Critical tax characteristics of debt financing
6.6 Hybrid financing
The distinction between equity finance and debt finance is important in the practice of financing, for tax purposes and in law. Although far more rules of law affect the company/shareholder relationship than affect the company/lender relationship, both relationships are essentially contractual. Significant scope exists for the company and a supplier of finance, be it a lender or putative shareholder, to agree the terms on which they will deal with one another.
This is particularly so where a company has more than one class of shares. Although some rules of company law apply to all shares (such as the prohibition on dividends unless the company has distributable profits out of which to pay them (s 830) and the prioritising of creditors over shareholders in a winding up (Chapter VIII of the Insolvency Act 1986)), other legal requirements can be satisfied by one class of shares. This allows for second and subsequent classes of shares to be set up with fewer legal constraints.
Consider the following examples:
n Provided a company has a class of shares entitled to vote at general meetings, it may create classes of non-voting shares.
n Provided a company has a class of shares entitled to share the surplus assets on a winding up, it may limit the rights to return of capital of the holders of one, several or all other classes of shares.
n Provided a company has a class of non-redeemable shares, it can establish second and further classes of redeemable shares.
The number of classes of shares a company may have is unlimited.
Demand for flexibility from both sides has resulted in enormous variety in the types of financial arrangements in place between companies and suppliers of funds. Arrangements do not always fit obviously into the legal categories of ‘equity’ and ‘debt’: the delivery of commercial flexibility in financing often results in legally complex arrangements with characteristics of both equity and debt, sometimes called ‘hybrid’ financing. It is possible to have shares that look very much like debt and debt that looks very much like equity.
Preference shares are an example of equity financing with one or more characteristics that make them resemble debt. Convertible loan stock is a debt arrangement which, at the option of the holder, can be replaced by ordinary shares, becoming equity financing, usually at a specified conversion price and on a specified date or on the occurrence of a specified event.
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Debt securities: corporate bonds and loan notes/loan stock/debenture stock Secured lending
Debenture
Not a term of art. Refers to all debts and the documents evidencing them.
Equity financing:
Equity shares: bear the greatest risk of any form of corporate financing. No right to dividends, last to participate on a winding up
Non-equity shares: ‘neither as respects dividends nor as respects capital, carr[y] any right to participate beyond a specified amount in a distribution’ s 548
Key distinguishing features of debt and equity financing
Debt Equity
Is the provider of the finance entitled receive payment for the sum of money provided to the company?
This is purely a matter of contract for the company and the lender to agree. Typically, a company is contractually obliged to pay interest at the contractually specified annual rate on the sum borrowed.
This matter is regulated by the articles, the terms of issue of the shares and company law, particularly capital maintenance laws.
Typically, an ordinary shareholder is entitled to receive such dividends as the directors recommend and the shareholders declare by ordinary resolution. If the company has no distributable profits, the company may not pay a dividend (s 830). (See also s 831 for public companies.) Is the provider of the finance
entitled to receive the sum of money provided to the company back from the company?
This is purely a matter of contract for the company and the lender to agree.
The essence of a loan is that the company is contractually obliged to repay the sum borrowed in accordance with the terms of repayment set out in the loan agreement.
This matter is regulated by the articles, the terms of issue of the shares and company law, particularly capital maintenance laws.
An ordinary shareholder is not entitled to insist in the return of his share capital. The company is entitled to keep any sum provided as ‘equity’ until the company is wound up and the assets of the company are distributed. Any agreement otherwise and any action by the company to return capital to the shareholder must be in accordance with the Companies Act 2006.
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HYBRID FINANCING
Key distinguishing features of debt and equity financing
Debt Equity
If the lender needs the money earlier than in accordance with the repayment schedule he may be able to assign the benefit of the debt in return for a lump sum, ie sell the debt.
Provided a company has a class of non-redeemable shares it can issue redeemable shares. A holder of redeemable shares can insist on the shares being redeemed, ie can receive the sum of money paid to the company back in accordance with their terms of issues provided the relevant sections of the Companies Act 2006 are complied with.
A shareholder can sell his shares to a third party unless the articles prohibit this or the shareholder has entered into an agreement not to do so.
Is the cost of funding paid out of pre- or post-tax income?
The cost of debt finance is paid out of pre-tax profit: the cost is deducted as a business expense in the calculation of company profits.
The cost of equity finance is paid out of post-tax profits: dividend payments are not a tax- deductible business expense but must be paid out of the profits of a company after tax has been paid on those profits.
ACTIVITY
Self-testing questions
1. What are the basic methods of funding a company’s operations?
2. What are the key characteristics of a finance lease?
3. Why is it important to recognise a lease as a finance lease rather than an operating lease?
4. Identify six types of debt financing.
5. What is the legal relationship between a bank and a company that has a current account with the bank?
6. May all registered companies offer loan securities to the public?
7. What is a secured loan?
8. Name two types of loan security.
9. What benefit does security confer on a lender?
10. What are the two key legal restrictions on share finance that do not apply to debt finance?
11. State three distinguishing features of equity compared to debt financing.
12. Distinguish equity share capital from non-equity share capital.
SUMMARY
Funding a company’s operations
The basic methods of funding a company’s operations are debt and equity financing.
Lease financing is also available.
Debt financing
n Typical debt arrangements are overdraft facilities, simple loan contracts, syndicated loans, subordinated loans, debt securities and secured lending.
n The rights of creditors are basically contractual though these rights may be supplemented by property rights by way of charges over property of the company put in place to secure debts so that the creditor becomes a secured creditor.
n Security is usually by way of a charge which may be a fixed charge or a floating charge.
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CHAPTER 6 FINANCING A COMPANY
Debentures
n A debenture is a document which either creates a debt or acknowledges it. Not all debentures evidence secured debt, though most do.
Equity financing
n The relationship between a company and a shareholder is partly contractual in nature but in addition to generic legal limits to contract enforcement, mandatory rules of company law regulate the relationship. A company can have any number of classes of shares but the rights attached to each share in a class of shares are uniform (Birch v Cropper (1899) 14 App Cas 525; s 629).
Hybrid financing
n The myriad financial arrangements between companies and suppliers of funds do not always fit obviously into the legal categories of ‘equity’ and ‘debt’.
n Preference shares are equity financing resembling debt.
n Convertible loan stock is a debt arrangement which can be converted into ordinary shares, becoming equity financing.
Further reading
Books
Ferran, E, Principles of Corporate Finance Law (Oxford University Press, 2008).
Ferran, E, Company Law and Corporate Finance (Oxford University Press, 1999) (do not rely on this book for current legal detail because it is written based on the Companies Act 1985).