses can afford the high distribution and underwriting costs of a public issue • Additional costs to sell to a wider range of investors • Substantial costs associated with registering the bond with the SEC • Securities Underwriting (Figure 14.3) • 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

19. Securities Underwriting

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

21. Financing Large Businesses • 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 • Also issue equities, through underwriters, which is another form of external long-term financing