Chapter 14
Understanding
Financial
Contracts
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Learning Objectives
• Differentiate among the different mechanisms of
external financing of firms
• Explain why mechanisms of external financing
depend upon firm size
• Understand how financial contracts may reduce
the adverse selection and moral hazard problems
of asymmetric information
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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
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Introduction (Cont.)
• Asymmetric information—problems
associated with the availability of information
about the borrowers who seek funding
• Apply this concept to analysis to contrast the
differences between consumer and business
financing
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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
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How Business Obtains Financing
(Cont.)
• 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 selffinancing
– Banks are most likely source of external financing
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How Business Obtains Financing
(Cont.)
• Financing Small Businesses (Cont.)
– Provide funds via a short-term loan or line of credit (L/C) for
either working capital or purchase of plant and equipment
• 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
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How Business Obtains Financing
(Cont.)
• Financing Small Businesses (Cont.)
– Bank Loan Origination (Figure 14.1)
• 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
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FIGURE 14.1 Bank loan origination.
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How Business Obtains Financing
(Cont.)
• Financing Small Businesses (Cont.)
– Bank Loan Origination (Figure 14.1) (Cont.)
– 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
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How Business Obtains Financing
(Cont.)
• Financing Small Businesses (Cont.)
– Unique features of a small business loan
• During application period and after the loan is granted,
develop a relationship between bank and borrower
• Banks offer a wide menu of options to 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
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How Business Obtains Financing
(Cont.)
• Financing Small Businesses (Cont.)
– Unique features of a small business loan (Cont.)
• Loans are often collateralized (Cont.)
– Unsecured lender—have right to proceeds from sale of assets
after secured lenders have been paid
– Owner may pledge personal assets as collateral
• 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
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How Business Obtains Financing
(Cont.)
• Financing Small Businesses (Cont.)
– Unique features of a small business loan (Cont.)
• 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
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How Business Obtains Financing
(Cont.)
• Financing Small Businesses (Cont.)
– Unique features of a small business loan (Cont.)
• Loan may contain restrictive covenants (Cont.)
– If violated, bank may demand immediate payment of loan
– Possible for the borrower to renegotiate the terms of the loan
to reflect higher risk
• Maturity of small business loans rarely exceeds 5 years
• With very small firms, often loan is strictly dependent on
creditworthiness of the individual not the small business
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How Business Obtains Financing
(Cont.)
• 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
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How Business Obtains Financing
(Cont.)
• Financing Midsize Businesses (Cont.)
– 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
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How Business Obtains Financing
(Cont.)
• Financing Midsize Businesses (Cont.)
– Long-term debt financing is often provided by nonbank 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
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How Business Obtains Financing
(Cont.)
• Financing Midsize Businesses (Cont.)
• Private Placement Market (Cont.)
– Generally not resold by original investor for at least two years
– Have covenants that are generally less restrictive than when
borrowing from a bank
– Terms will be renegotiated one or more times during the life
span of the loan if the company wishes to embark on a new
strategy
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How Business Obtains Financing
(Cont.)
• Financing Midsize Businesses (Cont.)
– Private Placement Origination (Figure 14.2)
• Issued through agents, commercial banks or investment
banks who structure the contract and market the issue
• Due diligence—the agent handling the private placement
evaluates the firm’s management, financial condition, and
business capabilities
• Based on due diligence, the placement issue will receive a
formal credit rating which measures the perceived risk
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FIGURE 14.2 Private placement
origination.
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How Business Obtains Financing
(Cont.)
• Financing Midsize Businesses (Cont.)
– Private Placement Origination (Figure 14.2) (Cont.)
• The terms of the contract are negotiated to be attractive to investors—
interest rate, maturity, covenants, and any special features
• Offering memorandum/term sheet containing information of the
firm and the offering are sent to prospective investors
• Once the issue is placed, the investors do their own due diligence
which verifies the original information
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How Business Obtains Financing
(Cont.)
• 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
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How Business Obtains Financing
(Cont.)
• Financing Large Businesses (Cont.)
– 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
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FIGURE 14.3 Securities underwriting.
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How Business Obtains Financing
(Cont.)
• Financing Large Businesses (Cont.)
– Securities Underwriting (Figure 14.3) (Cont.)
• Underwriter does due diligence on the issuer and then
issues the following items
– Registration Statement—conforms to specific disclosure
requirements
– Offering (preliminary) prospectus—contains all relevant
factual information about the firm and its financing
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How Business Obtains Financing
(Cont.)
• Financing Large Businesses (Cont.)
– Securities Underwriting (Figure 14.3) (Cont.)
• Registration statement is blessed by the underwriter, the
accountants, and issuing firm’s attorneys
• The registration statement is approved by the SEC and can
now be distributed
• Role of underwriter in the distribution
– Underwriting syndicate is formed by the managing underwriter
to share responsibility for distribution the issue and the
underwriting risk
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How Business Obtains Financing
(Cont.)
• Financing Large Businesses (Cont.)
– Securities Underwriting (Figure 14.3) (Cont.)
• Role of underwriter in the distribution (Cont.)
– 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
– Underwriting Spread—hope to sell bonds at a higher offering
price, above the commitment price
• It is difficult to incorporate highly restrictive covenants in
publicly traded bonds
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How Business Obtains Financing
(Cont.)
