What is finance?
The company needs to have some capital in order to start its business. Capital includes money for expenses in relation to starting up a business, buying new premises or another business etc. For all these a company will have to have some money on its account. There are several types of finance which the company can use in order to be able to fully function. The main types of finance are Equity finance and Debt finance. A company can however finance itself through other means too e.g. its earnings.
A company may decide to issue shares. The Buyer who buys such shares is called a shareholder. The shareholder will also acquire some rights together with the shares. Shareholders may have voting rights and may therefore have an influence in decision making. By buying the shares of the company the shareholder becomes partly an owner of the company. The company will have Issued Share Capital and this will also be shown in the company’s balance sheet. Shares can be issued to existing shareholders of the company, allotted to the new members and transferred from existing members to new members.
Debt finance is a type of finance where a company borrows money and creates a debt which will then have to be repaid. E.g. taking out and repaying a loan. The Lender will simply lend the money to the Borrower. The Lender can be another company, some financial institution, a bank etc. There is however a different types of debt finance. One of them, as already stated above, is a loan.
A loan is an agreement between the Borrower and the Lender as to how much money is borrowed, when it is to be repaid how often or in what instalments. Such an agreement may contain some other important clauses which should be reviewed by a solicitor or an authorised person in order to get a professional legal advice in relation to them. By signing such an agreement, the Borrower agrees to comply with its terms and conditions. It is important to comply with those terms as their breach may give the right to the Lender to call for repayment of all money. Loan can be long term or short term. Short term loan is called overdraft and the banks usually charge an interest on money which was overdrawn.
Another type of debt finance is issuing debt securities. These are similar to equity securities. Debt security constitutes a document which gives some rights to the investor (in this specific company). These documents can circulate and can be sold to some other investors who may have an interest in them. A commonly known debt security is a bond. Bonds are traded at markets which are called capital markets. There are some other bonds called hybrid bonds which can become shares after some time. What constitutes shares is explained above.
Taking security for a debt priority
By taking security for a debt priority, the Lender makes sure he will be paid in case of the company’s winding up. There are different types of securities for instance mortgages, floating and fixed charges etc. Security provider will therefore take possession of the assets until the debt is repaid. Usually the agreements contain the condition that such assets may be sold in case if there is a default on payment. The difference between the fixed and floating charge is that the floating charge becomes fixed at a later stage and until such time the asset over which this charge was imposed is free to be used and controlled. If there is a fixed charge over an asset this prevents the owner of the asset to do anything with it as the right of control is in the hands of a security holder. It is a significant disadvantage of a floating charge that the owner of the asset can for instance sell it before it becomes a fixed charge.
Liabilities of the company
If a company has too many liabilities it will be less attractive to the banks. The banks will not want to lend any more money to it as it will represent a risk for them.
Advantages and Disadvantages of Equity and Debt
If a company decides to issue shares and the shareholders buy shares in the company, the return on such an investment will be dividends. Selling shares may represent a capital growth as more possible investors will be interested in shares and they can sell them for a profit. In case of debt finance the return on investment will be interest paid. The amount invested will be returned e.g. on the winding up of the company, by the company buying its shares back or on the sale of the shares.
In relation to Debt finance the amount invested will be returned on the date of the repayment of the loan or by selling the debt. In case of winding up of a company priority on who gets the money first differs. Effectively, the shareholders get paid last. The shareholders may however decide between themselves who will get paid first and who will get priority amongst themselves. Creditors are paid before the shareholders. Creditors are investors to whom the company owes the money. Sometimes these agree to give priority to others. Shareholders as opposed to creditors get voting rights depending on what types of shares they own. If a shareholder holds more than 50 percent of shares, it will enable him to have more powers in decision making.
In relation to debt finance, the borrower may bind himself to do or not to do some things while carrying out its business. If securities are issued, these may give some powers to the owner of securities. There is a significant advantage relating to dividends, they are considered as a profit therefore not for deducting tax purposes. As opposed to this there is a significant disadvantage in having a loan. Such a loan may prevent other loans to be taken out and interest is taxable.