10 - Debt Finance Flashcards
How can companies raise finance, and what are some limitations for private companies?
Companies can raise finance by either:
- Issuing shares (equity finance).
- Borrowing money (debt finance), typically from a bank or other lenders.
However, private companies may find it challenging to raise finance through equity, as they cannot offer shares to the public due to restrictions in s 755 CA 2006.
Borrowing money through debt finance provides an alternative for companies, but it’s essential to:
- Check the company’s Articles of Association for any restrictions on borrowing.
- Note that most companies have unrestricted power to borrow, but this can vary depending on when the company was incorporated.
What is debt finance, and how is it classified?
Debt finance involves a company borrowing money from external sources, and it can be divided into two main types:
- Loan facilities: Agreements where a lender gives the borrower the right to borrow money under terms specified in the agreement.
- Debt securities: Tradable instruments issued by the company, acknowledging the investor’s rights, like bonds.
To protect against the risk of non-repayment, a lender may take security over the borrower’s assets.
It’s essential to distinguish between:
- “Debt security”: Refers to a type of debt finance (like a bond).
- “Security for a debt”: Refers to the lender’s protection over the borrower’s assets to safeguard their investment.
What are the types of loan facilities available to companies?
Overdraft:
- A short-term, on-demand facility allowing the bank to demand repayment at any time.
- Interest is charged only on the amount by which the customer is overdrawn.
- Unsuitable for long-term financing due to its on-demand nature.
Term loan:
- A loan of money for a fixed period, repayable on a specified date.
- Early repayment cannot be demanded unless the borrower breaches the terms.
Two repayment structures:
- Bullet repayment: Full repayment in a single lump sum at the end.
- Amortising: Repayment in instalments over time.
Revolving credit facility:
- A loan allowing the borrower to repeatedly borrow and repay up to an agreed maximum amount.
- Offers flexibility as interest is only charged on borrowed funds.
- Suitable for managing short-term cash needs, combining features of overdrafts and term loans.
What are debt securities and how do they function in company finance?
Debt securities share similarities with equity securities as both are ways for a company to raise funds from external investors.
- In exchange for the finance provided, the company issues a security acknowledging the investor’s rights—a formal document indicating debt.
- The security can be held by the initial investor or sold to another investor.
Maturity Date: The company repays the value of the security to the holder on this date.
Bond:
- A typical example of a debt security.
- The company (issuer) agrees to pay back the bond’s value at maturity.
- Interest Payments: Issuer pays interest, usually biannually, to the bondholder.
- Tradability: Bonds are issued for trade on the capital market.
- Whoever holds the bond at maturity will receive its repayment value from the company.
Restrictions for Private Companies:
- Private companies can only issue bonds to targeted investors, not the general public.
- Issuing bonds to the public risks a violation of s 755 CA 2006.
What are debt/equity hybrids, and how do they work in company finance?
Debt/equity hybrids blend features of debt and equity, with convertible bonds and preference shares serving as key examples.
Convertible Bonds:
- Begin as debt securities, allowing bondholders to receive interest and principal repayment.
- Offer an option to convert into shares, giving up rights to interest and repayment upon conversion.
- Exhibit both debt and equity characteristics, starting as debt and transitioning to equity if the bondholder chooses to convert based on the terms of issuance.
Preference Shares:
- Considered equity but often resemble debt.
- Generally provide no voting rights and guarantee a set dividend ahead of other shareholders, similar to interest.
- If the preference share has a fixed maturity date and/or a fixed dividend, it resembles debt.
- If there’s no maturity date and dividends are paid only if declared by the company, it aligns more closely with traditional equity.
What are the main documents in a debt finance transaction, and what purpose do they serve?
Term sheet:
- Summarises the main terms of the transaction, including loan amount, interest rate, fees, key representations, undertakings, and events of default.
- Acts as a statement of understanding and is non-binding, similar to heads of terms in other transactions.
Loan agreement:
- Details the commercial terms of the loan, such as interest rates, payment dates, principal repayment, and any fees.
- Expands on the term sheet with more extensive detail and is a heavily negotiated document in debt finance transactions.
Security document:
- Used when a loan is secured; it outlines the security arrangements in detail.
- This document is negotiated separately from the loan agreement and finalises the security interests for the lender.
What is a debenture, and how is it used in debt finance?
The term debenture has two meanings:
Under s738 CA 2006, it broadly refers to any debt security issued by a company, such as debenture stock, bonds, or other securities.
In secured loan transactions, it refers to a specific type of security document separate from the loan agreement.
This security document is sent to Companies House for registration and typically outlines the security terms for the loan, while the loan agreement details the loan terms.
What are key terms in loan agreements, and why are they significant?
Representations:
- Known as representations and warranties, they are statements about legal and commercial matters made when the loan agreement is signed.
- These statements are periodically repeated throughout the loan’s life to confirm their accuracy and ensure protection for the lender.
Undertakings (or covenants):
- Undertakings (or covenants) are promises to do (or not do) something, or to procure that something is done (or not done).
Events of Default:
- Crucial clause granting the bank the power to call in the loan early if the borrower’s financial condition declines.
- Triggered by breaches of representations or undertakings, this clause helps the bank manage credit risk effectively.
Provide a summary of Debt Finance.
Types of debt finance include loan facilities and debt securities.
Loan Facility:
- A loan facility is an agreement between a borrower and a lender which gives the borrower the right to borrow money on the terms set out in the agreement.
- Loan facilities are classed as overdrafts, term loans or revolving credit facilities.
