This article is written by Pallavi Jain pursuing a Diploma in Law Firm Practice: Research, Drafting, Briefing and Client Management from Lawsikho. This article has been edited by Yashprada (Associate, Lawsikho) and Ruchika Mohapatra (Associate, Lawsikho).
This article has been published by Sneha Mahawar.
Table of Contents
Introduction
We frequently assume that debt adds unnecessary stress and generates financial uncertainty. Unquestionably, having too much debt is not a good thing for a corporation or an organisation. A company’s balance sheet with too much debt might result in excessive debt-servicing costs, which include interest payments. As a result, organisations that are in debt may see unpredictable earnings.
Any company can raise funds from two sources: debt capital or equity capital. Without a doubt, equity capital is beneficial since the firm just has to share earnings with the shareholders rather than paying a fixed monthly interest rate that may be excessively high. As a result, debt repayments deplete the company’s cash flow.
So, is it bad for a company to raise capital through debt?
Borrowing money to support a company’s operations and expansion is undeniably a wise move, but only under the appropriate conditions. In contrast to equity capital, which entails selling a portion of the company’s ownership rights to investors through the issuance of stocks, in debt capital, members of the company are not required to give up control and significant influence over the company’s operations. However, it is important to remember that too much debt might stifle a company’s growth.
Definition of debentures
The term ‘Debentures’ is derived from the Latin word ‘debere’ which means to borrow, defined under Section 2 (30) of the Companies Act, 2013 which states that any instrument of a company demonstrating a debt, whether constituting a charge on the company’s assets or not. It can be issued as collateral security for the company or as consideration other than cash where the company can issue debentures to vendors against purchases made to acquire some assets for the company.
Features
- Debentures have documentary value. It is an instrument issued under the common seal of the company. These documents serve as proof of debt. This demonstrates that the company owes a debt to the debenture holder.
- Issuing debentures ensures that the ownership and control is not diluted to the investors.
- Debenture interest is always paid at a predetermined rate. Furthermore, whether the company earns profits or not, it must pay interest.
- Debenture holders have no voting rights at the company’s annual meeting.
- The company has the option of repaying the loan or converting the debenture into shares or can issue additional debentures.
- Debentures may or may not be charged against the company’s assets. That is, they can be granted with or without collateral.
- Debentures, in general, are transferrable. Debenture holders can sell them at any price on stock markets.
- Debenture holders are given priority when it comes to repayment during liquidation.
Advantage of raising capital through debt
Have you ever considered how debt may benefit a business? To commence with, the Government supports debt since the interest may be deducted from corporate income tax, which is one of the highest in the world. This deduction is highly appealing. It lowers the company’s debt cost after accounting for the interest tax deduction. It would be irrational to fund a public company entirely with equity. It is far too inefficient. Debt is a lower-cost source of funds that allows equity investors to earn a higher return by leveraging their money. In other words, the cost of debentures is lower than that of preference shares and equity shares. As a result, debt financing enables a company to leverage a modest amount of money into a much larger sum, allowing for faster expansion. Moreover, debenture issuance is beneficial during periods of inflation.
Disadvantage of raising capital through debt
Taking on too much debt increases the likelihood that the company may have difficulty paying loan payments if cash flow declines. Investors will also view the firm as a bigger risk and will be hesitant to make more stock investments. In addition to it, lenders often insist that some assets of the company be kept as collateral, and the director is frequently needed to personally guarantee the loan. Moreover, payments of principal and interest must be made on the stipulated dates every time. Companies with erratic cash flows may have difficulty paying loan payments. Sales declines might cause significant difficulties in reaching loan payment deadlines.
Types of debentures
A company can issue debentures based on several parameters such as security, tenure, and convertibility.
Based on Security
Secured debentures
Secured debentures are debentures in which a charge is levied on the enterprise’s properties or assets for payment.
Unsecured debentures
Unsecured debentures are those that are not guaranteed by collateral security. There will be no explicit assets set aside to cover unsecured debentures.
Based on Tenure
Redeemable debentures
Redeemable debentures are those that are due at the end of the period, either in a lump sum or in installments throughout the enterprise’s existence. Debentures can be redeemed at a premium or at par.
Irredeemable debentures
Irredeemable debentures, also known as perpetual debentures, do not have a redemption date. They are redeemed either upon the company’s liquidation or, according to the conditions of the issue, when the company chooses to pay them off to decrease its debt by providing advance notice to the debenture holders.
Based on Convertibility
Convertible debentures
Convertible debentures are debt instruments that can be converted into equity shares or any other security at the discretion of the firm or the debenture holders. These debentures are either fully convertible or partially convertible.
Non-convertible debentures
Non-Convertible Debentures cannot be converted into shares or other securities. The majority of debentures issued by companies come into this category.
Condition on the issuance of debentures (Section 71)
According to Section 71 of the Companies Act of 2013, a company can issue debentures with the option to convert them into shares, either whole or partially, at the time of redemption. Notwithstanding, the issuance of debentures with a conversion option must be approved by a special resolution voted by the shareholders at a duly called general meeting of the company.
- No company can issue debentures with voting rights.
- The company cannot offer debentures to more than 500 people unless one or more debenture trustees are appointed. When a company issues debentures, it must maintain a debenture redemption reserve account out of its earnings available for dividend payment, and the money credited to such account may not be used by the company for any purpose other than the redemption of debentures.
- A debenture trustee will take steps to safeguard the rights of debenture holders and to address their grievances.
- Any provision in a trust deed or contract covered by a trust deed exempting or indemnifying a trustee from liability for breach of trust shall be null and void.
- A company is required to pay interest and redeem debentures in line with the terms and conditions of their issuance.
Who can issue debentures
Debentures can be issued by corporations and governments. Governments often issue long-term bonds with maturities of more than ten years. These government bonds are considered low-risk investments since they are backed by the government.
