FINC 4330 Ch. 6 Loan Structuring

Maturity on the loan should correspond with the ______ point in current assets when both the bank and trade credit should be paid out

low

Banker and borrower should agree on the use of ________ normally to paying expenses and suppliers for inventory - _____ should not be used for payments of term debt, dividends, or capital expenditures

proceeds

Borrowers often have other loan facilities, such as _________ - All loans should be reviewed at the time the seasonal loan is paid out

term loans

Seasonal Loans

· Seasonal lines of credit are used to finance periodic increases in current assets, such as inventory, in anticipation of a seasonal surge in sales volume o Build-up of holiday inventory o Agriculture line for planting, growing, harvesting, & storing a crop. · Any business that has seasonal fluctuations is a candidate for a seasonal line of credit to be repaid upon sale of product.

Banker Must Determine Structure

- Banker should not defer to client about how to structure a loan. - Borrower may request short-term loan to finance inventory increase, when longer term would be more appropriate. - Most small business owners rely on their banker to structure loans properly. - Unlike large businesses, small companies don't usually have CFO/Controller to do all of the analysis. - Bankers usually find small businesses negotiate price, collateral, and guaranties, but look to banker to set terms, repayment source, & overall loan structure. - Proper structure requires banker to understand purpose & use of funds, source of repayment, & overall loan elements.

Collateral Consideration for Permanent Capital Loans: Inventory

- Costs of storage, transportation and security - Obsolescence - Warranties - Perishable Items - Costs of Disposal - Commercially reasonable means of sale

Collateral Consideration for Permanent Capital Loans: Accounts Receivable

- Credit Policies - Credit Quality - Concentrations - Selling Terms - Aging - Returns and Allowances

Common Lender Errors in Bridge Loans

- Failure to consider all contingencies that could prevent repayment - Overvaluing the asset being sold - Cost overruns in construction - Insufficient cash flow for permanent financing

Common Lender Errors in Seasonal Loan

- Failure to react immediately to a lack of cleanup - Cash flow is not sufficient for a "term out" of carryover debt - Line is too large or overfunded - Line is too small to complete the production cycle - Borrower is permitted to use advances for purposes other than current asset and liabilities

Common Lender Errors in Permanent Capital Loans

- Ignoring red flags leading to loan request or increase - Placing excessive value on inventory - No established procedure for collecting receivables in event of default - Advancing more credit in a deteriorating situation

Steps in Loan Process

- Interviews with the client. - Visits to his/her place of business. - Calls to suppliers, customers, & creditors. - Analyzing financial statements. - IF LOAN APPROVED--determine structure.

Analysis of Permanent Capital Loan

- Management: margins for error are reduced by heavy debt burden - Long-term cash generation: primary source of repayment - Internal controls: inventory management and timely reporting - Credit policies: receivables collection - Collateral valuation and control: frequent examination and valuation

Collateral Considerations for Term Loan

- May be secured by a mortgage on land and buildings and/or a security interest in equipment - Receivables and inventory can be taken as well, but not as primary collateral - All loans should be cross-collateralized and cross-defaulted - Collateral value is liquidation value, not related to book value

What can go wrong with a permanent capital loan?

- Proceeds not used for current asset purchases - Losses in receivables - Inventory cannot be sold - Insufficient cash flow

Definition and Importance of Loan Structuring

- Process where repayment terms and loan amount, its support, and its price are matched to purpose of borrowing. - Involves fine line between setting terms that are too limiting & terms that are too liberal. - Too strict repayment terms or too low loan amount leaves borrower without capital to operate business. o Establishing a $100,000 line of credit when $200,000 is needed will lead to a $100,000 loan which cannot be re-paid and a borrower who needs either a new loan or more time to repay - Too lenient terms leave banker with little control over how funds are used to repay debt. o Establishing a $200,000 line of credit when $100,000 is needed may entice the borrower to finance more assets than what are actually needed

Permanent Capital Loans

- Revolving credit used to purchase current assets or pay current liabilities - Collateral usually accounts receivable and inventory, but equipment and real estate are often included - Different from seasonal loans in that it is not "rested" - Used as a substitute for equity - Also called asset-based lending, receivables and inventory financing, secured lending, working capital loans, evergreen credit, dealer floor plans - Often needed for new or rapidly expanding businesses - May result from a seasonal loan not being paid - Repaid through long term cash flow generation

What can go wrong with a term loan?