Debt Security:
- Debt securities eg bonds have similarities to equity securities as they are a means by which the company receives money from external sources. In return for finance provided by an investor, the company issues a security acknowledging the investor’s rights. The security is a piece of paper acknowledging the debt, which can be kept or sold onto another investor. At the maturity date of the security, the company pays the value of the security back to the holder.
- Convertible bonds and preference shares are examples of debt / equity hybrids.
- The main documents required for a term loan are a term sheet, a loan agreement and a security document (if the loan is to be secured) commonly known as a debenture.
What is the nature of security in debt finance, and what are some common forms of security?
In debt finance, ‘security’ refers to temporary ownership, possession or other proprietary interest in an asset to ensure that a debt owed is repaid (ie collateral for a debt).
Main Purpose:
- Protects the creditor if the borrower undergoes formal insolvency.
- Can improve the priority of the debt, giving creditors an advantage over unsecured creditors.
- Enforcement of security is usually unnecessary if the borrower can repay, but may be simpler than suing if repayment issues arise.
Forms of Security:
- Pledge: The borrower gives the asset to the creditor until repayment. Common example: pawning valuables like jewellery.
- Lien: The creditor holds possession until the debt is paid. Example: a mechanic’s lien, where a mechanic can retain a repaired vehicle until the invoice is settled.
What are the key features of a mortgage as a form of security?
A mortgage is a form of security where the security provider (usually the borrower) retains possession of the asset but transfers ownership to the creditor (usually the lender), subject to specific conditions:
Creditor’s Rights:
The creditor has the right to take possession of the asset and sell it if the security provider defaults on the debt.
Equity of Redemption:
The security provider retains the right to require the creditor to transfer the asset back once the debt is repaid.
Type of Mortgage:
With a mortgage, the security provider retains possession of the asset but transfers ownership to the creditor. This transfer is subject to the security provider’s right to require the creditor to transfer the asset back to it when the debt is repaid. This right is known as the ‘equity of redemption’.
A charge by way of legal mortgage is typically taken over land, although, unusually, the ownership of the land will remain vested in the security provider in this case.
What is a charge as a form of security, and what types of charges are there?
A charge is a form of security where the security provider retains possession of the asset but grants the creditor an equitable proprietary interest in the asset, rather than transferring ownership.
Creditor’s Contractual Rights:
The charging document gives the creditor certain rights, such as the ability to appoint a receiver or administrator to take possession of and sell the asset, or, in some cases, to take possession and sell the asset directly if the debt is not repaid.
Types of Charges:
- Fixed Charge: A more secure form of charge, generally preferred by creditors, but not suitable for all asset types.
- Floating Charge: Used for assets that are not suitable for a fixed charge, typically applied to assets like stock that change over time.
What are the key features of a fixed charge as a form of security?
A fixed charge is typically taken over specific assets, such as machinery or vehicles, and provides the creditor with a significant level of control over the asset:
Control of Assets:
- The creditor has control over what the security provider can do with the charged asset, including restrictions on disposal or further charging.
- The security provider can continue using the asset in the ordinary course of business but cannot sell or encumber it without the creditor’s consent.
Enforceability: If the charge becomes enforceable, the creditor can appoint a receiver or exercise the power of sale over the asset.
Example:
- A company takes out a 5-year loan and grants a fixed charge over machinery to the lending bank.
- The company cannot sell or further charge the machinery without the bank’s consent, although it can still use the machinery for its business.
- If the loan is not repaid, the bank can appoint a receiver to sell the machinery and apply the proceeds to satisfy the debt.
What is a floating charge and what happens upon crystallisation?
A floating charge is a form of security that applies to a class of assets, allowing the security provider to dispose of or deal with the assets in the ordinary course of business until certain conditions are met:
Floating Charge:
A floating charge “floats” over a class of circulating assets, such as stock or inventory.
The security provider is free to dispose of or deal with these assets as it wishes until crystallisation occurs.
Crystallisation:
Crystallisation occurs when the floating charge “fixes” to the assets owned by the security provider at the time, meaning the creditor gains control over those assets.
At this point, the floating charge becomes similar to a fixed charge.
Crystallisation may happen:
- By operation of law, or
- When triggered by specific events, such as the borrower breaching significant terms of the loan agreement or becoming insolvent.
Recovery of Debt:
Upon crystallisation, the lender can recover the debt by appointing an administrator or, in some cases, exercising its power of sale over the charged assets.
What are the disadvantages of a floating charge from the creditor’s perspective?
Uncertainty of Asset Value: The security provider has the freedom to dispose of assets in the ordinary course of business, meaning the creditor cannot be certain of the value of the secured assets. The assets could be sold before crystallisation occurs.
Priority in Winding-Up:
A floating charge generally ranks below a fixed charge and preferential creditors when a company is wound up and its assets are realised. Crystallisation does not change this order of priority.
However, if the floating charge includes a negative pledge clause that prohibits the creation of a later fixed charge, the floating charge will take priority if the fixed charge holder had notice of the restriction.
Prescribed Part Fund: Floating charges created on or after 15 September 2003 are subject to a ‘prescribed part fund,’ where part of the proceeds from the assets is set aside for unsecured creditors.
Avoidance: Floating charges can be avoided under s 245 of the Insolvency Act 1986, especially in the case of voidable transactions.
Administrator’s Control: An administrator can deal with floating charge assets without reference to the charge holder or the court, and can use the proceeds to cover their own remuneration and expenses.