Can a Private Company that is publicly listed issue debentures
Yes, under the Companies Act of 2013, a private company can issue bonds/debentures. There are laws regarding asset cover, credit score rating, debenture redemption reserve, holding liquid assets for current maturities, and so forth. After complying with the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, a private company can do a private placement as well as list it on the BSE or NSE in the debt category.
Convertible debentures
A convertible debenture is a sort of long-term debt issued by a company that may be converted into equity stock after a predetermined period. Convertible debentures are often unsecured bonds or loans with no underlying security to back them up.
Since a company can issue wholly or partly convertible debentures. Partially convertible debentures are a sort of debt. A set fraction of these loans can be converted to shares. The conversion ratio is calculated at the start of the debt issuing process. Whereas, fully-convertible debentures, on the other hand, have the option to convert all of the debt into equity shares based on the parameters established at the time of issue.
These long-term debt securities, like any other bond, pay interest to bondholders. Convertible debentures are distinguished by the fact that they can be exchanged for shares at defined intervals. This feature provides the bondholder with some security, which may mitigate some of the dangers associated with investing in unsecured debt.
Condition of conversion of debentures into equity shares
A convertible debenture is a composite asset that combines the characteristics of debt and equity securities. Convertible debentures are fixed-rate loans issued by companies that make set interest payments to bondholders regularly. The number of shares received by a bondholder for each debenture is decided at the time of issue using a conversion ratio. Bondholders can choose to keep the bond until maturity, at which point they will get a return of their principal, or they can convert the debentures into stock. The debenture is often only convertible into stock after a specific period, as indicated in the bond’s issuance.
However, a convertible debenture often pays a reduced interest rate since the debt holder has the opportunity to convert the loan to shares, which benefits the investors. As a result, investors are ready to accept a lower interest rate in return for the option to convert debentures into ordinary shares. As a result, convertible debentures enable investors to participate in buying shares at increased prices.
Benefits of convertible debentures
- Convertible debentures are composite financial instruments that attempt to establish a balance between debt and equity.
- Investors are paid a set rate with the ability to participate in any growth in stock price.
- Investors can retain the bond until maturity and get interest income if the issuer’s stock price falls.
- In the case of a company’s collapse, convertible bondholders are paid before shareholders.
Drawbacks of convertible debentures
Convertible debentures may appear to be lucrative on the surface, but they do have significant limitations, which are as follows-
- In return for the opportunity to convert to stock, investors receive a lower interest rate than regular bonds.
- Investors may lose money if the stock price falls as a result of the bond-to-equity conversion.
- Bondholders face the risk that the company will default and be unable to repay the principal.
Redemption of debentures
Redemption of debentures refers to repaying or clearing any outstanding obligations and loans to the debenture holder or lender who provided the loan, essentially settling the loan once its duration expires. It is accompanied by a set of terms and conditions agreed upon by both parties regarding the loan or debt repayment.
Method of redemption of debentures
The Companies Act, 2013 does not prescribe any rigid method or condition for the redemption of debentures. According to Rule 18(7) of the Companies Share Capital and Debenture Rules 2014, at least 15% of the face value of the debenture amount must be repaid during the fiscal year in which the company invests in designated securities. This must be completed by the 30th of April of the maturity year. Furthermore, companies should keep in mind that the DRR account must be created in any financial institution in India that is authorised by the Reserve Bank of India.
The redemption of debentures can be accomplished in a variety of ways. These can be classified as follows:
Payment in lump-sum on the debenture’s maturity
The whole amount of debentures is paid to the debenture holders as a single full quantity of money at the end of a defined time, i.e. at the debentures’ maturity.
Payment in installments after the maturity date
In this form of debenture redemption, the borrowed funds are repaid in a series of payments, which may be regular or irregular, depending on the terms of the debenture’s redemption requirements.
Redemption through the purchase of the debenture on the market
Companies and corporations are eager to sell their debentures on the open market. They can also opt to cancel them immediately, allowing the company to extend the maturity of the debenture until the payment is appropriate for its financial capacities. Furthermore, if the debentures are purchased on the open market at a discount, the company can take advantage of the chance to decrease the overall redemption payment, hence enhancing overall business income.
Redemption through the conversion of debentures into new debentures or equity shares
The terms and conditions of the conversion of such a debenture are addressed to the holder at the time the debenture is issued. Such debentures are converted to fresh debentures, or the company might issue equity shares at par, at a discount, or even at a set premium.
Conclusion
As with equity financing, the company must determine whether or not to retain some control over the company while continuing to operate debt-free. It will raise future responsibilities with debt financing, but the future of the company will stay in the hands. Most companies will require some type of debt financing for additional cash as it enables the company to invest in the resources it requires to expand or requires cash to purchase equipment, machinery, supplies, inventory, and real estate. The real issue with debt financing is that the borrower must ensure that they have enough cash flow to satisfy the loan’s principal and interest commitments. Both options have distinct attractions and trade-offs. Therefore, before making any permanent decisions, a company should conduct research and examine a variety of issues.
References
- https://www.investopedia.com/terms/d/debtfinancing.asp#:~:text=Debt%20financing%20occurs%20when%20a%20company%20raises%20money%20by%20selling,bonds%2C%20bills%2C%20or%20notes.
- https://www.investopedia.com/ask/answers/032515/how-does-company-choose-between-debt-and-equity-its-capital-structure.asp
- https://taxguru.in/income-tax/debentures-companies-act-2013.html#:~:text=Section%2071(4)%20of%20the,for%20the%20redemption%20of%20debentures.
- https://taxguru.in/company-law/issue-debentures-companies-act-2013.html
- https://taxguru.in/company-law/debentures-issue-process.html
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