AIMS AND OBJECTIVES
After reading this chapter you should be able to:
Identify the basic methods of funding a company’s operations
Recognise a financing lease distinct from an operating lease
Identify six types of debt financing
State the benefits to a lender of a secured loan compared to an unsecured loan
Discuss the main legal restrictions on share finance that do not apply to debt finance
Understand the composition of share capital
Understand the key distinguishing features of debt and equity financing
The aim of this chapter is to introduce you to:
how a registered company limited by shares funds or obtains the money and assets it requires in order to conduct its business operations;
the basic legal principles governing different types of funding or financing arrangements.
The financing structure of a company is not static. It changes over time in response to the business needs of the company and the relative costs of different types of financing. The financing structure of a closely held company may also often change in response to the needs of its shareholders.
The amount of funding a company needs will be determined by the business needs of the company from time to time. If a company seeks to expand its business for which it requires new manufacturing equipment but does not have the money to pay for the required machinery, for example, it will need to fund the acquisition of the machinery.
The type of financing arrangement used to obtain the required funding will largely be determined by the relative costs of different types of financing. It is assumed that a company run for profit will seek to minimise the cost of funding its business operations as part of its endeavour to maximise profits. If this is correct, all other things being equal, the structure of a company’s financing will change over time in response to one type of finance becoming less expensive than another. All other things being equal, when interest rates are high, we would expect to see a company that has borrowed a lot of money at an interest rate that varies with market rates seeking to refinance its debt, possibly by raising money from the issue of shares and using that money (equity financing) to reduce its borrowings (debt financing).
The cost of funding is a combination of the sums payable to the provider of the funding, such as interest payable to a bank pursuant to a bank loan, and the administration costs of setting up and managing the relationship with the funding provider (referred to as ‘transaction costs’), such as lawyer’s fees for advice and drafting contracts, and other expenses incurred to ensure compliance with applicable laws and regulations. What appears to be a cheap source of funds may turn out to be an expensive funding option if the transaction costs to access it are high. The interest rate payable on money borrowed from a bank or banking syndicate may be higher than the rate payable on money borrowed from members of the public, yet the costs of entering into debt arrangements with the public, typically by the issue of debenture stock, are high. Once transaction costs are taken into account, the bank loan may be the less expensive funding option.
A third factor, critical in assessing the relative cost of funding options, is the impact of the proposed financial arrangements on the tax position of the company. The growth of lease financing in the period up to the mid-1980s was driven by tax incentives which made lease financing a relatively inexpensive type of financing arrangement. Corporate tax is a complex subject on which companies seek advice from highly specialised accountants and lawyers. Extremely complicated financing arrangements are often put in place because they are ‘tax efficient’. Even for small, family owned companies, tax efficiency is a significant factor affecting the company’s financing arrangements. The aim in such cases will not necessarily be to minimise the taxes payable by the company, but to arrive at the most tax efficient position for the sole or major shareholders. This involves consideration of the taxes payable by both the company and the shareholder.
The financing arrangements of a large listed company are likely to be far more complex than those of a small, closely held company, yet the basic legal framework of corporate financing explained here is the same for all companies limited by shares.
The basic methods of funding a company’s operations are:
issue shares: equity financing;
borrow money: debt financing.
Equipment needed by a company can also be acquired by lease financing.
Most companies are financed by a combination of debt and equity financing. A company with a high proportion of its financing in the form of debt is known as a highly geared company. It is also described as highly leveraged. A highly geared, or highly leveraged, company is more vulnerable to insolvency than a company with low gearing. This is because it must service its debts, that is, make the payments due under its loan agreements, regardless of its turnover or profits. In contrast, the level of dividend paid to equity shareholders will reflect the profitability of the company and will fall following an extensive period of poor trading. Moreover, it is unlawful for a company to pay a dividend to its shareholders unless it has distributable profits out of which to pay it.
The law governing debt financing is principally contract law. Other sources of governing law are banking law and, if the company is borrowing directly from the public by the issuing of debt securities (also called debenture stock), securities regulation.
Core company law focuses on equity financing: the relationship between the company and its shareholders. The introduction to equity financing in the final section of this chapter leads into the more detailed consideration of shares, shareholders and share capital in the next chapter.
