Understanding Financial
Contracts

Financial Contracts
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Business borrow funds from the financial markets primarily through two ways:
Direct Financing
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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
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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
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 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
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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
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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

Origination Mechanism
Credit Analysis
 Reviewing of financial statements by a loan officer
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Visiting the place of business
Assessing managerial strengths
 Future growth potential and cash flow projection
 Seeking additional information about the firm
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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 bankdependent 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
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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 institutions
 Through Private Placement Market

Long Term Debt Financing
Non-Bank Institutions
 Mezzanine debt funds provide loans to smaller midsize companies
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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 Origination.

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 Businesses
Features
 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)
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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.

Securities Underwriting
Registration Statement
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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
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Underwriting syndicate
Formed by the managing underwriter to share responsibility of
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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
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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
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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
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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
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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 shortterm basis

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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 tailormade contract
 May have access to long-term debt in the private placement market