Debt financing means borrowing money and not giving up ownership. Debt financing often comes with strict conditions or covenants in addition to having to pay interest and principal at specified dates. Failure to meet the debt requirements will result in severe consequences. This means that the effective interest cost is less than the stated interest if the company is profitable. Adding too much debt will increase the company’s future cost of borrowing money and it adds risk for the company. The company receives a loan and gives its promise to repay the loan.
It includes both secured and unsecured loans. Security involves a form of collateral as an assurance the loan will be repaid. If the debtor defaults on the loan, that collateral is forfeited to satisfy payment of the debt. Most lenders will ask for some sort of security on a loan. Debt funds are preferred by individuals who are not willing to invest in a highly volatile equity market. A debt fund provides a steady but low income relative to equity. It is comparatively less volatile. Debentures are one of the common long-term sources of finance. They normally carry a fixed interest rate and a certain date of maturity. Interest is paid every year and principal is paid on the date of maturity.
Advantages of Debt Financing:-
(a) to the Company:
(i) Debentures provide long-term funds to a company.
(ii) The rate of interest payable on debentures is usually, lower than the rate of dividend paid on shares.
(iii) The interest on debentures is a tax-deductible expense and hence the effective cost of debentures (debt-capital) is lower as compared to ownership securities where dividend is not a tax-deductible expense.
(iv)Debt financing does not result into dilution of control because debenture-holders do not have any voting rights.
(v) A company can trade on equity by mixing debentures in its capital structure and thereby increase its earnings per share.
(vi)Many companies prefer issue of debentures because of the fixed rate of interest attached to them irrespective of the changes in price levels.
(vii) Debentures provide flexibility in the capital structure of a company as the same can be redeemed as and when the company has surplus funds and desires to do so.
(viii) Even during depression, when stock market sentiment is very low, a company may be able to raise funds through issue of debentures or bonds because of certainty of income and low risk to investors.
(ix) Benefit of Tax: ‘Debt Financing’ or ‘Issuing of Debenture’ results in interest expense for the borrower which is a tax deductible expense. A company can claim an interest as an expense against its profits whereas dividends paid to equity or preference shareholders are paid out of net profits after taxes. In short, debt financing brings tax benefit to the borrower which is not there in case of equity.
(x)No dilution of control: Issuing of debentures or accepting bank loan does not dilute the control of the existing shareholders or the owners of the company over their business. If the same fund is raised using equity finance, the control of existing shareholders would dilute proportionately.
(Xi) No dilution in share of profits: Opting for debentures over the equity as a source of finance keeps intact the profit-sharing percentage of existing shareholders. Debenture holders or financial institutions do not share profits of the company. They are liable to receive the agreed amount of interest only. Therefore, profits are shared among the same number of hands before and after the new project. The profit sharing percentage of individual shareholders would reduce in case if the equity funds are availed.
(b) to the Investors:
It is not only the company but also the investors who are benefited by investing in debentures or bonds.
(i) Debentures provide a fixed, regular and stable source of income to its investors.
(ii) It is comparatively a safer investment because debenture-holders have either a specific or a floating charge on all the assets of the company and enjoy the status of a superior creditor in the event of liquidation of the company.
(iii) Many investors prefer debentures because of a definite maturity period.
(iv) A debenture is usually more liquid investment and an investor can sell or mortgage his instrument to obtain loans from financial institutions.
(v) The interest of debenture-holders is protected by various provisions of the debenture trust deed and the guidelines issued by the Securities and Exchange Board of India in this regard.
Disadvantages of Debenture Finance:
In spite of many advantages, debenture financing suffers from certain limitations. The following are the major disadvantages of debentures:
(a) From the Point of View of Company:
A company suffers from the following disadvantages of debt- financing:
(i) The fixed interest charges and repayment of principal amount on maturity are legal obligations of the company. These have to be paid even when there are no profits. Hence, it is a permanent burden on the company. Default in these payments, adversely affects the credit-worthiness of the firm and even may lead to winding up of the company.
(ii) Charge on the assets of the company and other protective measures provided to investors by the issue of debentures usually restrict a company from using this source of finance. A company cannot raise further loans against the security of assets already mortgaged to debenture-holders.
(iii) The use of debt financing usually increases the risk perception of investors in the firm. This enhanced financial risk increases the cost of equity capital.
(iv)Cost of raising finance through debentures is also high because of high stamp duty.
