Business - Debt Finance and Security (12) Flashcards
What is debt finance?
Debt Finance: Debt finance is the raising of funds through borrowing and loans. Lenders may require security.
(1) Loan: Loans are money lent to a business to be repaid later.
(2) Debt Instrument: Debt instruments are the sale of debts, effectively IOUs (i.e. corporate bonds).
What are loans?
Loans: When considering to take out a loan, a number of considerations must be made.
(1) Restrictions: Whether bespoke articles or existing loans restrict borrowing in any way.
(2) Authority: Directors have authority to enter into loans unless restricted (MA 3).
What different types of loan are there?
Types of Loan: Loans are typically offered by a lending institution such as a bank, or less commonly, by an owner/manager.
Overdraft
Overdraft: An overdraft is an unsecured contract permitting a business to overdraw its current account.
(1) Process: Business agrees size of overdraft and can withdraw and repay at will.
>Repayment can be demanded at will, but this is rare.
(2) Cost: Overdrafts tend to involve a premium plus compound interest at the BoE base rate.
>Compound means interest applied to current capital and interest.
(3) Summary: Flexible, but more expensive as it is unsecured.
Term Loan
Term Loan: A term loan is a secured contract for a fixed term loan.
(1) Process: Business agrees size of loan in a facility agreement, drawn in lump sum or instalments.
(2) Cost: Regular interest payments and capital repayment at the end of term.
(3) Summary: Useful for single asset purchases but cumbersome to draft. Sums cannot be reborrowed.
Revolving Credit Facility
Revolving Credit Facility: A revolving credit facility is a secured contract providing a pot of money to be used at will.
(1) Process: Business can borrow and repay at will, including reborrowing, as agreed in the facility agreement.
Bilateral Loan: Loan is provided by a single lender.
Syndicated Loan: Loan is provided by multiple lenders to mitigate risk.
(2) Cost: Interest charged at regular intervals.
(3) Summary: Flexible and useful to bolster income for seasonal businesses, but cumbersome and often expensive.
What are the key terms of a loan/facility agreement?
Terms of Loan: Term Loans and Revolving Credit Facilities are governed by complex ‘facility agreements’, binding both parties once funds are committed. They cover the currency, sum and type of loan, as well as:
(1) Length of Loan: The period of the loan.
(2) Repayment Schedule: The repayment schedule.
Bullet: Capital repaid at end of term (RCFs).
Balloon: Capital repaid in rising unequal instalments (TLs).
Amortisation: Capital repaid in equal instalments (TLs).
(3) Interest Rate: The interest rate applied to the loan.
Fixed: Fixed at a specific rate.
Variable: Attached to a formula (i.e. BoE rate).
(4) Interest Penalty: Default interest applied to late payments.
>Must be carefully drafted to be effective.
(5) Covenants: Lenders will impose express covenants to mitigate risk (if overly strict = shadow director). Dividend Limit: Dividend payments limited to specified percentage of net profit. Minimum Capital: Current assets required to exceed current liabilities by a specified amount. Asset Disposal Consent: Consent may be required to dispose of certain assets. Nature of Business: Consent may be required to change the nature of business. Security: Security may be required in respect of the loan. Negative Pledge: Negative pledge prohibits business from creating further charges over a secured asset. Information Disclosure: Information may be required to be disclosed to lender on ongoing basis.
(6) Instance of Default: Instance of default clauses tend to permit loan termination by lender. Instances include late payments, insolvency proceedings, and breach of loan covenant.
Implied Terms
Implied Terms: Certain terms are implied into the facility agreement.
(1) Compound Interest: Lenders have the right to charge compound interest on debts.
(2) Court Terms: Courts will impose covenants that ‘go without saying’.
What is security?
Security: It is typical for businesses to offer security over loans. This is safer, so attracts lower interest repayments.
(1) Securable Assets: Virtually all assets can be secured against.
(2) Authority: Directors have authority to offer assets a security unless restricted (s30).
Lender Considerations
Lender Considerations: Lenders make several considerations when seeking security.
(1) Authority: Ensure directors have authority to act by searching records and resolutions.
(2) Assets: Determine whether offered assets are subject to existing charge (and if so, whether sufficient equity remains). Determinable through Registrar of Companies (Land also on LR; IP from IP Office).
(3) Solvency: Ensure no insolvency proceedings or procedures have been issued against business.
What different types of security are there?
Types of Security: There are several types of security.
(1) Charge: Charges are the creation of ‘charges’ over an asset, to act as security in default.
Mortgage: The highest form of security vesting legal title in the lender.
Fixed Charge: Security over a single asset which the borrower cannot dispose of without consent.
Floating Charge: Security over assets in flux to crystallise on default, i.e. stock. Incorporated only.
>Floating and fixed charges may be known as debentures.
(2) Guarantee: Person guarantees loans from their personal assets.
(3) Pledge: Lender obtains physical possession of asset until end of loan.
(4) Lien: Lender has right to physical possession of asset until end of loan.
(5) Title Retention: Lender purchases the asset for the borrower, and retains legal title until repayment.
What different types of charges are there?
Mortgage
Mortgage: Mortgages are the higher form of security, taken over high-quality assets like land. Note that most ‘mortgages’ over land are in fact fixed charges secured by deed.
(1) Process: Lender is given immediate right to possession (but will only exercise on default - see land).
