Loan Security

Corporate Finance InstituteⓇ

 Course Introduction

Corporate Finance InstituteⓇ

 Learning Objectives (Text lesson)

Compare different types of Determine the security

01. security and assets used as
security
02. value of different assets
based on MAST principles

Discuss the role of legal

03. counsel and the importance
of legal representation

Corporate Finance InstituteⓇ

 Types of Security and Assets

Corporate Finance Institute®

 An Overview of Security

Manage the risk of a borrower defaulting on the loan:

Assess sources of loan repayment

Assess security

Security is a form of insurance that is provided by the borrower.

• No loan should be granted if the • Security is taken as a final safeguard

lender expects security will have to be in case of default.
enforced or realized.

Corporate Finance Institute®

 An Overview of Security

How to secure a loan?

Types of security

Direct Indirect

• Real estate • Personal

• Machinery and guarantees
equipment • Corporate
• Inventory guarantees
• Letters of comfort

Corporate Finance Institute®

 Direct Security

Direct security relates to collateral that can be used to secure a loan.

Intellectual
property
Land Inventory Cash

Real-Estate Tangible Intangible

Patents

Buildings Machinery Receivables Distribution

agreements

Corporate Finance Institute®

 Direct Security

Two ways for a financial institution to secure its financing position using assets:

Fixed Charge Floating Charge

• Attaches to a specific item of the company’s • Attaches to a general class of assets.

property. • Borrower can trade its assets during
• The lender has legal right to the asset. the ordinary course of business.
• The charge fixes to the asset. • The charge would fix if there’s an
insolvency or a loan default.

Land Buildings Machinery Inventory Accounts Marketable

Receivable securities

Corporate Finance Institute®

 Two Approaches to Direct Security

Two common ways to protect the lender with direct security:

Specific Collateral General Security Agreement

• Specific asset(s) • All assets as a whole
• In the case of default, the • In the case of default, the
lender takes ownership of lender seizes the
the asset(s) borrower’s assets

Corporate Finance Institute®

 General Security Agreement Example

Show a GSA sample document

Corporate Finance Institute®

 Indirect Security

Direct Security:

Buildings Land Machinery Inventory Patents

Indirect Security:

Guarantees Letter of Comfort

Corporate Finance Institute®

 Indirect Security

A guarantee is the most common form of indirect security.

Lender

$ $

Borrower Guarantor

Corporate Finance Institute®

 Indirect Security

Here is a brief overview of three types of guarantees.

Personal

• The guarantor is an individual.

• The individual is personally responsible if the
borrower is unable to repay the debt.
• The lender has the right to pursue the
guarantor’s personal assets.

Corporate Finance Institute®

 Indirect Security

Here is a brief overview of three types of guarantees.

Personal Corporate

• The guarantor is a company.

• The company is responsible if the borrower is
unable to repay the debt.
• The companies are related through
ownership.

Corporate Finance Institute®

 Indirect Security

Here is a brief overview of three types of guarantees.

Personal Corporate Joint & Several

• There are multiple guarantors.

• Any and all guarantors may be required to
fulfill a borrower’s debt obligation.
• The lender may pursue any one of the
guarantors for the full amount of the
guarantee.

Corporate Finance Institute®

 Indirect Security

Here is a brief overview of three types of guarantees.

Personal Corporate Joint & Several

Limited guarantees Unlimited guarantees

Corporate Finance Institute®

 Guarantees Example

Show examples of personal guarantee and corporate guarantee

Corporate Finance Institute®

 Indirect Security

Letter of Comfort:
It is a letter given by a third party (often the parent
company) to help secure lending facilities for the
borrower.

It is a weaker form of reassurance because it is non-

binding and there is typically no recourse against the
letter of comfort provider.

Example wording:
“The parent company will manage the business of the
subsidiary (the borrower) in such a way as to meet its
liabilities under the loan agreement.”

Corporate Finance Institute®

 Types of Assets Used as Security

How assets are used to secure a loan:

Assets Used as Security

Real Property Personal Property

Corporate Finance Institute®

 Types of Assets Used as Security
Real property is all about land and buildings.
Land
• Immovable
• Simple to establish and
transfer legal title
• Generally retains its value
Corporate Finance Institute®
Buildings
• Office buildings
• Shopping centers
• Hotels
• Warehouses and factories
 Types of Assets Used as Security

Personal property is any property other than real property.

Goods Cash Instruments Chattel Paper

Inventory and Cash and money Conditional sales
equipment market securities contracts

Securities Intangibles
Bonds and Licenses and
equities patents

Corporate Finance Institute®

 Evaluating Security

Corporate Finance Institute®

 Evaluating Security

It is important to evaluate the quality of assets to be used as security. Consider the

following 4-point checklist when assessing potential collateral:

Marketable Ascertainable Stable Transferable

Is there an active Is it easy to value the Does the asset’s value Can the asset be easily
secondary market to asset? change frequently or transferred to a new
sell the asset if Does the asset have a is it relatively stable? owner?
needed? readily ascertainable
price?

Corporate Finance Institute®

 Evaluating Security Quality

Applying the MAST framework to different types of assets.

