What is the Best Type of Company Financing?
You can ask our solicitors online for advice on company financing using the question box on the front of our website or the following free legal advice guide may answer your questions.
Many businesses will require some form of capital or company financing to start trading. Capital is a term used to describe the money required to pay expenses for starting a business such as acquiring premises or purchasing equipment and resources.
To make these purchases, the company will require some money in its accounts. Funding is not always required, when the owners have enough funds of their own to start the business for example. However, the majority of businesses will require some form of company financing. There are many different types of finance that you can secure to meet your start-up costs, but the two main types include Equity Finance and Debt Finance.
What is Equity Finance?
A business may decide to issue shares. When this happens, a buyer will purchase shares in the company and become a shareholder. In doing so, the shareholder will gain some rights, particularly when it comes to decision making. Investing in shares means that the shareholder will own a proportion of the business. The business will then have what is known as Issued Share Capital which will be displayed on the balance sheet. Shares can be issued to existing shareholders, transferred from current members to new or assigned to new members.
What is Debt Finance?
Debt Finance on the other hand, is a method of finance which is obtained by borrowing money through a loan. With this type of company financing, the debt must be repaid at some point. A lender will usually lend a set amount of money to the borrower, in this instance it will be the business. There are many different types of lender for business finance including financial institutions or companies and a number of different debt finance options.
Company Financing Loan
One of the most common options when it comes to debt finance is a loan. This is an agreement made between you as a business owner (the borrower) and a third party such as a bank or another business (the lender).
This agreement will state how much you will borrow, for how long and what interest you will be charged. Any loan agreement will include a number of clauses which must be reviewed by a qualified solicitor. Once the agreement is signed, you are legally obliged to fulfil the terms and conditions contained within it. It is extremely important that you comply with the loan agreement terms and conditions because a breach can result in the lender exercising their right to request repayment of the entire loan in full.
A loan can be taken out on a short term or long term basis. Short term loans are often referred to as an overdraft because the lender will usually charge interest on any money which was overdrawn.
The second type of debt finance that you can obtain is something known as a debt security. This is very similar in nature to an equity security but a debt security will involve the creation of a document that assigns certain rights to the investor.
These documents can be sold multiple times to other investors who may express an interest in the company. One of the most popular debt securities is known as a bond. A bond is traded in capital markets and in some instances, a bond can evolve into shares after a certain period of time.
Debt Priorities and Security
When a loan is taken out, the lender will aim to seek some form of security if the company is dissolved or wound up. This safeguards the lender to make sure that they will get paid.
There are various types of securities such as floating or fixed charges or a mortgage. In these circumstances, the lender will take possession of the assets or property until the debt is repaid. If there is a default on repayment, the agreement will include a condition that states the assets can be sold to repay the debt.
There are some key differences between a fixed and a floating charge. A floating charge will become fixed at some point until a point in time that the asset can be freely used. Where there is a fixed charge over an asset, this prevents the owner of the asset to do anything with it, because the asset is controlled by the holder of the security i.e. the lender.
Sometimes, a company may have too many liabilities and therefore they will prove less attractive to a lender. Large organisations such as banks will be very reluctant to lend money in these cases because the risk is much higher.
Some common examples of current liabilities include:
- Accounts payable, i.e. payments you owe your suppliers
- Principal and interest on a bank loan that is due within the next year
- Salaries and wages payable in the next year
- Notes payable that are due within one year
- Income taxes payable
- Mortgages payable
- Payroll taxes
Equity and Debt: Pros and Cons
There are many reasons why a business may decide to issue shares. If this happens and the shareholders purchase shares, the return on investment is known as dividends. The sale of shares may result in capital growth because the business will generate interest from potential investors because the shares can be sold at a profit. In terms of debt finance, the return on the investment is the interest that is paid.
Any sums of money that are invested will be repaid, for example if the company is closed down, or the company purchases its shares back from shareholders or it sells shares.
When a company is wound up, who gets the money first will differ from business to business. Shareholders will receive their shares last. Shareholders may sometimes decide the order in which all of the involved parties are paid from the proceeds of winding the company up. Creditors are always paid before the shareholders. Creditors are simply investors that the company owes money to. If a shareholder owns greater than 50% of shares, they will have more power in decision making processes.
Financing a business through any of the above avenues is a complex process which involves entering into some type of legal agreement. Before you do so, you must seek assistance from a solicitor to review the information contained within the document.
This ensures that there are no onerous clauses or conditions that will be detrimental to your position and the contract is in your best interests.