>Registered against property on charges register.
(2) Summary: Mortgages should be sought by lenders at first instance as they are most effective.
Fixed Charge
Fixed Charge: Charge over a single fixed asset only (though each asset may be subject to multiple charges). Borrower is restricted from disposal or reducing value without consent.
(1) Process: Lender has right to realise and sell asset on default (subject to fixed charges with priority).
(2) Summary: Takes priority over floating charges, but value capped at highest securable asset.
Floating Charge
Floating Charge: Charge over general assets in flux, such as stock. Borrower is entitled to deal with those assets until default. This is only available to incorporated businesses.
(1) Process: Lender has right to realise and sell assets on default, known as ‘crystallisation’.
(2) Summary: Value of security can be much higher, but floating charges rank below fixed charges over any relevant assets.
(3) Constraint: Floating charges rank below fixed charges and preferential debtors. A sum of floating charge funds are also ring-fenced for unsecured creditors (insolvency). Invalid floating charges can be set aside on insolvency.
What is a charging document?
Charging Document: Charges are agreed in charging documents, similar to facility agreements for the security itself.
(1) Authorisation: Directors have authority to enter into charging documents by board resolution (MA 3).
(2) Representations: Business must disclose certain information to lender, such as other securities over asset.
(3) Clauses: Charging documents set out the type of security, assets subject, and may include covenants.
Covenants: Typically requirements to maintain asset value and take out insurance.
Administration: Floating charge holder may be given right to appoint administrators out-of-court (QFCH).
(4) Registered Office: Charging document must be kept at the registered office for inspection. Failure does not invalidate the charge, but constitutes a criminal offence (s859).
How is a charge over an incorporated buisiness registered?
Registration of Charge: Incorporated business charges must be registered to ensure the lender’s order of priority.
(1) Application: Charges must be registered at Companies House within 21 days of creation using Form MR01 and a copy of the charging document (s869).
Inspection: Form and copy are publicly inspectable online.
Extension: Courts have limited powers to extend deadline provided creditors would not be prejudiced.
(2) Certificate: Companies House will issue a certificate as conclusive evidence of valid charge (s859I).
(3) Purpose: A validly registered charge binds creditors subordinate to the relevant lender. Failure to register the charge means the loan is only binding on the borrower, and usually triggers immediate repayment.
(4) Removal of Registration: Charges can be unregistered following repayment or lender consent (Form MR04).
What is the priority of charges?
Priority of Charges: The order of priority regarding an asset with multiple charges is determined by statute (s859A).
(1) Floating Charges: Floating charges are always subordinate to mortgages and fixed charges over the same asset, provided they are all valid. This is irrespective of the date of charge/registration (unless subject to deed of priority).
(2) Priority of Mortgages and Fixed Charges: Fixed charges and mortgages take priority according to the date of creation, not registration, so long as registration did occur within 21 days of creation.
>Neither ranks above the other by default.
(3) Priority of Floating Charges: Floating charges take priority over other floating charges according to the date of creation, as above.
Can the priority of charges be altered?
Alteration of Statutory Priority: Lenders can alter the statutory priority amongst one another by deed (s44).
(1) Process: A lender may permit a second lender to take priority over them.
>A fixed charge holding shareholder may relent priority to a bank’s floating charge to incentivise growth.
(2) Deed Formality: Clear on face, signed, witnessed, dated (s1 LPMPA).
What is a negative pledge/charge prohibition?
Negative Pledge: Charging documents may include a negative pledge, prohibiting the business from taking further securities over that asset without lender consent.
(1) Process: Subsequent lenders become subordinate to negative pledge security if they have actual knowledge of the negative pledge, as should be identified on the public Form MR01.
>Businesses will be in breach of the original lender for failure to inform.
>Constructive knowledge is insufficient, so original lender should require business to disclose.
(2) Disclosure: Lenders should require the business to disclose negative pledges.
How does equity finance compare to debt finance?
Risk of Investment
Shares are riskier (downturn means dividends less likely, and capital value decreases)
Debts are safer as a contractual liability, and will often be secured to guarantee repayment.
Involvement
Shareholders have voting rights.
Lender has no say in company operations.
Repayment
Shares are not generally repaid by the company, but can be sold to others.
Loan capital must be repaid, sometimes on demand.
Restrictions on Sale
Share transfer may be governed by company articles. Directors have discretion to refuse registration.
Lenders may sell debentures to third parties - company articles cannot restrict this right.
Capital Value of Investment
Share value may rise and fall as the company succeeds.
Capital value of the loan generally remains constant - income is the benefit.
Statutory Controls
Equity finance is tightly controlled by CA 2006.
Debt finance is governed by contract law, so can be more flexible.
**Payment of Income **
Company pays dividends only if profits are available, and has discretion in any case.
Debt interest must be paid according to terms of loan, regardless of profits.
Tax Treatment of Income
Dividend payments are not tax deductible for the company.
Loan interest repayment is tax deductible for the company.
Cost
The cost of equity is the likely return to a new shareholder.
The cost of debt is the interest rate charged to the company. Consider tax savings.
Existing Restrictions
Articles may restrict company’s ability to issue shares.
Terms of loan agreement may restrict taking of new loans/require consent.
Existing Capital Structure
If a company has high debt, it may only be able to obtain equity (‘high gearing’).
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