• Financing Large Businesses (Cont.)
– 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
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How Business Obtains Financing
(Cont.)
• Financing Large Businesses (Cont.)
– Large companies with good credit ratings tend to
rely on the commercial paper market for shortterm 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
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The Economics of Financial
Contracting
• Figure 14.4 summarizes method and nature of financial
contracting according to firm size.
• The concept of transactions costs helps explain why
firms of different size rely on different financial
contracts to raise funds
• However, to fully understand the differences must rely
on the concept of asymmetric information—buyers
and sellers are not equally informed about the quality
of the product
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FIGURE 14.4 Credit market
comparison.
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The Economics of Financial
Contracting (Cont.)
• Asymmetric Information and Financial Contracting
– 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
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The Economics of Financial
Contracting (Cont.)
• Asymmetric Information and Financial
Contracting (Cont.)
– Adverse Selection (Cont.)
• As a result, loans are often structured such that borrowers
can signal their true quality based on the types of loans
they will accept
– Is owner willing to pledge personal outside assets as collateral or
offer a personal guarantee?
– If owner is not willing, this would signal that they are uncertain
of the future
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The Economics of Financial
Contracting (Cont.)
• Asymmetric Information and Financial
Contracting (Cont.)
– Moral Hazard
• Occurs after the loan is made
• Loan contract may give the firm the 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
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The Economics of Financial
Contracting (Cont.)
• Asymmetric Information and Financial
Contracting (Cont.)
– Moral Hazard (Cont.)
• Therefore, owners disproportionately share in the upside
of increased risk, while lenders disproportionately share in
the downside
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The Economics of Financial
Contracting (Cont.)
• Contracting and Firm Continuum
– There are things firms can do to convince potential lenders
that they will not engage in risky tactics
– Large firms
• Relatively easy to observe—any risk shifting is easily detected
–
–
–
–
Labor contracts are often public knowledge
Supplier relationships are often well known
Marketing success or failure is well documented
Motivated to not switch to high risk activities—the firm’s desire to
maintain their reputation
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The Economics of Financial
Contracting (Cont.)
• Contracting and Firm Continuum (Cont.)
– Large firms (Cont.)
• Therefore, public markets for stocks and bonds will
generally reflect true riskiness of investment strategies,
with prices and yields determined accordingly
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The Economics of Financial
Contracting (Cont.)
• Contracting and Firm Continuum (Cont.)
– Small firms
• External reputations are difficult to establish
• Most activities are beyond the public’s scrutiny
• Therefore, need proxies to demonstrate they are low risk and
committed to not shifting their risk profiles
– Outside collateral or personal guarantees place more of the owner’s
wealth at risk
– Inside collateral, bank files a lien against collateral
– Loan covenants prevent risk shifting by explicitly constraining borrower
behavior
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The Economics of Financial
Contracting (Cont.)
• Contracting and Firm Continuum (Cont.)
– Small firms (Cont.)
• Small firms cannot enter into long-term debt contracts
since there is too much flexibility given the incentives to
shift risk
• Therefore, bank loans to small business are typically
made on a short-term basis
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The Economics of Financial
Contracting (Cont.)
• Contracting and Firm Continuum (Cont.)
– Midsize Companies
• Their information problems lie between small and large size
companies
• More visible publicly than small, but more informationally impaired
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
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14-40
The Economics of Financial
Contracting (Cont.)
• Firm Continuum (Figure 14.5)
– Describes the relationship between information and
market access in terms of a firm continuum
– The larger the firm, greater and more accurate
information becomes available
– As a firm matures there is more access to long-term
financial contracts, first in the private placement
market progressing into publicly traded stocks and
bonds
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FIGURE 14.5 Firm continuum.
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The Economics of Financial
Contracting (Cont.)
• Firm Continuum (Figure 14.5) (Cont.)
– Growth also enables the firm to obtain different
types of short-term credit
– A firm may revert back to a form of financial
contract typically associated with a smaller firm, but
this is consistent with the concept of firm
continuum and the firm will do what is in their best
interest
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The Economics of Financial
Contracting (Cont.)
• Consumer Lending, Financial Contracting and
Securitization
– Asymmetric information also exists in consumer lending
– Some consumers are high-risk borrowers, some are low-risk
– Adverse selection exists since it might be difficult to
determine the riskiness of a potential borrowers
– Moral hazard is also present since consumers may borrow for
one purpose and switch to a riskier activity
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14-44
The Economics of Financial
Contracting (Cont.)
• Consumer Lending, Financial Contracting
and Securitization (Cont.)
– Consumer lenders use some of the same techniques
as business lenders to solve these problems
– Banks may use subtle pricing schemes to sort out
low-risk borrowers from high-risk ones and permit
loan packages to be tailored for both groups
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14-45
The Economics of Financial
Contracting (Cont.)
• Consumer Lending, Financial Contracting and
Securitization (Cont.)
– Asymmetric information is probably less in consumer lending
than business lending
• Easier to access consumer risk since personal financial information is
much less complex
• Relatively fewer types of consumer loans so evaluating consumer risk
is easier than business loans
• Collateral virtually eliminates the asymmetry problem
– Easier to securitize consumer loans—pooling a group of
loans into a trust and then selling securities issued against the
trust
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