This article is written by Khushnum Motafram, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.com. Here she discusses “Different Types of Debentures and their Use”.
With the opening of doors to market globalization, every business house, whether a startup or a well-established business house needs funds from a third party for research and development to acquire a market edge over its competitors. These age of competitive business spares no one who struggles coming up with an innovative idea to capture the market share. Such business houses tend to fall even before they get started. The situation is worse for the startup businesses which along with the cut-throat competition also has restraint on financial stability to their despair. For a business house to acquire the market innovation which would work in their favor needs funds for research and development, innovation, implementation and what not. Now the question arises, where do these funds come from? In the corporate world, there are various sources from which such business houses can acquire funds from the market. Business houses can acquire funding by way of floating shares of the company in the form of equity and preference or can procure a loan from banks and financial institutions upon mortgage of company’s asset or can sale some of their shares to third party or can even float and issue bonds and debentures to third parties in accordance with the provisions of applicable laws. Since all these modes have their own advantages and disadvantages along with the procedural and legal requirements, business houses prefer to appoint professional advisors for understanding the implication of each and every mode.
Depending upon various scenarios, a business house and the professional advisor comes up with the best mode feasible to such houses. A business house which would want to retain control over itself would prefer floating of debentures as against the equity or preference shares given the dilution of ownership caused upon the issue of equity and preference shares. Sine, the cost of issuing debt is less than the cost of issuing equity, debt financing is one of the most lucrative ways of raising funds for business growth and development.
As discussed above, a debenture is one of the capital market instrument which helps business houses to raise funds from the market for the development of the business. The word debenture has been derived from the Latin word “debere” which means borrowing or taking a loan. In layman’s language, debenture can be defined as an acknowledgement of debt issued by the company to the third parties under the common seal of the company. In accordance with Section 2(30) of the Companies Act, 2013, debentures include debenture stock issued by the company as an evidence of debt taken by such company, either by creation or non-creation of the charge over the assets of the company.
Salient Features of Debentures
Some of the salient features of debentures are as follow:
- It is an acknowledgement of the debt;
- It is issued by the company under its common seal;
- Debentures can be both secured or unsecured;
- The rate of interest and the date of payment is pre-determined;
- Debentures issued are freely transferrable by debenture holders;
- Debenture holders do not get any voting right in the company;
- Interest payable to the debenture holders are charged against the profits of the company.
Provisions Governing Debentures
Following provisions of the Companies Act, 2013 governs the floatation, issue and allotment with regards to the debentures:
- Section 2(30) – Definition;
- Section 44 – Nature of debentures;
- Section 71 – Provisions relating to issue and allotment of debentures;
- Rule 18 of the Companies (Share Capital and Debenture) Rules, 2014 – Rules pertaining to issue and allotment of debentures.
Types of Debentures
There are various forms of debentures which a company can issue depending upon its requirement. Debentures can be issued based on various factors i.e. performance, security, priority, convertibility and record.
1. Based on Performance
Based on the performance, there are two types of debentures which are issued i.e.
Redeemable debentures are the debentures where the date of redemption of the debentures are specifically mentioned in the debenture certificate issued, where on such date, the company is legally bound to return the principal amount to the debenture holder.
Irredeemable debentures continue for perpetuity and unlike redeemable debentures, there is no fixed date on which the company needs to pay the debenture holders. It becomes redeemable only when the company goes into liquidation.
2. Based on security
When the debentures are issued by way of creation of charge over the assets of the company, then such debentures are called as secured debentures. The charge created over the debentures may be fixed or maybe floating. In accordance with the provisions of the Companies Act, 2013, such charge created has to be registered with the Registrar within 30 days of such creation.
Unlike secured debentures, unsecured debentures are issued by the company without creation of charge over the assets of the company. In other words, these debentures do not offer any protection to the debenture holder in case the company is unable to pay the principal amount on the due date.
3. Based on Priority
First Mortgaged Debentures
Basically, the distinction of debentures based on priority can be called as a subcategory of the secured debentures. First Mortgaged Debentures are those debentures which has first preference over all the other debentures issued by the company. Such preference is claimed at the time of liquidation of the company when the assets of the company are distributed among the credit holders.
Second Mortgaged Debentures
Second Mortgage Debenture, as the name suggests, has second preference over the assets of the company at the time of liquidation after the first mortgaged debentures. Only after the first mortgaged debenture holders are satisfied, will the second mortgaged debenture holders can claim their principal amount from the company at the time of liquidation.
4. Based on Convertibility
Fully Convertible Debentures
Fully convertible debenture holders have the right to convert their debentures into equity shares of the company at a future date, at the option of the debenture holders. The conversion ratio, the rights of the debenture holders post-conversion and the trigger date for conversion are defined at the time of issue of these debentures.
Partially Convertible Debentures
Partially convertible debentures can be divided into two parts. The first part being the debentures which are convertible to equity shares of the company and the second part being non-convertible debentures which shall redeem at the expiry of its tenure. An option is given to the debenture holder to partially convert its debt into shares of the company. Partially convertible debentures are also deemed as optionally convertible debentures.
Debentures which do not have an option to get converted into equity shares of the company are called non-convertible debentures. These debentures get redeemed at the end of the maturity period.
5. Based on Record
In case of registered debenture, the name, address, number of debentures and other details pertaining to holding are entered by the company in the register of debentures. In such cases, the transfer of debentures from one debenture holder to another debenture holder is recorded in the register of debenture holders as well as register of transfer.
Unregistered debentures are also called bearer debentures. Unlike registered debentures, the company does not maintain the records of such debentures and the principal amount and the interest is paid to the bearer of the instrument as against the name written over such instrument. These debentures are easily transferrable in the market.
Use of Debentures
Debentures are issued by the company in order to raise funds from the market. Such funds are then used by the company for research and development and growth in the market. Debentures or debt financing is preferred over the issue of equity shares for two major reasons i.e. issue of debentures does not lead to dilution of the ownership in the company and the cost of raising funds through debt is cheaper as compared to cost of raising equity.
Considering its various types, debentures are issued by the company as required by the investor investing in the company. In case the investor insists on issuing first mortgaged debenture to have an added protection over and above the secured debenture, the company may issue such debenture to the investor, which again depends on the necessity of funds to the company. In the usual course of business, registered non-convertible redeemable secured debentures are issued by the company as it provides protection to the investors against the failure of the company to repay the principal amount. Where the investor prefers to have a shareholding in the company after a fixed period of time, the company may be required to issue fully or optionally convertible debentures.
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