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Business basics Part 3: finance

In the third part of his series on how businesses work, Ricky Ghosh talks money

Business basics part 3 finance

Appropriate financing is crucial to the growth and well-being of any company. The difference between corporate success and failure often comes down to whether or not the company can find the right balance of financing. Too little investment may mean that the company won’t have the resources to compete with other businesses in the field and may find itself being overtaken. But if a company takes on too many financial obligations, it may get into difficulties.

The two major methods of corporate finance are debt finance and equity finance.

Debt finance

Debt finance is cash given to a company which it is obliged to repay in the future. The two main forms of debt finance are bank finance (borrowing from banks or other lenders), or debt capital markets (issuing bonds to investors).

The main types of bank finance are overdrafts (short-term facilities which the lender may withdraw at will), term facilities (loans where the lender is obliged to lend an amount of money for a particular period of time), and revolving facilities (hybrids of the other two which allow companies to borrow and repay funds up to a certain limit multiple times over a particular term).

Bonds are tradeable pieces of debt which can be issued by companies, and might be purchased by banks or pension funds and insurance companies, who thereby effectively lend the purchase price of the bond to the issuing company. Bonds can be issued for various time periods and in various currencies. Interest payments from the issuer to the purchasers are usually due every six months. After the bond’s term has expired, the purchase price must be repaid to the purchaser.

Lenders, and occasionally bondholders, may require some of the borrower’s assets to be pledged as security. On bank finance deals with multiple lenders, it’s usual for one lender, or sometimes a third party entity, to hold these rights over the borrower’s assets on behalf of all the lenders. If the borrower fails to meet its repayment obligations, the lender or lenders can exercise these rights over the secured assets and potentially sell them to recover the funds owed to them.

There are many types of security giving different rights to lenders. Deciding the exact combination to be used and the terms of the security agreements will form a significant part of the negotiations on a bank finance deal. Pledges involve the lender taking possession of the asset until repayment. Mortgages involve the transfer of the ownership of an asset to the lender or lenders, subject to the right of the borrower to reclaim the asset once the loan has been repaid. Charges give the lender or lenders the right to appropriate certain of the borrower’s assets if they fail to make repayments on time, and may be “fixed” over particular assets, or “floating” over a fluctuating class of the borrower’s assets, such as a manufacturing company’s current stock.

Equity finance

Equity finance involves the issue of shares in return for cash or other asserts. Because it involves diluting the existing shareholdings (by proportionally reducing each existing shareholders ownership and dividend rights), it’s usually reserved for particularly large investments or situations where a significant new investor who wishes to exercise some control over the running of the business becomes involved.

In order to use this method, the directors must have the legal authority to allot the required number of new shares, either from the company’s articles of association or from a shareholder resolution. However, the directors must bear in mind the statutory “pre-emption rights” of existing shareholders. Unless these are disapplied in the articles or by a special resolution of the shareholders, they oblige the company to first offer any new shares to the existing shareholders in proportion to their holdings.

There are various different kinds of shares which the company may choose to issue. Ordinary shares usually carry basic voting rights and the right to a dividend if one is declared. Preference shares take priority over ordinary shares in relation to dividends and capital rights (which come into play when a company wants to increase its equity financing), but may have limited voting rights. Redeemable shares may be bought back by the company at some point in the future. The rights held by each class of shares must be entered into the company’s articles.

Debt vs equity financing

Here are some of the factors that a company might think about when considering whether to use debt or equity finance.

Payments to investors:

  • Debt: Interest must be paid when due regardless of whether the company has profits available.
  • Equity: Dividend payments are paid completely at the discretion of directors and only if there are available profits.

Repayment:

  • Debt: The money loaned must be repaid at some point in the future, so the company must ensure funds are available to do so.
  • Equity: The company does not generally have to repay anything to equity investors unless the company iswound up.

Power of investors:

  • Debt: Lenders have no direct involvement in the running of the company (although, in practice, they will require full, immediate repayment if there is mismanagement). However, the company’s control over secured assets is limited.
  • Equity: Shareholders have many rights and the power to veto many decisions.