Obtaining Debt Obtaining Debt CapitalCapital

Venture PlanningVenture PlanningChapter 15Chapter 15

DowlingDowlingFall 2006Fall 2006

Sources of Debt CapitalSources of Debt Capital

Sources of debt capitalSources of debt capital Trade creditTrade credit Commercial banksCommercial banks Finance companiesFinance companies FactorsFactors Leasing companiesLeasing companies

Exhibit 15.1Exhibit 15.1

Exhibit 15.2Exhibit 15.2

Trade CreditTrade Credit

Trade creditTrade credit 30-40 percent of current liabilities of non-30-40 percent of current liabilities of non-

financial companiesfinancial companies The smaller the firm, the higher this The smaller the firm, the higher this

percentagepercentage Suppliers offer trade credit to attract new Suppliers offer trade credit to attract new

customerscustomers Bad debt risk is built into pricesBad debt risk is built into prices Costs of trade credit include lost Costs of trade credit include lost

discounts for prompt paymentdiscounts for prompt payment

Commercial BanksCommercial Banks

Common types of financing involving Common types of financing involving the use of a bank:the use of a bank: Line of credit loansLine of credit loans Time-sales financeTime-sales finance Term loansTerm loans Chattel mortgages and equipment loansChattel mortgages and equipment loans Conditional sales contractsConditional sales contracts Plant improvement loansPlant improvement loans

Commercial Bank Commercial Bank FinancingFinancing

Commercial Bank FinancingCommercial Bank Financing Generally more readily available to Generally more readily available to

existing businesses with a track record existing businesses with a track record of sales, profits, satisfied customers and of sales, profits, satisfied customers and a current backloga current backlog

Positive cash flow and collateralPositive cash flow and collateral Great importance placed on quality of Great importance placed on quality of

management teammanagement team

Line of Credit LoansLine of Credit Loans

Line of credit loansLine of credit loans Agreement setting out maximum loan Agreement setting out maximum loan

balance a bank will allow the borrower for a balance a bank will allow the borrower for a one-year periodone-year period

Used for such seasonal financings as Used for such seasonal financings as inventory buildup and receivables financinginventory buildup and receivables financing

For “prime risk” (financially sound) For “prime risk” (financially sound) companies, lines of credit generally companies, lines of credit generally available at 1 to 2 percent over Fed’s available at 1 to 2 percent over Fed’s rediscount raterediscount rate

Accounts Receivable Accounts Receivable FinancingFinancing

Accounts receivable financingAccounts receivable financing Short-term financing involving either Short-term financing involving either

pledge of receivables as collateral for a pledge of receivables as collateral for a loan or the sale of receivables loan or the sale of receivables

Made on a discounted value of the Made on a discounted value of the receivables pledgedreceivables pledged

Time Sales FinancingTime Sales Financing

Time-sales financeTime-sales finance Way of obtaining short-term financing Way of obtaining short-term financing

from long-term installment accounts from long-term installment accounts receivablereceivable

Bank purchases installment contracts at Bank purchases installment contracts at discount rate from their full value and discount rate from their full value and takes as security an assignment of the takes as security an assignment of the manufacturer/dealer’s interest in the manufacturer/dealer’s interest in the conditional sales contractconditional sales contract

Unsecured Term LoansUnsecured Term Loans

Unsecured term loansUnsecured term loans Provide needed growth capital to those Provide needed growth capital to those

that can’t obtain the capital from the that can’t obtain the capital from the sale of stocksale of stock

Substitute for a series of short-term Substitute for a series of short-term loans made with the anticipation of loans made with the anticipation of renewal by both the borrower and the renewal by both the borrower and the lenderlender

Chattel Mortgages and Chattel Mortgages and Equipment LoansEquipment Loans

Chattel Mortgages and Equipment Chattel Mortgages and Equipment LoansLoans Chattel is any machinery, equipment, or Chattel is any machinery, equipment, or

business property that is made the business property that is made the collateral of a loan in the same way as a collateral of a loan in the same way as a mortgage on real estatemortgage on real estate

Obtaining Debt CapitalObtaining Debt Capital

Conditional sales contractsConditional sales contracts Effective rate of interest on a conditional Effective rate of interest on a conditional

sales contract is high, running to as high sales contract is high, running to as high as 15-18 percent if the effect of as 15-18 percent if the effect of installment features is consideredinstallment features is considered

Plant improvement loansPlant improvement loans Can be intermediate- and long-term, and Can be intermediate- and long-term, and

are generally secured by first mortgage on are generally secured by first mortgage on that part of the property that is being that part of the property that is being improvedimproved

Sources of Debt CapitalSources of Debt Capital

Commercial finance companiesCommercial finance companies FactoringFactoring Leasing companiesLeasing companies

Commercial Finance Commercial Finance CompaniesCompanies

Frequently lend money to companies Frequently lend money to companies that do not have positive cash flowthat do not have positive cash flow