(v) A company whose expected future earnings are not stable or who deals in products with highly elastic demand or who does not have sufficient fixed assets to offer as security to debenture-holders cannot use this source of rasing funds to its benefit.
(b) From the Point of View of Investors:
Many investors do not find debentures or bonds as an attractive investment because of the following:
(i) Debentures do not carry any voting rights and hence its holders do not have any controlling power over the management of the company.
(ii) Debenture-holders are merely creditors and not the owners of the company. They do not have any claim on the surplus assets and profit of the company beyond the fixed interest and their principal amount.
(iii) Interest on debentures is fully taxable while shareholders may avoid tax by way of stock dividend (bonus shares) in place of cash dividend.
(iv)The prices of debentures in the market fluctuate with the changes in the interest rates.
(v) Uncertainty about redemption also restricts certain investors from investing in such securities.
Eligibility for Debt Financing:
Anyone who is having funds and want to invest into some business plan can invest in debt. There are various types of debentures like redeemable, irredeemable, perpetual, convertible, non-convertible, fully, partly, secured, mortgage, unsecured, naked, first mortgaged, second mortgaged, the bearer, fixed, floating rate, coupon rate, zero coupon, secured premium notes, callable, puttable, etc.
The debenture classification is based on their tenure, redemption, mode of redemption, convertibility, security, transferability, type of interest rate, coupon rate, etc. Following are the various types of debentures vis-a-vis their basis of classification.
Redemption / Tenure
Redeemable and irredeemable debentures
Redeemable debentures carry a specific date of redemption on the certificate. The company is legally bound to repay the principal amount to the debenture holders on that date. On the other hand, irredeemable debentures, also known as perpetual debentures, do not carry any date of redemption. This means that there is no specific time of redemption of these debentures. They are redeemed either on the liquidation of the company or when the company chooses to pay them off to reduce their liability by issues a due notice to the debenture holders beforehand.
Convertible debenture holders have an option of converting their holdings into equity shares. The rate of conversion and the period after which the conversion will take effect are declared in the terms and conditions of the agreement of debentures at the time of issue. On the contrary, non-convertible debentures are simple debentures with no such option of getting converted into equity. Their state will always remain of a debt and will not become equity at any point of time.
Fully and partly convertible debentures
Convertible Debentures are further classified into two – Fully and Partly Convertible. Fully convertible debentures are completely converted into equity whereas the partly convertible debentures have two parts. Convertible part is converted into equity as per agreed rate of exchange based on an agreement. Non-convertible part becomes as good as redeemable debenture which is repaid after the expiry of the agreed period.
Debentures are secured in two ways. One when the debenture is secured by the charge on some asset or set of assets which is known as secured or mortgage debenture and another when it is issued solely on the credibility of the issuer is known as the naked or unsecured debenture. A trustee is appointed for holding the secured asset which is quite obvious as the title cannot be assigned to each and every debenture holder.
First Mortgaged and second mortgaged debentures
Secured/Mortgaged debentures are further classified into two types – first and second mortgaged debentures. There is no restriction on issuing different types of debentures provided there is clarity on claims of those debenture holders on the profits and assets of the company at the time of liquidation. First mortgaged debentures have the first charge over the assets of the company whereas the second mortgage has the secondary charge which means the realization of the assets will first fulfill the obligation of first mortgage debentures and then will do for second ones.
Transferability / Registration
In the case of registered debentures, the name, address, and other holding details are registered with the issuing company and whenever such debenture is transferred by the holder; it has to be informed to the issuing company for updating in its records. Otherwise, the interest and principal will go the previous holder because the company will pay to the one who is registered. Whereas, the unregistered commonly known as bearer debenture can be transferred by mere delivery to the new holder. They are considered as good as currency notes due to their easy transfer-ability. The interest and principal are paid to the person who produces the coupons, which are attached to the debenture certificate and the certificate respectively.
Type of Interest Rates
FIXED AND FLOATING RATE DEBENTURES
Fixed rate debentures have fixed interest rate over the life of the debentures. Contrarily, the floating rate debentures have the floating rate of interest which is dependent on some benchmark rate say LIBOR etc.
No Coupon Rate
ZERO COUPON AND SPECIFIC RATE DEBENTURES
Zero coupon debentures do not carry any coupon rate or we can say that there is zero coupon rate. The debenture holder will not get any interest on these types of debentures. Need not get surprised, for compensating against no interest, companies issue them at a discounted price which is very less compared to the face value of it. The implicit interest or benefit is the difference between the issue price and the face value of that debenture. These are also known as ‘Deep Discount Bonds’. All other debentures with specified rate of interest are specific rate debentures which are just like a normal debenture.