Lease financing is separated out from equity and debt as a type of financing because it is legally distinct from both. From a financial and accounting perspective, however, finance leases are essentially the same as term loans. If a company requires a particularly costly asset for use in its operation, instead of borrowing or issuing shares in return for the money to buy the asset, it may decide to hire the asset under a contract. The contract is called a lease.
Certain types of leases are regarded as part of corporate finance because from a non-legal perspective they function in the same way as borrowing a sum of money and spending the borrowed money on the relevant asset. These ‘finance leases’ are distinguished from operating leases by key characteristics:
they are typically long term (ten years is not unusual) and cannot be terminated earlier by the company except in very limited circumstances involving cause (for example, the asset is defective) or payment of a significant sum;
the sum of the lease payments is at least 90 per cent of, and is almost always more than, the price at which the company could buy the leased asset;
the asset is not intended to be hired out to any other person: the term (length) of the lease is at least as long as the useful lifespan, or economic life, of the leased asset;
the lessee is responsible for the servicing and maintenance of the leased asset so assumes substantially all the risks of ownership (as well as the rewards, i.e. the right to possession and use).
The true nature of finance leases is indicated by the fact that the lessor is usually a finance company, a bank or a banking subsidiary. Special rules govern how finance leases, distinct from operating leases, have to be accounted for. Essentially, these special accounting rules result in the same accounting entries in the balance sheet of a company in relation to a finance lease as for a loan and subsequent purchase of an asset with the borrowed sum. Even if in law the company is neither the owner of the asset nor a borrower of money it must regard itself as such for finance and accounting purposes.
A person to whom a debt is owed
Debt financing occurs when a company enters into a contract to borrow money from another person, typically a bank, which lends money to the company. The cost of borrowing is usually expressed as interest on the sum borrowed (the capital sum) and interest payments are a tax-deductible business expense payable by the company.
Lenders are a type of creditor and are often called ‘financial creditors’ to distinguish them from other creditors to whom the company owes sums of money. Unlike other creditors, even if lending money is not the principal business of a financial creditor, it is the principal purpose of the financial creditor’s transaction with the company.
Other types of creditors are trade creditors and judgment creditors. An example of a trade creditor is a supplier to the company who agrees that the company may pay for the goods or services supplied to the company some time after delivery or performance. A judgment debtor is a person who has secured a judgment for a sum of money against the company which the company has not paid. The judgment may have arisen out of a range of legal wrongs, including, for example, negligence on the part of the company. If a company fails to pay its taxes by the due date, HM Revenue & Customs (HMRC) will also be a creditor of the company.
A creditor who has sued the company owing him money and obtained judgment from the court in his favour against the company
Critical legal characteristics of debt financing
Subject to generic legal limits to contract enforcement such as illegality and public policy considerations, essentially, the law will give contractual effect to whatever bargain a lender and company reach. The legal essence of debt financing is that if the company defaults on any payment due under the loan agreement, whether interest payments, repayment of the sum borrowed or both, the lender can sue the company to recover the unpaid sums.
Critical tax characteristics of debt financing
The different tax treatment of the cost of debt finance (interest payments) and the cost of equity finance (dividends) has made debt financing very popular in the UK.
The cost of debt financing is deducted, along with other costs of doing business, from the receipts of the company from its business operations, in the calculation of a company’s profits. The cost of debt finance is paid out of pre-tax profit. In contrast, the cost of equity finance is paid out of the profits of a company after tax has been paid on those profits. The cost of equity finance is paid out of post-tax profits. This difference in taxation gives debt finance a tax benefit over equity financing. All other things being equal, UK tax treatment makes debt financing less expensive than equity financing.
The key characteristics of common types of debt financing are examined below.
The most common type of debt or loan financing is an overdraft facility. An overdraft is called a ‘facility’ because it is an arrangement available to the borrower should the borrower wish to use it or ‘draw-down’ on it. It is a revolving facility because the borrower can repay sums borrowed and draw-down further sums at will, so that the sum borrowed increases and decreases over the life of the facility.
The relationship between a bank and a company (or any person) that has an account with an overdraft facility is contractual. When the company deposits money in the bank account, the bank becomes the debtor and the company is the creditor: the bank owes money to the company. When the account becomes overdrawn, the character of the parties to the contract is reversed and the bank becomes the creditor and the company is now the debtor: the company owes money to the bank.
