Financial Contracts
Business borrow funds from the financial markets primarily through two ways:
Direct Financing Directly from savers Issuing traded securities
Indirect Financing Through financial intermediaries Issuing non-traded securities
Financial contracts are written between lenders and borrowers
Financial Contracts
Non-traded financial contracts Tailor-made to fit the characteristics of the borrower
Lenders tend to hold these securities until maturity
Financial Contracts
Publicly traded financial contracts Standardized Suitable to meet the needs of large number of investors
Lenders may not hold these securities until maturity
In this case, they will only receive holing period returns
Financial Contracts
Features of Financial Contracts Describes how instruments/securities are originated
Describes terms of contract Maturity Interest rates
Describes restrictive covenants
Why Business Needs Financing
Common Reasons for Financing To finance permanent assets such as plant and equipment
To finance working capital Inventory accounts receivable
To finance payroll To finance the acquisition of another business
Financing Small Businesses
Definition of Small Business Assets size: less than $10 million
Most of them are privately owned Therefore, do not issue stocks Ownership concentrated in a single family
Financing Small Businesses
Features of Small Business Financing Profitable ones often have sufficient capital to be self-financing
Generally, do not need external financing beyond trade credit Delayed payment offered by suppliers
Banks are most likely source of external financing
Financing Small Businesses
Features of Small Business Financing Receives funds from banks in two forms: Negotiated Short-term loan Line of credit (L/C)
Financing Small Businesses
Short Term Loans Negotiated contract with short maturity
One time, needs renegotiation each time loans are extended
Typical maturity is 90 days of less
Financing Small Businesses
Line of Credit (L/C) Bank extends a credit for specified period of time
The borrowing firm draws down funds against L/C
Provides a continuous source for working capital
Removes uncertainty of denials or credit rationing Credit Rationing: A situation when banks curtails issuance of new loans often in response information asymmetry
Financing Small Business
Origination Mechanism Locate a bank that meets business’s needs
Usually through a referral (bank’s accountant)
Origination involves three steps: Credit analysis Negotiation of terms Loan approval or Denial
Origination Mechanism
Credit Analysis Reviewing of financial statements by a loan officer
Visiting the place of business Assessing managerial strengths Future growth potential and cash flow projection
Seeking additional information about the firm
Obtaining credit report on the firm Addressing any other concerns with the borrower
Origination Mechanism
Negotiation Phase Borrower and bank negotiate terms of the loan
Loan Approval Small loans can be approved by a loan officer
Larger loans are approved by more senior officers
Above a certain amount must get approval from loan committee
Financing Small Businesses
Unique Features Loans have shorter maturity (rarely exceeds 5 years)
Loans are often secured (collateralized): Pledging of assets against the loan Owner often pledges personal assets as collateral and be personally liable for any unpaid balance
Bank has the right to petition the bankruptcy court to sell the asset pledged as collateral to recoup the balance
During application period and after the loan is granted, a personal relationship between bank and borrower is developed
Financing Small Businesses
Unique Features Loan contains restrictive covenants
Covenant: Restrictions placed by the lender on future actions and strategies of the borrowing firm
Designed to make sure that firm does not become risky
An audited financial statement is required to verify the convents are not been broken
When covenants are broken, bank may demand immediate payment of loan
Possible for the borrower to renegotiate the terms of the loan to reflect higher risk
Financing Midsize Businesses
Definition of Midsize Business Assets between $10 million and $150 million
Owner managed or managed by someone other than the owner
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 publicly owned that issue equity or stocks traded in the over-the-counter market
Financing Midsize Businesses
Features For short-term debt, primarily rely on commercial banks
May rely on a local or non-local bank May have restrictive covenants May be required to pledge collateral For long-term debt, commercial bank may combine a line of credit with intermediate-term loan known as Revolving Line of Credit
Financing Midsize Businesses
Long Term Debt Financing Forms of financing:
Through non-bank institutionsThrough Private Placement Market
Long Term Debt Financing
Non-Bank Institutions Mezzanine debt funds provide loans to smaller midsize companies
Recall, these are financing that lie between straight debt and equity. Typical forms are: Combination of both debt and equity financing
Convertible Debt Subordinate Debt
Long Term Debt Financing
Private Placement Market Mid-size business issues bonds over $10 million
Sold only to financial institutions and high net worth investors with sophisticated knowledge of investment
Bonds do not have to be registered with the SEC
Public disclosure of information is not required
Private Placement Market
Features Generally not resold by original investor for at least two years
Covenants that are less restrictive than when borrowing from a bank
Terms can be renegotiated one or more times during the life span of the loan if the company wishes to embark on a new strategy
Private Placement Market
Origination Structured and marketed by an agent, commercial banks or investment banks
Due diligence: the agent handling the private placement evaluates the firm’s management, financial condition, and business capabilities