Cash and Land and Equipment and Accounts

Inventory
Securities Buildings Machinery Receivable

Marketable

Ascertainable

Stable

Transferable

Corporate Finance Institute®

 Evaluating the Quality of Accounts Receivable and Inventory

Commodity vs specialized
Customer base Bad debt experience

Raw vs
finished Shelf life

Accounts
Receivable
Inventory

Aging Credit policies

Liquidity Inventory
turnover
Corporate Finance Institute®
 Evaluating the Quality of Accounts Receivable and Inventory

Valuing Accounts Valuing Inventory

Receivable

• Aged receivable list • List of inventory

Corporate Finance Institute®

 Evaluating the Quality of Equipment and Real Estate

Market value Location Market value Location

Machinery and
Real Estate
Equipment

Condition Useful life Condition Type

Corporate Finance Institute®

 Valuing Machinery and Equipment

Typical ways of valuing machinery and equipment include:

Appraisals Accepted Offers Bills of Sale Markets

to Purchase

Detailed breakdown of the machinery and equipment

• Fixed asset or PP&E register

Corporate Finance Institute®

 Valuing Machinery and Equipment Example

Show financial statement & discuss the P&E

• Types of equipment
• When it’s bought
• Original cost
• Estimated secondhand value

Corporate Finance Institute®

 Valuing Real Property

Sources of information when ascertaining the value of real property:

Property Tax Assessments Real Estate Listings Property Appraisers

• Reasonable proxy to • For similar properties in a • Most reliable source
current market value similar geographic location • Expensive to obtain
• Easy to obtain • It may be difficult to find
like for like properties

Corporate Finance Institute®

 Understanding a Real Estate Appraisal

Real estate appraisers use 3 standard approaches to estimate real estate value:

Cost Income
Approach Approach

Sales comparison
Approach

Corporate Finance Institute®

 Valuing Real Property

Cost Approach

Improvements
Total
Cost
= or <
Cost

Property we are Substitute property

trying to value

Corporate Finance Institute®

 Valuing Real Property

Sales Comparison Approach

Subject Property

$ Sold $ $ Sold $ $ Sold $ $ Sold $ $ Sold $ $ Sold $

Corporate Finance Institute®

 Valuing Real Property

Income Approach

Net Operating Income (NOI)

Value =
Capitalization Rate

This approach also relies on market data to

establish appropriate capitalization rates.

Corporate Finance Institute®

 Valuing Real Property

Final Estimate

Cost Income
Approach Approach

Sales Comparison
Approach

The land value estimate is a separate step accomplished by applying either

sales comparison or income capitalization techniques.

Corporate Finance Institute®

 Valuing Real Property Example

Show financial statement & discuss the P&E

• When it’s bought

• Appraisal
• Real estate listing

Corporate Finance Institute®

 Security Case Study

Identify the best security to take for a $5 million loan.

• Accounts receivable
• Inventory
• Equipment
• Real Estate
• Guarantees

Do not under-secure or over-secure

Corporate Finance Institute®

 Security Case Study Debrief

Identify the best security to take for a $5 million loan.

• Accounts receivable
• Inventory
• Equipment
• Real Estate
• Guarantees

Do not under-secure or over-secure

Corporate Finance Institute®

 Security Solution Example

Is the amount enough? How much does the lender need to secure a loan of $XXX?

Create a summary document listing all securities & possible guarantees – item, value, MASK
score

Corporate Finance Institute®

 Legal Counsel

Corporate Finance Institute®

 Role of the Legal Counsel for the Lender

Legal counsel plays an important role in protecting the interest of

both the lender and the borrower.

From the lender’s perspective, legal counsel will: Borrower

• Review all the security and guarantee

documentation.
• Determine the enforceability of all legal
agreements.
• Ensure the completeness of the documentation.
• Determine whether the borrower has the legal
power to enter into loan agreements.
• Ensure the accuracy of the agreements. Lender

• Ensure any security is properly registered and

confirm the security position of the lender.
Corporate Finance Institute®
 Role of the Legal Counsel for the Borrower

Legal counsel plays an important role in protecting the interest of

both the lender and the borrower.

From the borrower’s perspective, legal counsel will: Borrower

• Advise the borrower on the legal liability that they

will be subject to under any loan agreement.
• Advise the borrower on the enforceability of those
agreements including what rights the lender has in
the event of default.
• Holds funds until title transfer is completed.

Lender

Corporate Finance Institute®

 Role of the Legal Counsel for the Guarantor

The legal counsel should also advise the guarantor that:

1. If the borrower fails to make a payment on time, the

guarantor will be liable to remedy the failure.

2. If the guarantor fails to remedy any failure by the

borrower, the lender can sue the guarantor.

3. The lender can exercise its rights against the guarantor

even if it has not pursued the borrower.

4. The liability of the guarantor is either unlimited or is limited

to a specified sum as outlined in the guarantee agreement.

Corporate Finance Institute®

 Opinion Letters

To provide proof of legal counsel’s advice and conclusions.

List of Documents Factual Legal Qualifications

Reviewed Conclusions Enforceability
Opinion

Corporate Finance Institute®

 The Importance of Legal Representation

Lenders may enter into an agreement with no

enforceability in the event of a default.

What are the risks when no legal

No Proper Due No Proper representation is obtained?
Diligence Registration

No Proper
Completion

The result would be a loan loss with no opportunity

to recover any of the principal amount owing.

Corporate Finance Institute®

 The Importance of Legal Representation

Borrowers may not understand the true implications

that exist in the event of a loan default.

What are the risks when no legal

Hardship Confusion representation is obtained?

Lack of Trust

Example: If personal guarantees are not fully understood, the borrower may
be under the impression that their personal assets are protected regardless
of whether a guarantee was signed.

Corporate Finance Institute®

 Security Registration and Documentation

It is the lender’s responsibility to ensure all loans are adequately secured

with loan documentation properly completed, registered, and on file.

The registration of security is done differently in various jurisdictions around the world.

Real Estate Personal Property

• Mortgage attached to a • General Security Agreement

specific property
• Assignment of leases and
rents

Corporate Finance Institute®

 Role of the Legal Counsel for the Borrower Example

What advice would a legal counsel give to the borrower?

• No need for unlimited guarantees

(consequence)
• No need to use all the assets

Corporate Finance Institute®