Nobody starts a business expecting to fail, but it’s a potential that lenders must consider when making loans, which is where debentures come in. Borrowers are frequently asked to provide security for a loan in the form of a debenture. This article examines the practical actions that a borrower must take in order to provide good security and seeks to address and alleviate some prevalent worries.
What is a Debenture?
A debenture is a written loan agreement between a borrower and a lender that is recorded at Companies House. It provides security for the lender over the borrower’s assets.
A bank, factoring company, or invoice discounter will typically use a debenture to secure a loan. A debenture can only be issued to a limited company or a limited liability partnership; it cannot be issued to a sole proprietorship or a standard partnership.
A director who has advanced or lent money to his or her own company may use a debenture to secure the loan. A debenture can also be accepted by a private lender.
What is the Purpose of Debentures?
A debenture means that if you default on your loan, your lender will be able to make a claim against your business’s assets, such as laptops, property, or machinery (but not your personal assets). Technically, the lender “places a charge on your business assets” – but it doesn’t cost you anything; it’s merely a legal “charge.”
Once you and the lender have agreed on the loan terms and signed the debenture, the lender must submit it with Companies House within 21 days. If they do not do this and your business fails, the lender will have the same right to the debt as any other unpaid unsecured creditor.
Types of Debenture Charges
A debenture can grant one of two types of charges, with lenders typically seeking one or both of the following.
#1. Fixed Charge
If a borrower fails on a loan, a lender can use this sort of charge to ensure that it is the first creditor to reclaim any outstanding debt. In essence, it gives the lender control and ownership of a borrower’s asset in the event of nonpayment, with any future sale used to pay off the outstanding debt. Property is the most prevalent type of fixed charge.
A fixed charge can cover building fittings, trade fixtures, fixed plant and machinery, and motor vehicles in addition to the freehold or leasehold of a property. With a fixed charge, the borrower would be unable to sell the asset without the lender’s approval, and the proceeds would typically go to the lender or towards a new asset, over which the lender would then apply a fixed charge.
#2. Floating charge
A floating charge can be applied to any or all of a company’s assets, including stock, raw materials, debtors, cars, fixtures and fittings, cash, and even intellectual property. Because the charge is ‘floating,’ these assets may fluctuate over time, with the borrower entitled to shift or sell any assets throughout the normal course of business.
The floating charge ‘crystallizes’ and effectively becomes a fixed charge only when the lender attempts to enforce the debenture in a default situation. The borrower will no longer be able to interact with the assets in question unless the lender grants authorization. A floating charge gives a lender priority over unsecured creditors in the allocation of repayments in the event of insolvency or liquidation.
#3. Multiple Debentures Charges
A lender – or lenders – may have numerous debentures on the same borrower. These can be many fixed debentures against distinct assets, multiple floating debentures, or a combination of the two. When the initial lender issues a debenture to the company, they frequently block a second lender from issuing another without their permission.
When many lenders have debentures with recourse against the same borrower’s assets, the lenders will agree on a priority of payments. A Deed of Priority is frequently used to document this between the lenders and the borrower.
How can a Holder of a Debenture enforce their Security?
If the company defaults on the loan, the lender (debenture holder) have the authority to appoint an administrator to seize control. This comes once the lender calls in the loan for repayment.
The threat of appointing an administrator is often enough to force a corporation to repay the debt or agree to repayment arrangements.
If the company goes bankrupt, how does the debenture holder get their money back?
The administrator or liquidator must turn over to the lender any assets captured by the debenture. Typically, the lender agrees to pay the administrator or liquidator a fee to sell the assets on their behalf. The debenture can catch assets that fall into either a fixed or floating charge category.
A fixed charge typically applies to the following assets: book debts under a factoring agreement, freehold or leasehold property, and plant and machinery fixed to the floor. Floating charge assets are items that are not covered by the debenture’s fixed charge and are often mobile assets such as trading stock, equipment, furniture, and computers.
Debenture Features
A trust indenture must first be drafted before issuing a debenture. The first trust is an agreement between the issuing corporation and the trustee who manages the investors’ interests.
#1. Interest Rate
The coupon rate is calculated, which is the interest rate that the corporation will pay to the holder or investor of the debenture. This coupon rate can be either fixed or floating. A floating rate may be linked to a benchmark, such as a yield on a 10-year Treasury bond, and will fluctuate in response to changes in the benchmark.
#2. Credit Score
The interest rate that investors will get is influenced by the company’s credit rating and, eventually, the credit rating of the debenture. Credit rating agencies assess the creditworthiness of a business and government securities. These organizations provide investors with an understanding of the dangers associated with debt investing.
Credit rating companies, such as Standard & Poor’s, usually assign letter grades that indicate the underlying creditworthiness. The Standard & Poor’s system has a scale that spans from AAA for good ratings to C and D for the lowest ratings. Any debt instrument with a rating lower than a BB is considered a speculative grade. These are also known as garbage bonds. It all comes down to the underlying issuer’s proclivity to default on the loan.
