Lecture 7

Obtaining Debt Capital

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 Sources of Debt Capital
• Trade credit
• Commercial banks
• Finance companies
• Factors
• Leasing companies
• Mortgage Finance Companies

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 Trade Credit
• Trade credit—the ability to buy goods and services and
have 30, 60, or 90 days to pay for them
• Major source of short-term funds for small businesses
• Represents 30 to 40 percent of the current liabilities of non-
financial companies, with generally higher percentages in
smaller companies

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 Commercial Banks
• Commercial banks prefer to lend to existing businesses with
a proven track record.
• They like to be lower-risk lenders.
• Banks are likely to require personal guarantees of the owners.

• Nevertheless, certain banks do, rarely, make loans to

startups that have strong equity financings.
• Commercial banks are the primary source of debt for
existing businesses.

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 Commercial Banks
• Most of the loans made by commercial banks are for one
year or less.

• Some of these loans are unsecured.

• Receivables, inventories, or other assets secure others.
• For intermediate-term loans (one to five years) the banks
usually require collateral.
• Commercial banks make few loans with maturities
greater than five years.

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 Commercial Banks
• Common types of financing involving the use of a bank

• Line of credit loans: an agreement between a bank and a

borrower concerning the maximum loan a bank will allow the
borrower for a one-year period

• Time-sales finance: Dealers or manufacturers who offer

installment payment terms to purchasers of their equipment
may sell and assign the installment contract to a bank or sales
finance company

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 Commercial Banks
• Common types of financing involving the use of a bank

• Term loans: Bank term loans are generally made for periods
of one to five years and may be unsecured or secure.
Term loans provide growth capital for companies

• Chattel mortgages and equipment loans: Chattel is any

machinery, equipment, or business property that is made the
collateral of a loan. The term of a chattel mortgage is
typically from one to five years.

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 Commercial Banks
• Common types of financing involving the use of a bank
• Conditional sales contracts: Conditional sales contracts are
used to finance much of the new equipment purchased by
businesses.
• The buyer agrees to purchase a piece of equipment, makes a
nominal down payment, and pays the balance in installments.
• The seller holds title to the equipment; thus the sale is
conditional.
• A sales contract is financed by a bank that has recourse should
the purchaser default on the loan

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 Commercial Banks
• Common types of financing involving the use of a bank

• Plant improvement loans: Loans made to finance

improvements to business properties can be
intermediate and long term and are generally secured
by a first or second mortgage

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What is Bankable?

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Commercial Finance Companies
• Frequently lend money to companies that do not have
positive cash flow
• Will not make loans to companies unless they consider them
viable risks; usually more accepting of risk than are banks
• Commercial finance companies lend against the liquidation
value of assets .
• Finance companies usually place a larger reporting and
monitoring burden on the borrowing firm. They have tough
prepayment penalties, more strict conditions and much higher
cost.

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 Factoring
• Factoring—a form of accounts receivable financing where
the receivables are sold, at a discounted value, to a factor
• The factor buys the client’s receivables outright, without
recourse, as soon as the client creates them, by shipment of
goods to customers
• Cash is made available to the client as soon as proof is
provided (old-line factoring) or on the average due date of the
invoices (maturity factoring)

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 Leasing Companies
• Leasing companies—leases common and readily resalable
items such as automobiles, trucks, typewriters, and office
furniture to both new and existing businesses
• Up front payment required of about 15 percent of the value of
the item being leased
• Interest may be more or less than other forms of financing,
depending on the equipment leased, and the credit of the
lessee.

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 Mortgage Finance Companies

• A loan secured by the collateral of some specified real

estate property which obliges the borrower to make a
pre- determined series of payments with fixed or
variable interest

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 What to Look for in a Bank
• Knowledge
• Sense of urgency
• Industry knowledge
• Financial stability
• Qualified Management
• Also important is a good personal chemistry between
the entrepreneur and the lending officer.

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Steps in obtaining the loan

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What the bank wants to know

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 Lending Criteria
• The most important criteria is the quality and track record
of the management team.
• Lenders do not like to see total debt-to-equity ratio greater
than one.
• Other factors.
a. Historical financial data.
b. Well-developed business projections.
• What is needed is analysis of the available collateral and of
debt capacity.
• The bottom line is the ability of the company to repay both
interest and principal on time.
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 Loan Restrictions
• A loan agreement defines the terms and conditions under
which a lender provides capital.
a. Negative covenants are restrictions on the borrower,
such as prohibiting further additions to the borrower’s total
debt.
b. Positive covenants define what the borrower must do,
such as maintain some minimum net worth or working
capital.

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 Loan Restrictions
• An entrepreneur should negotiate to get terms that the venture can live
with.
• The entrepreneur should be careful if the bank:
a. Wants to put constraints on your permissible financial ratios.
b. Stops any new borrowing.
c. Wants a veto on any new management.
d. Disallows new products or new directions.
e. Prevents acquiring or selling any assets.
f. Forbids any new investment or new equipment.

• The entrepreneur should expect personal guarantees in certain

circumstances.
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 Beware of Leverage: The ROE Mirage
• According to the theory, one can significantly improve
return on equity (ROE) by utilizing debt.
• Theoretically the present value of the company would
increase as the debt-to-equity ratio increased.
• The actual increase in present value is less significant.
• The odds of the company getting into trouble also increase.
• Leverage creates an unforgiving capital structure that is
often not worth the risk.

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