Credit Rating: Based on due diligence, the placement issue will receive a formal credit rating which measures the perceived risk from a rating agency (such as NAIC)
Private Placement Market
Origination Contract Construction The terms of the contract including interest rate, maturity, covenants, and any special features are negotiated to make it attractive to investors
Offering memorandum and Term sheet containing information of the issuing firm and the contract terms are sent to prospective investors
Once the issue is placed, the investors do their own due diligence which verifies the information in the issue
Financing Large BusinessesFeatures Large firms are the ones with assets in excess of $150 million
Cost effective to enter the public bond market Public bonds are liquid. Issuer receives a Liquidity Premium (offer a lower interest rate)
However, public bond issues can be costly For Issues more than 100m, gain from liquidity premium can more than offset the cost of public bond issuance
Financing Large Businesses
Cost of Issuing Public Bond Distribution cost: costs to sell to a wider range of investors
Registration cost: costs associated with registering the bond with the SEC
Underwriting cost: costs of issuing and marketing a public issue
Securities Underwriting
Underwriting Process: Issuer selects an underwriter, generally an investment bank or a commercial bank to assist in issuing and marketing the bond
Underwriters also market their services to companies large enough to issue in the public market
Underwriter does due diligence on the issuer and comes up with two items: Registration Statement Offering (preliminary) prospectus
Securities Underwriting
Registration Statement Must conform disclosure requirements Certified by underwriter, accountants, and issuing firm’s attorneys
The registration statement must be approved by the SEC before distribution
Offering (preliminary) prospectus Must contain relevant factual information about the firm and its financing history
Role of Underwriter
Underwriting syndicate Formed by the managing underwriter to share responsibility of Distribution the issue Underwriting risk
Underwriter provides a firm commitment to sell the issue at a commitment price
Involves extensive market research Ability to attract institutional investors
Role of Underwriter
Underwriting Spread The difference between the offering price and the commitment price
Serves as the profit to underwriters Underwriting risk Occurs when the underwriters make a firm commitment to sell the bonds at an agreed price (implied interest rate)
If bonds sell below this price, underwriter takes a loss
Financing Large Businesses
Shelf Registration Permits the issuer of a public bond to register a dollar capacity with the SEC
This avoids lengthy registration time Permits issuers to respond instantaneously to changing market conditions
Draw down on this capacity by calling for competitive bids from investment bankers
Whenever underwriting syndicate is formed after the winning the bid, it is called a bought deal
Financing Large Businesses
Summary For short-term financing, Large companies with good credit ratings tend to rely on commercial paper market
Very large businesses may be able to issue medium-term notes.
For long-term financing, they issue public bond or equities through underwriters
Equity issues are much less frequent than bond
Equity issuance requires larger syndicate and enable higher profits to investment bankers.
Economics of Financial Contracting
Why do firms of different size rely on different financial contracts to raise funds Transactions costs Asymmetric information
Asymmetric Information
Adverse Selection Caused by asymmetric information before a transaction is consummated
Bank loan officer cannot easily tell the difference between high and low quality borrowers
Part of the loan officer’s job is to use credit analysis to uncover relevant information
Asymmetry of information is particularly acute for small firms since there is little publicly available information
Asymmetric Information
Moral Hazard Occurs after the loan is made Loan contract may provide the firm an incentive to pursue actions that take advantage of the lender If the firm does very well, the owner does not pay more to the issuer of the bank loan
If the firm does poorly, the owner’s liability is limited to the terms of the loan
Therefore, owners disproportionately share in the upside of increased risk, while lenders disproportionately share in the downside
Economics of Financial Contracting
Large firms Relatively easy to observe Labor contracts are often public knowledge
Supplier relationships are often well known
Marketing success or failure is well documented
Cares about its reputation and therefore, motivated to not switch to high risk activities
Economics of Financial Contracting
Large firms Public markets for stocks and bonds will generally reflect true riskiness of investment.
Prices and yields for large firms will be determined accordingly
Economics of Financial Contracting
Small firms External reputations are difficult to establish
Most activities are beyond the public’s scrutiny
Need proxies to demonstrate they are low risk and committed to not shifting their risk profiles
Economics of Financial Contracting
Small firms Some common proxies include:
Outside collateral or personal guarantees plays an important role
Inside collateral, bank files a lien against collateral
Loan covenants prevent risk shifting by explicitly constraining borrower behavior
Economics of Financial Contracting
Small firms Cannot enter into long-term debt contracts
Small business are made on a short-term basis
Economics of Financial Contracting
Midsize Companies Their information problems lie between small and large size companies
More visible publicly than small, but more informationally opaque than large companies
Still need a financial intermediary at the origination stage to address adverse selection problems and design a tailor-made contract
May have access to long-term debt in the private placement market