Debt finance Flashcards
What is debt finance?
An option to raise finance for any company: borrowing money usually from a bank or other lenders
It can be classified as:
- loan facilities
- debt securities (type of debt)
What will the lender be concerned about?
The lender will want to ensure that they are protected from the possibility that the borrower may be unable to repay the loan. The key method of protection is to take security over assets
What is a loan facility
It 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
Includes:
- Overdraft
- Term loan
- Revolving credit facility
What are debt securities?
Debt securities are a means by which the company receives money from external sources. In return for finance provided by an investor, the company issues security acknowledging the investor’s rights
- piece of paper acknowledging the debt
- at the maturity date of the security, the company pays the value of the security back to the holder
What is an example of a debt security?
A bond - the issuer (company) promises to pay the value of the bond to the holder at maturity
- bonds are issued with a view to being trader on the capital market
- private companies can only issue bonds to targeted investors
What are examples of debt/equity hybrids
Convertible bonds:
- Bonds which can be converted into shares. These start off as debt security, and later if the investor decides to convert them, the bond is swapped for shares
Preference shares:
- It is wholly equity, but can be considered hybrid as a holder commonly has no voting rights and usually gets a definite amount of dividend ahead of other shareholders
What are the main debt finance documents?
Term sheet: statement of key terms of the transaction agreed by lender and borrower
- not intended to be legally binding
Loan agreement: sets out the main commercial terms of the loan
- heavily negotiated
- includes private terms/agreement between the two parties - not made public and not sent to Companies House
Security document: if a loan is secured, a separate security document is negotiated and entered into
What is a debenture?
- In the context of secured lending, it is a form of security agreement that grants security interests over a broad range of the security provider’s assets as collateral in the event of default - type of security document
- It can also refer to the document which creates or acknowledges debt - covers any form of debt security
What are the filing requirements at Companies House?
Send:
- Form MR01
- Certified copy of the debenture
- Relevant fee
Do NOT send:
- Loan agreement
- Guarantee
What are important terms in loan agreements
Consider for negotiation purposes
- Representations
- Undertakings
- Event of default - breach of either representations or undertakings give the bank/lender contractual remedies where the breach constitutes Event of Default
What are common types of default
- Non-payment of interest or capital
- Not paid loan repayment in another lender’s loan
- Breach of financial covenant (e.g., regarding gearing ratio)
What is security?
Temporary ownership, possession or other proprietary interest in an asset to ensure that a debt owed is repaid. It is to protect the creditor in the event that the borrower enters into formal insolvency
Forms of security:
- Pledge - security provider gives possession of asset to the creditor until debt is paid back (delivery of goods and transfer of possession)
- Lien - creditor retains possession of asset until debt is paid back (retain goods to secure payment)
- Mortgage - if the borrower cannot repay, the lender can take ownership of the asset to repay the loan
- Charge - security provider retains possession of the asset. The borrower retains ownership but the lender has the right to the asset or its proceeds if the borrower defaults.
When is a fixed charge appropriate?
- Plant and machinery (machinery and vehicles)
- Under a fixed charge, the creditor can control what the security provider (borrower) can do with the fixed charge assets (controls significant changes and restricts company from selling or charing further)
- This is usually done by the security provider undertaking not to dispose of or create further charges over the asset without the creditor’s consent
- The borrower can still use the asset in the ordinary course of business, but is restricted from disposing of or charging it
- If the charge becomes enforceable, the creditor can appoint a receiver of that asset or exercise a power of sale
- A creditor can take legal action to prevent the sale or claim the proceeds to satisfy the loan
When is a floating charge appropriate?
- It is not always practical for a security provider to undertake not to dispose of its assets. For example, a trading company must be able to dispose freely of its stock
- This means that a floating charge is more appropriate for stock
- It floats over the whole class of circulating assets
Crystalisation - the process where a floating charge stops floating and ‘fixes’ to the assets in the class which are owned by the security provider at the time of crystallisation. This means the creditor acquires control and this may occur if there is a breach of particular terms of the loan agreement
What are the disadvantages of a floating charge from a creditor’s perspective (advising a client on)?
- Cannot be certain of the value of the assets
- Statutory order of priority upon a winding up: floating charge ranks below a fixed charge and below preferential creditors
- An administrator is free to deal with floating charge assets in their control without reference to the charge holder
What is a guarantee?
A guarantee for a loan means an agreement that the guarantor will pay the borrower’s debt if the borrower fails to do so
- a holding company can act as a guarantee
How and when must charges be registered (advising clients on practical / legal steps)?
To ensure that the bank/lender has effective security, the security document needs to be registered at Companies House within 21 days beginning with the day after the date of the creation of the security
Documents to deliver to Companies House:
- Form MR01
- Copy of the charge
- Relevant fee
Advising clients on next steps
- Timeline: 21 days
What is the effect of a failure to register within the time limit? (advising clients on consequences)
- The charge is void against an administrator or liquidator and any creditor; and
- The debt becomes immediately due and payable
This means the security taken is effectively worthless if it is not registered and in the event of insolvency, the lender would be ranked as an unsecured creditor
What records must a company keep of its charges? (Considering practical advice for a client)
A company must keep available for inspection a copy of every charge and every instrument which amends or varies any charge. These are kept at the companies registered office and must be available for inspection by a creditor or member free of charge
- Failure to comply with these requirements would be an offence and company is liable to a fine
What is gearing?
The ratio of debt to equity is an important indicator of financial health of a company
The higher the ratio of debt to equity, the more highly geared a company is
What is the effect on gearing by raising finance through taking a loan (advising client on consequences/considerations of debt finance)?
Taking out a loan would increase the company’s gearing
- A loan has no effect on total equity
- A company’s liabilities are increased, but the company’s assets are also increased (net assets remain unchanged)
Considerations:
- A company needs to be confident that it is financially strong enough and able to pay the interest and other sums due under the loan agreement
What are the risks of a company being highly geared?
- Highly geared companies are more of a credit risk fr banks/lenders, which may make it harder to raise further loans in the future
- Less equity to protect the creditors (higher risk)
- Will need to make more profits before interest and tax to meet demands for interest payments
- In difficult financial times, gearing is risky (commercial awareness context)
What are the advantages of being highly geared?
- By borrowing money, a company can make bigger investments. Any profits from successful investments belong to the company
- Advantageous for shareholders: raising money through debt finance does not involve diluting the rights of existing shareholders, as not issuing new shares
- Improves earning per share for shareholders (advantage for shareholders)
Negative pledge clause (consider advising a client when to use this - negotiation)
A promise made by a borrower who is giving security in return for a loan, that it will not create any future charges that will rank in priority to the floating charge, for example a fixed charge, without the lender’s consent.
The purpose is to ensure future creditors of the company do not obtain security that ranks in priority to the bank
