Debt finance for companies

Introduction

Why does a company need capital?

In order to fund:

• start-up expenses;
• working capital; and
• expansion and growth (e.g. purchasing new premises or another business).

Capital can come from:

• equity (shareholder funds);
• debt;
• hybrids (such as preference shares and convertible bonds); and
• retained profits (also known as ‘retained earnings’).

What is debt finance?

A simple definition is ‘borrowing money’ from banks, other financial institutions or other lenders (such as directors or other group companies).

Types of debt finance

Although there are many types of debt finance available under different names, they can all be classified as either loan facilities or debt securities. In general terms, a loan facility is an agreement between a borrower and a lender which gives the borrower the right to borrow money on terms set out in the agreement.

A debt security (bond) is in many ways similar to an equity security (share). In return for the finance provided by an investor, a company (known as the ‘issuer’) issues a piece of paper acknowledging the investor’s rights against the company. This piece of paper (a security) can either be kept or sold to another investor. However, as we shall see below, investors in debt securities have rather different rights from investors in equity securities. The terms ‘equity security’ and ‘debt security’ should not be confused with a security interest granted by a company to the lender(s) over one or more of its assets.

Some of the basic types of debt are detailed below:

Loan facilities

• Overdraft – This is a form of loan facility that is familiar to most individuals. It is an on-demand facility (which means that the bank can call for all the money owed to it to be paid back at any time) and is usually not used as a long-term borrowing facility. Companies also use overdraft facilities. Interest is paid to the bank on the amount that the customer is ‘overdrawn’.
• Term loan – A term loan is borrowed for a fixed period of time and repaid on a certain date (‘maturity date’). For example, a company may borrow a sum of money to purchase new machinery for the business. The loan is to be repaid in five years’ time. The lender will not be able to call for repayment before the agreed repayment date in five years unless the borrower breaches the terms of the loan agreement. The borrower pays interest to the lender on the amount borrowed for the duration of the loan.

Term loans which are repayable in a single lump sum at the end of the agreement are referred to as having a ‘bullet repayment’. Alternatively, the loan may be repayable in instalments, in which case it is referred to as ‘amortising’.

Debt securities

• Bonds – A bond is a debt security. Each bond is represented by a piece of paper (a security) which records the rights of the investor. As bonds are a form of debt, those rights are similar to the rights of a lender under a loan facility. The issuer promises to repay the value of the bond to the holder of the bond at maturity. Until then, the issuer promises to pay interest to the holder on a periodic basis (often bi-annually).

Bonds are usually issued with a view to being traded. Whoever holds the bond on maturity will receive the value of the bond back from the issuer. The markets on which bonds are traded, whether physical or virtual, are referred to as the ‘capital markets’.

Debt/equity hybrids

• Convertible bonds

Convertible bonds are bonds which can be converted into shares in the issuer. On conversion, the issuer issues shares to the bondholder in return for its agreement to give up its right to receive interest and repayment of the principal amount invested.

Note that a convertible bond has the characteristics of both debt and equity, but not at the same time. It starts off as a debt security: a bond. The investor receives interest. Later on, if the investor so elects (in accordance with the terms of the bond issue) the bond is swapped for shares. The investor then enjoys all the characteristics associated with shares. At that point there is no longer any debt element to his holding: he has become an ordinary shareholder. Therefore, convertible bonds have the characteristics of debt until they are converted into shares. After that, the holders receive shares with all the characteristics of equity.

• Preference shares

Preference shares are an anomaly. In fact, a preference share is wholly equity, but it is often called a hybrid because it has elements that make it look similar to debt. Indeed, depending on the rights attached to the preference shares, the International Financial Reporting Standards (commonly used by many companies today) provide that there are times when preference shares should be treated as debt for accounting purposes.

The holder of a preference share commonly has no voting rights, and will usually get a definite amount of dividend ahead of other shareholders (making it look similar to interest). So, if the preference share has a fixed maturity date on which the company must redeem or purchase the share and/or such preference dividend is fixed (for example, must be paid if the company has sufficient distributable profits), then the preference share actually looks more like debt.