- Sales lower than projected - Falling margins - Sales growth leads to increased cash need - Fixed assets may become obsolete before loan is repaid

4 Types of Loans in Terms of Repayment

- Seasonal Loans - Term Loans - Bridge Loans - Permanent Capital Loans

What can go wrong with a seasonal loan?

- The bank gets paid but trade creditors do not: will cause problems in next operating cycle - The bank is not fully paid: serious problem, must make decision on next year, term loan if temporary problem or other exit strategy - Adding other lines of business may smooth cash flow, but may also lead to a seasonal loan becoming a permanent capital loan (fireworks and Christmas tree farm) - Production problems (serious for ag loans) - Problems with sales or collections of receivables - Cash is used for other purposes (use credit card to make other payments)

Term Loans

- Used to purchase plant equipment, office furniture, leasehold improvements, vehicles, and most other fixed assets - They are for more than 1 year and payments are amortized to cash flow - While most are amortized over several years, some are ballooned - Repaid from long run net profits.

Collateral Consideration for Permanent Capital Loans: Equipment

- Useful Life - Obsolescence - Cost of Sale - Deferred Maintenance

Analysis of a Seasonal Loan

Focusses on 2 points in time: 1. The point at which the bank has the most risk: When inventory is at its peak and the seasonal loan is fully disbursed 2. The payout period when both the bank and the trade credit should be repaid - Bank and trade creditors both rely on the borrower's ability to convert inventory into receivables and receivables into cash, both of which involve risk - Examining historic patterns of borrowing and repayment is important - Quarterly or monthly balance sheets, income statements, and cash flow statements are the best tools for analysis

Analysis of a Bridge Loan

Focusses on the likelihood of the event occurring that will repay the loan and the ability to service the debt if the event does not occur - Bank will be stuck with the loan if the event does not occur

Collateral Considerations for Bridge Loans

For an asset sale or refinance, the loan is secured by the assets being sold or refinanced; bank should have title For equity infusion, the use of proceeds should be known

Term Loan Facilities

Funds advanced for a specific period of time, with payments amortized - Monthly payments preferred for better monitoring Loan agreement is needed - Identifies the term, conditions, expectations, responsibilities of the borrower and the bank, remedies if the agreement is breached, any covenants, etc.

Bridge Loan Facilities

Maturity will match the anticipated event Should avoid demand notes or 90 day renewable notes

What can go wrong with a bridge loan?

Nonoccurrence of the anticipated event - Failure of asset to sell, or lower than expected sales price - Prior liens or tax claims · uninsured damage to the asset - Lack of refinance - Increasing interest rates

Collateral Considerations for Seasonal Loan

Normally secured by a perfected security interest in accounts receivable, inventory, and equipment - An annual lien search may be appropriate Collateral may be of little value in a default: if the borrower can't sell the inventory, the bank will not either Personal guarantees may be needed

Seasonal Loan Facilities

Often advanced under an advised, revocable line of credit sufficient to take care of the peak borrowing need; some leeway for additional requirements or timing differences

Common Lender Errors in Term Loan

Unrealistic straight line, compounded sales projections Incomplete sensitivity analysis Management cannot adapt to changing environment Projected sales growth without recognizing need for additional fixed asset investment Value of collateral is overestimated Loan policy issues: - Loan policy sets maximum maturities on term loans - 5 to 7 years for equipment; 10 to 15 for real estate is common

Analysis of a Term Loan

- While a seasonal loan analysis emphasizes the balance sheet, term loan analysis focuses on the cash flow statement - Requires a fundamental understanding of the borrower's management, industry, and market position - Focuses on long term generation and disbursement of cash - Rarely goes exactly as planned 5 year loan may pay out in 7 years - Key is to balance setting maximum payments while maintaining borrower solvency what does this mean? - Borrowers may focus on how long they can take to repay rather than how quickly they can repay paying off quickly may free up cash flow for future opportunities - Term obviously should not exceed the useful life of the equipment - Loan should be profitable to both lender and borrower positive NPV or IRR

Bridge Loans

They "bridge" a gap until a specific event occurs that repays the loan 1. The sale of noncurrent assets: land, building, equipment, etc. 2. Refinancing debt with other debt: construction loan 3. Infusion of equity: new investors

A ______________ of funding may result in the borrower going out of business - All terms should be made clear and should be in writing

discontinuance