5. Equity and Debt Finance

Equity Financing

Equity finance is a way by which a company raises money through the issuance of new shares in return for cash, referred to as share capital.

• Share capital makes up part of the funds used to run the business, e.g. operational expenditures like paying rent or purchasing machinery

• This is the opposite of debt finance given that it positively affects the company’s balance sheet:

  • Increases assets (via additional cash)

  • Increases capital (due to raised company capital)

Shares

A share represents a bundle of rights. Upon purchasing shares, shareholders gain various rights, including:

• Voting rights

• The right to receive dividends, which represent a return on their investment

Every share will have the following:

According to the doctrine of maintenance of capital, share capital cannot be returned to shareholders and is meant for the company's growth and investment.

Alloting New Shares

Allotting shares ≠ issuing shares:

• Allotment refers to the contractual agreement to allocate specific shares to a person

• Issuance refers to the subsequent legal act of entering them into the register of members

Process for Allotting New Shares

1. Check Articles of Association (AoA): Verify if the company has a cap on the number of shares that can be allotted/issued (if a limit exists companies may remove or change it via SR)

2. Authority Confirmation: Ensure that directors have the authority to allot shares — check the type of company and classes of share it has:

   • LTD (usually has one class of shares): BR is only needed if the shares being allotted are of the same class

   • PLC (usually has more than one class of shares): if AoA does not grant authority for the allotment of shares, then both OR+BR are required

3. Pre-emption Rights: Addresses the rights of existing shareholders to avoid dilution of ownership, i.e. right of first refusal (the right to buy new shares before non-members)

   • only applies when allotting ordinary shares

     • shares must be offered in proportion to current holdings, e.g. if X owns 30% shares = must be offered to buy 30% of new shares to be allotted

     • members will have 14 days to accept such offer

   • to disapply pre-emption rights, a SR must be passed

4. Allot the Shares: After pre-emption rights are complied with or disapplied, directors can now allot new shares to others via BR

5. Administration: Maintain proper meeting minutes and file requisite documents with Companies House

   • Keep board and general meeting minutes for 10 years

   • File copies of SRs and any OR within 15 days

   • File SH01 within 1 month of allotment 

   • Amend the register of members

   • Prepare share certificates within 2 months

Transfer of Shares

Where a shareholder sells their shares to another, no money goes to the company – there is only a contract of sale between one shareholder and another

Transfer Procedure:

1. Check AoA for restrictions on share transfers (e.g. pre-emption rights)

2. Obtain BR Authorization of share transfer

   • board must provide justification for any refusals within 2 months of the transfer application

3. Administer Transfer

   • after payment and stamp duty, buyer must submit a stock transfer form (STF) to register new ownership

   • board must issue share certificate and enter buyer’s name into register within 2 months

Maintenance of Share Capital

Once share capital is raised, it cannot be returned to shareholders – it must stay in the business so that creditors have a guaranteed amount they can get if the company goes insolvent

Returns to Shareholders - Shareholders may recoup their investments through:

1. Dividends: Directors must review the latest audited accounts to ensure distributable profits are available for dividends, paid after tax.

   • Power to pay dividends (lawfully; i.e. AoA allows it), MA usually covers the following: 

     • Interim Dividends: Paid during the year by board resolution

     • Final Dividends: Declared at year-end by board, but approved by shareholders via OR

   • If an unlawful dividend is paid (i.e. company had no profits for payment), directors are held personally liable if they knew/should have known

     • shareholders that receive unlawful dividends may have to repay them if they knew or should have known it was unlawful

2. Buybacks: Companies may buy back shares using distributable profits

   • Involves following steps:

     • shareholder approval of contract via OR - draft must be available for inspection at least 15 days before GM

     • board enters contract, buys, and then cancels the shares

     • filings to company house:

       • notice of cancellation + return to company’s house within 28 days

       • update register and check PSC information on register

Debt Financing

Debt finance refers to the funds a company secures by borrowing money

• Funds borrowed that typically bear interest, increasing company liabilities on the balance sheet.

Types of Debt Finance

1. Loans: Borrowing from banks or other lenders, categorized into:

   • Term Loans: fixed loan amount repayable by a set date - more affordable and certain but involves security.

     • can be payed as bullet repayment (lump sum paid at end of term), or amortization (during term)

   • Revolving Credit Facilities: Acts similar to a credit card by granting a maximum borrowing limit for a period, providing flexibility in borrowing and repayment. Flexible but involves set up costs and formalities.

   • Overdrafts: Allows companies to overdraw on bank account for temporary cash needs - considered quick and flexible but high risk and costly due to unsecured nature.

2. Debt Securities: Bonds (IOUs) sold to investors promising future repayment with interest - this is a long term debt funding

   • Legal Mortgage: strongest form of security - lender gets legal title over asset and is allowed to sell teh property on default

   • Charge: No transfer of ownership like mortgage but lender retains rights to the asset which can be a:

     • Fixed Charge: over specific identfiable assets where the company cannot sell without lender’s consent - there is high priority to lender in insolvensy

     • Floating Charge: over changing assets (e.g., stock) and allows the company to use/sell the assets until the charge crystallizes upon default. Offers lower priority than fixed charges.

   • Pledge: borrower gives physical possession of an asset to the lender until the debt is repaid, with the lender having an implied right to sell if the debt is unpaid.

   • Lien: creditor's right to retain possession of an asset until debt is paid, resulting from operation of law.

   • Guarantee: A third party promises to pay the debt if the borrower defaults; this is a voluntary commitment and often includes a charge over the guarantor's assets. It does not offer direct security to lenders in case the borrower defaults.

Charges must be registered at CH within 21 days of creation - failure to register means:

1. Loan is immediately repayable

2. Security is void against liquidators, administrators, and creditors

3. Charge holder becomes unsecured creditor

Example Q: floating charge dated 15 feb registered 20 feb, and floating charge dated 1 Jan registered 2 feb

First floating charge (dated 15 Feb) takes priority due to the second charge being void bc of not registering within the 21-day deadline, making lender an unsecured creditor

Comparing Equity & Debt Financing

Advantages & Disadvantages

• Debt Finance: Requires repayment and may limit business operations due to covenants; however, it doesn't dilute ownership.

• Equity Finance: Enhances balance sheet attractiveness but dilutes ownership and complicates management with more shareholders.