Will not make loans to companies Will not make loans to companies unless they consider them viable risks; unless they consider them viable risks; usually more accepting of risk than are usually more accepting of risk than are banksbanks

FactoringFactoring

Factoring—a form of accounts receivable Factoring—a form of accounts receivable financing where the receivables are sold, at a financing where the receivables are sold, at a discounted value, to a factordiscounted value, to a factor The factor buys the client’s receivables The factor buys the client’s receivables

outright, without recourse, as soon as the outright, without recourse, as soon as the client creates them, by shipment of goods client creates them, by shipment of goods to customersto customers

Cash is made available to the client as soon Cash is made available to the client as soon as proof is provided (old-line factoring) or as proof is provided (old-line factoring) or on the average due date of the invoices on the average due date of the invoices (maturity factoring)(maturity factoring)

Leasing CompaniesLeasing Companies

Leasing companies—leases common and Leasing companies—leases common and readily resalable items such as automobiles, readily resalable items such as automobiles, trucks, computer equipment, and office trucks, computer equipment, and office furniture to both new and existing businesses:furniture to both new and existing businesses: Up front payment required of about 150 Up front payment required of about 150

percent of the value of the item being percent of the value of the item being leasedleased

Interest may be more or less than other Interest may be more or less than other forms of financing, depending on the forms of financing, depending on the equipment leased, the credit of the lessee, equipment leased, the credit of the lessee, and the time of yearand the time of year

What to Look for in a What to Look for in a BankBank

KnowledgeKnowledge Sense of urgencySense of urgency Teaching talentTeaching talent Industry knowledgeIndustry knowledge Financial stabilityFinancial stability Manager (Loan Officer) with Manager (Loan Officer) with

backbonebackbone

Exhibit 15.3Exhibit 15.3

Managing the Banking Managing the Banking RelationshipRelationship

Managing and orchestrating the Managing and orchestrating the banking relationshipbanking relationship The lending decision:The lending decision:

Need more today than a good Need more today than a good relationship with a loan officer to relationship with a loan officer to secure funding.secure funding.

Analysis and documentation are Analysis and documentation are generally required.generally required.

Managing the Banking Managing the Banking RelationshipRelationship

The TLC of a banker or other lender:The TLC of a banker or other lender: Your banker is your partner, not a difficult Your banker is your partner, not a difficult

minority shareholderminority shareholder Be honest and straightforward in sharing Be honest and straightforward in sharing

infoinfo Invite the banker to see your business in Invite the banker to see your business in

operationoperation Always avoid overdrafts, late payments and Always avoid overdrafts, late payments and

late financial statementslate financial statements Answer questions frankly and honestly. Tell Answer questions frankly and honestly. Tell

the truth. Lying is illegal and undoubtedly the truth. Lying is illegal and undoubtedly violates covenants.violates covenants.

Bank Lending CriteriaBank Lending Criteria

Lending criteria:Lending criteria: Quality and track record of Quality and track record of

management teammanagement team Historical financial statements show 3-5 Historical financial statements show 3-5

years of profitabilityyears of profitability Well-developed business planWell-developed business plan Analysis of debt capacityAnalysis of debt capacity Ability of company to repay both Ability of company to repay both

principal and interest on timeprincipal and interest on time

Bank LoansBank Loans

After the loan decision:After the loan decision: Loan restrictionsLoan restrictions

Negative covenantsNegative covenants Positive covenantsPositive covenants

Personal Loan Personal Loan GuaranteesGuarantees

Personal guarantees and the loanPersonal guarantees and the loan When to expect them:When to expect them:

You’re under-collateralizedYou’re under-collateralized You’ve had poor or erratic performanceYou’ve had poor or erratic performance You’ve had management problemsYou’ve had management problems Your relationship with your banker is strainedYour relationship with your banker is strained You have a new loan officerYou have a new loan officer There is turbulence in credit marketsThere is turbulence in credit markets Wave of bad loans made by lending Wave of bad loans made by lending

institutionsinstitutions

Personal Loan Personal Loan GuaranteesGuarantees

Personal guarantees and the loanPersonal guarantees and the loan How to avoid them:How to avoid them:

Good to spectacular performanceGood to spectacular performance Conservative financial managementConservative financial management Adequate collateralAdequate collateral Careful management of the balance sheetCareful management of the balance sheet

Obtaining Debt CapitalObtaining Debt Capital

Beware of leverage: the ROE mirageBeware of leverage: the ROE mirage Leverage creates an unforgiving capital Leverage creates an unforgiving capital

structure and the potential additional structure and the potential additional ROI often is not worth the riskROI often is not worth the risk

Exhibit 15.4Exhibit 15.4

Exhibit 15.5Exhibit 15.5

Exhibit 15.6Exhibit 15.6

Exhibit 15.8Exhibit 15.8