SECURED PREMIUM NOTES / DEBENTURES
These are secured debentures which are redeemed at a premium over the face value of the debentures. They are similar to zero coupon bonds. The only difference is that the discount and premium. Zero coupon bonds are issued at the discount and redeemed at par whereas the secured premium notes are issued at par and redeemed at the premium.
Mode of Redemption
CALLABLE AND PUTTABLE DEBENTURES / BONDS
Callable debentures have an option for the company to buyback and repay to the investors whereas, in the case of puttable debentures, the option lies with the investors. Puttable debenture holders can ask the company to redeem their debenture and ask for principal repayment.
In these types of debentures, the debenture is given priority after other debts when company goes into liquidation. They are also known as subordinated loan, subordinated bonds, subordinated debt or junior debt
PROCEDURE TO ISSUE DEBENTURES UNDER THE COMPANIES ACT, 2013
Section 56, 72, of the Companies Act, 2013 read with Rule 18 and 19 of the Companies (Share Capital and Debentures) Rules, 2014
- Call and hold Board meeting and decide which types of the debenture will be issued by the Company.
- If the Company decides to issue secured debenture the company has to comply with the condition prescribed in the Rule 18 of the Companies (Share Capital & Debentures) Rules, 2014.
- In case appointment of Debenture Trustee, consent shall be obtained from a SEBI registered Debenture Trustee, who is proposed to be appointed. If debentures to be issued are Secured Debentures, a Debenture Trust Deed in Form No. SH – 12 or as near thereto as possible shall be executed by the Company in favour of Debenture Trusteeswithin sixty days of allotment of Debentures.
- In the Board meeting pass resolutions for
i)Approval of Offer letter for private placement in Form No. PAS – 4 and Application Forms (In case of private placement of debentures);
ii)Approval of Form No. PAS – 5 (In case of private placement of debentures);
iii)Approval of Debenture Trustee Agreement and appointment of a Debenture Trustee (In case of Secured Debentures only)
iv)Appointment of an expert for valuation (In case of private placement of debentures);
v)Approval of increase of borrowing powers, if required;
vi)To authorize for creation of charge on the assets of the company;
vii)Approve the Debenture Subscription Agreement;
viii)To fix day, date and time for the extraordinary general meeting of shareholders
5. Prepare the draft of
i)Debenture Subscription Agreement;
ii)Offer Letter for private placement in Form No. PAS – 4 and Application Forms;
iii) Records of a private placement offer in Form No. PAS – 5;
iv)Debenture Trustee Agreement;
v)Mortgage Agreement for creation of charge on assets of the company.
- Issue notices of extraordinary general meeting along with the explanatory statement.
- Hold extraordinary general meeting and pass special resolution to issue convertible secured debentures and increase borrowing powers of the company and to authorize the Board to create charge on the assets of the company.
- File Form No. PAS – 4 and PAS – 5 in Form No. GNL – 2 with the Registrar of Companies.
- File Offer Letter in Form No. MGT – 14 with the Registrar of the Companies.
- File copy of Board resolutions, Special Resolution, Debenture Subscription Agreement, Debenture Trustee Agreement etc in Form No. MGT – 14 with the Registrar of Companies.
- File Form No. PAS – 3 (Return of allotment) with the Registrar of Companies after making allotment of debentures.
- File Form No CHG – 9 for creation of charge on assets of the Company(in case debenture are secured)
Issue of Debentures, whether redeemable or convertible involves compliance with the substantive and procedural aspects of law, therefore, documentation becomes very important
Filling of resolutions and agreements to the registrar
Within 30 days,
from the date of passing of the special resolution for allotment of securities on private placement in general meeting
– Certified true copy of special resolution
– Offer letter issue to the shareholders
Form for submission of documents with the Registrar of Companies
within 30 days,
from the issue of offer letter to the recorded person
– PAS 4 (Offer Letter)
– PAS 5 (Record of Private Placement)
Return of allotment
Within 30 days,
from the date of passing of the board resolution for allotment and issue of securities
– Certified true copy of Board minute
– List of allottees.
We at Wazzeer will be glad to help you in this matter, from drafting agreements to issuing share certificates, all funding compliance matter we are equipped to take care of.