#3. Date of Maturity
The maturity date of nonconvertible debentures, as previously indicated, is also a significant element. This date specifies when the corporation is required to repay the debenture holders. The corporation has alternatives for how the reimbursement will be made. Most commonly, it occurs as redemption from the capital, in which the issuer pays a lump sum amount at the debt’s maturity. Alternatively, the payment could be made via a redemption reserve, in which the corporation pays certain sums each year until complete payback is made at the maturity date.
The Benefits and Drawbacks of Debenture
Pros
- A debenture provides investors with a regular interest rate or coupon rate return.
- Convertible debentures, which can be converted to equity shares after a set length of time, are more tempting to investors.
- The debenture is paid before common stock shareholders in the event of a corporation’s insolvency.
Cons
- In circumstances when market interest rates are rising, fixed-rate debentures may be exposed to interest rate risk.
- When analyzing the possibility of default risk from the underlying issuer’s financial sustainability, creditworthiness is critical.
- Debentures may be subject to inflationary risk if the coupon payments do not keep pace with the rate of inflation.
Other Types of Debenture
Aside from fixed and floating charge debentures, there are several more types of debentures that you may encounter:
#1. Debentures with a guarantee
Secured debentures are most likely to be encountered in the United Kingdom. As previously stated, this means that the lender uses a borrower’s assets to provide security for the loan. If a repayment default occurs, the asset will be liquidated to satisfy the obligation.
#2. Debentures with no security
Unsecured debentures, sometimes known as ‘naked’ debentures, are those that are not secured by a charge against the borrower’s assets. Unsecured debentures are uncommon in the UK business climate.
#3. Debentures that are redeemable
Some debentures are redeemable, while others are not. The former means that the borrower is legally obligated to return the debenture holder, or lender, on a certain agreed-upon date. This can be done in one lump sum or in instalments over a certain time period. A fixed-term loan is an example of a redeemable debenture.
#4. Debentures that are irredeemable
On the other hand, irredeemable debentures, often known as perpetual debentures, exist. There is no particular time limit for redemption under this type of agreement, so they continue until a company is liquidated. A business bank overdraft is an example of this.
Investors’ Concerns About Debenture Risks
#1. Debenture holders may be exposed to inflationary risk.
The risk here is that the debt’s interest rate will not keep pace with the rate of inflation. Inflation is a measure of price rises in the economy. Assume that inflation generates a 3% increase in prices; if the debenture coupon pays at 2%, the holders may see a net loss in real terms.
#2. Debentures are likewise subject to interest rate risk.
During times of rising market interest rates, investors hold fixed-rate debts in this risk scenario. These investors may discover that their loan yields less than what is available from other investments paying the current, higher market rate. In this case, the holder of the debenture receives a lesser yield.
#3. Debentures may also be subject to credit risk and default risk.
As previously indicated, debentures are only as safe as the underlying issuer’s financial health. Investors are at risk of debenture default if the company experiences financial difficulties owing to internal or macroeconomic issues. In the event of bankruptcy, debenture holders would be paid first, followed by common stock owners.
Debenture Example
The U.S. Treasury bond is an example of a government debenture (T-bond). T-bonds are used to finance projects as well as day-to-day government activities. These bonds are issued by the United States Treasury Department at auctions held throughout the year. Some Treasury bonds are available for purchase on the secondary market. Investors can buy and sell previously issued bonds in the secondary market through a financial institution or broker. T-bonds are almost risk-free since they are guaranteed by the full faith and credit of the United States government. They do, however, face the risk of rising inflation and interest rates.
Personal Guarantees vs. Debentures
All of the debentures and charges we’ve looked at here at Funding Options use various strategies to attach a borrowed amount to a specific business asset (or a floating group of assets). As a result, you’d definitely classify these as secured lending.
To assist limit risk, lenders may utilize personal guarantees instead of debentures or charges for a variety of unsecured goods. Personal guarantees imply that the business owner is personally liable for repaying the loan if the business is unable to do so.
In more complicated circumstances, or when the business is borrowing a substantial sum of money, lenders may choose to utilize a combination of debentures, charges, and personal guarantees – resulting in finance that is both secured and unsecured. This type of arrangement could be referred to as asset-based lending.
These arrangements, whether secured or unsecured, debentures or personal guarantees, are designed expressly for lenders to provide them an alternative option for getting their money back if things go wrong and the business they’ve borrowed to is unable to pay.
Debenture FAQs
What is the purpose of a debenture?
Debentures, in general, serve a more particular purpose than other types of bonds. While both are used to raise capital, debentures are often issued to finance the expenses of an impending project or to pay for projected business development.
Why do companies use debentures?
A business debenture’s principal purpose is to give security and reassurance to the lender, and it typically includes a fixed and floating charge. If the business went bankrupt, they would get their money before unsecured creditors.
Are debentures debt or equity?
Because it is a type of borrowed capital, it is recorded as debt on the issuing company’s balance sheet.