The terms of the overdraft contract will state, amongst other things, the limit of the overdraft facility, i.e. the maximum sum the company may owe the bank at any point in time, the interest rate payable by the company on any sum borrowed/overdrawn and the circumstances in which the bank can require the company to repay the sum borrowed/overdrawn.
Understanding how an overdraft works is a precondition to understanding the application in certain circumstances of laws governing transaction avoidance procedures available to a liquidator (see Chapter 16).
The simplest type of debt or loan financing is a term loan. Consider the following simple example:
a bank (the creditor) (the lender);
contracts to lend (a loan);
to a company (the debtor) (the borrower);
£100,000 (the capital sum);
at a fixed rate of interest of 6 per cent per annum (or at a variable rate of interest);
interest is payable annually on the outstanding capital;
capital is repayable in ten annual instalments of £10,000;
if the company fails to make any capital or interest payment on the due date, the total outstanding sum and accrued interest becomes repayable immediately.
The term syndicated loan simply refers to a loan entered into between the company and more than one lender, the ‘syndicate’ of lenders or ‘banking syndicate’. The loan is usually large and the contractual arrangements between the various lenders and the company can be very complicated. There is usually a lead lender or ‘underwriter’ of the loan which is usually the bank providing the largest part of the loan. The main reason for syndicated loans is to share amongst a number of lenders the risk of the company not being able to repay the large sum of money borrowed.
A subordinated loan is a loan that provides for the company to repay to the lender the sum borrowed only after the lender has first repaid in full sums owed to other specified lenders under specified loans. The subordinated loan is said to rank after those other specified loans. The subordination makes the loan riskier for the lender than it otherwise would be as, should the borrowing company run into financial difficulties, the lender has less chance of being repaid the sum lent than it would have if the loan was not subordinated.
Rather than borrowing money from a bank or other financial institution, a company may choose to borrow money from the public directly. The money that banks and other financial institutions lend to companies is ultimately accessed from the public, who deposit money in current or savings accounts. Accessing the public directly can save a company costs by cutting out the bank’s and/or other middle man’s costs and profits.
Company borrowing from the public most commonly takes the form of a company issuing corporate bonds (such as eurobonds and medium term notes) or ‘loan notes’ (also referred to as ‘loan stock’ or ‘debenture stock’) all of which are forms of ‘debt security’. Debt security is a broad term encompassing securities issued by a range of issuers which includes companies but also includes, for example, the government. Treasury bonds, for example, are debt securities.
Securities regulation imposes strict legal rules on companies offering debt securities to the public. Compliance involves significant legal and administrative costs. Consequently, the issue of debt securities is only practical for raising large sums. Also, the issue of debt securities can only realistically be contemplated by companies that have established good commercial track records and are therefore attractive to investors.
Corporate debt securities are instruments of indebtedness of the company. They are usually freely transferable by the lender and are typically listed on a stock exchange where they are bought and sold just like shares: they are traded in the capital market. The term ‘debenture stock’ is usually reserved for corporate debt securities that are secured, typically by a floating charge. ‘Secured’ basically means that the contractual right to be paid is reinforced by a property right (see the next section). This is not always the case, however, and some debenture stock, notwithstanding its name, is not secured.
Banks are unwilling to lend large sums to companies on an unsecured basis. Revisit the example of a simple, unsecured, loan contract set out at section 6.4.2 above and consider what the bank can do if the company fails to make a payment to the bank under the agreement, i.e. ‘defaults’ on payment of interest, repayment of the sum lent (the capital or principal) or an instalment thereof, or both. Apart from writing letters demanding payment or renegotiating the terms of the loan, the bank may:
sue the company to recover the sum payable under the terms of the loan agreement, seek to enforce the judgment and, if execution of the judgment debt fails, petition the court to have the company wound up;
issue a statutory demand for payment (if £750 or more is owed) following which, if the company fails to pay, petition the court to have the company wound up.
Provided a company has the money to pay the sum owed, receipt of a statutory demand normally results in swift payment without the need for further legal action. If, however, a company cannot repay the sum due because it does not have the money, it is likely that the company will owe money to more than one creditor. Even if there are no judgment creditors, it is likely to have a mixture of financial and trade creditors and HM Revenue & Customs is likely to be a creditor due to unpaid taxes.
A company is insolvent and an application to wind it up can be made if it is unable to pay its debts