1. Dealing with the banks

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. Short-term loan—negotiated contract with short maturity
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. 1. Locate a bank that meets your needs, usually through a referral
Bank Loan Origination
1. Locate a bank that meets your needs, usually through a referral
2. 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
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
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. Draw down on this capacity at any time
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

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

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

26. A formal agreement must include:
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

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

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

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. Involves using any possible method for conserving cash, such as:
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

31. Disadvantages of using outside capital
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

32. Structuring capital requirements is paramount
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