Non-traded financial contracts

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1 11-1

2 Introduction Financial contracts are made 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 working capital inventory or accounts receivable Finance permanent assets such as plant and equipment Finance acquisitions of other businesses

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 2. The bank s loan officer conducts a complete credit analysis 1. Locate a bank that meets your needs, usually through a referral 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 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 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 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

22 Debt or Equity Financing Debt financing: Obtaining borrowed funds for the company Requires asset to be used as collateral Equity financing: Obtaining funds for the company in exchange for ownership Does not require collateral Offers investor some form of ownership position 11-22

23 Internal or External Funds Internal funds- Generated from sources within the company Profits Sale of assets Working capital reduction Accounts receivable Short-term internal source of funds: Reducing short-term assets Extended payment terms from suppliers

24 Personal Funds Least expensive in terms of cost and control Essential for attracting outside funding Sources include: Savings Life insurance Mortgage on a house or car 11-24

25 Family and Friends Likely to invest due to relationship with entrepreneur Advantage - Easy to obtain money Disadvantage - Direct input into operations of a venture 11-25

26 Family and Friends A formal agreement must include: Amount of money involved Terms of the money Rights and responsibilities of the investor Steps to be taken when a business fails 11-26

27 Commercial Banks Asset base for loan Tangible collateral valued at more than the amount of money borrowed Types of bank loans Accounts receivable Inventory Equipment Real-estate 11-27

28 Commercial Banks Conventional bank loans: Standard way banks lend money to companies Installment Straight commercial Long-term Character 11-28

29 Analyzing, managing, and pricing credit risk One of a lending officer s main tasks is to analyze a customer s creditworthiness (default risk premium) by using: Five C s of Credit: 1. Character (willingness to pay) 2. Capacity (cash flow) 3. Capital (wealth or net worth) 4. Collateral (security for the loan) 5. Conditions (economic conditions) Credit scoring: is an efficient, inexpensive and objective method of analyzing a potential customer s character. It involves assigning a potential borrower a score based on the information in the borrower s credit report

30 Bootstrap Financing Involves using any possible method for conserving cash, such as: Use of discounts for volume Frequent customer discounts Promotional discounts Obsolescence money Savings through bulk packaging Consignment financing 11-30

31 Bootstrap Financing Disadvantages of using outside capital Takes between three and six months to raise Decreases a firm s drive for sales and profits Increases the impulse to spend Decreases the company s flexibility May cause disruption and problems in the venture 11-31

32 Conclusions Banks are generally the least expensive alternative with minimal inference in a sound business Other alternatives should always be looked at in case of unforeseen difficulties Structuring capital requirements is paramount Your banker should be your friend 11-32

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