Business finance - Funding options: debt and equity

Learning Outcomes

After studying this article, you will be able to distinguish between debt and equity financing for companies, identify the legal and practical implications of each, and explain how funding choices affect ownership, risk, and control. You will be able to apply Companies Act 2006 requirements to share issues and debt arrangements, and compare the advantages and disadvantages of each method for SQE1-style questions.

SQE1 Syllabus

For SQE1, you are required to understand the main funding options available to businesses and their legal consequences. In your revision, focus on:

• The distinction between equity finance (issuing shares) and debt finance (borrowing).
• The legal requirements for issuing shares, including directors’ authority and pre-emption rights.
• The features and implications of debt finance, including security, priority, and registration.
• The impact of funding choices on ownership, control, risk, and company obligations.
• How funding decisions affect company structure and creditor/shareholder rights.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the main legal difference between equity and debt finance for a private limited company?
2. Which Companies Act 2006 provisions regulate pre-emption rights on new share issues?
3. How does granting a fixed charge differ from a floating charge in terms of creditor priority?
4. What are the main risks to a company of relying heavily on debt finance?

Introduction

When a business needs capital, it can raise funds by issuing shares (equity finance) or by borrowing (debt finance). Each method has distinct legal, financial, and strategic consequences. For SQE1, you must be able to identify the key features of each, apply the relevant statutory rules, and explain the practical effects of funding choices for companies and their stakeholders.

Equity Finance

Equity finance means raising money by issuing shares to investors, who become members (shareholders) of the company. This method is governed by the Companies Act 2006 and the company’s articles.

Key Term: equity finance
The process of raising capital by issuing shares, giving investors ownership rights in the company.

When a company issues new shares, it increases its share capital. Shareholders may receive dividends if profits are available, and they have voting rights according to the class of shares held. Equity finance does not require repayment, but it dilutes existing shareholders’ ownership and may affect control.

Key Term: share capital
The total nominal value of all issued shares in a company, representing the owners’ investment.

Directors must have authority to allot shares (s. 550 or s. 551 CA 2006). Existing shareholders may have statutory pre-emption rights (s. 561 CA 2006), meaning they must be offered new shares before outsiders. The company must update its register of members and file a return of allotment at Companies House.

Worked Example 1.1

A private company with one class of shares wants to issue 1,000 new shares to an external investor. What steps must the directors take?

Answer: The directors can allot the shares if not prohibited by the articles (s. 550 CA 2006). They must first offer the shares to existing shareholders if pre-emption rights apply (s. 561 CA 2006). If the shareholders do not take up the offer, the shares can be issued to the investor. The company must update the register of members and file form SH01 at Companies House within one month.

Debt Finance

Debt finance involves borrowing money, usually by taking out loans or issuing debt securities. The company enters a contractual obligation to repay the amount borrowed, often with interest.

Key Term: debt finance
Raising capital by borrowing, creating a creditor-debtor relationship with fixed repayment obligations.

Debt does not give the lender any ownership or voting rights. However, lenders may require security over company assets. Security can be a fixed charge (over specific assets) or a floating charge (over classes of assets that change, like stock).

Key Term: fixed charge
A security interest over a specific asset, restricting the company’s ability to dispose of it without the lender’s consent.

Key Term: floating charge
A security interest over a class of assets that can change in the ordinary course of business, crystallising into a fixed charge on certain events.

Secured creditors rank ahead of unsecured creditors on insolvency. Charges must be registered at Companies House within 21 days (s. 859A CA 2006) or they may be void against a liquidator or administrator.

Worked Example 1.2

A company borrows £100,000 from a bank, granting a fixed charge over its machinery and a floating charge over its stock. What happens if the company becomes insolvent?

Answer: On insolvency, the bank can enforce the fixed charge over the machinery and will be paid from the sale proceeds before other creditors. The floating charge will crystallise over the stock, but will rank after fixed charges and certain preferential creditors.

Comparing Debt and Equity Finance

The choice between debt and equity affects ownership, risk, and control.

• Equity finance dilutes existing shareholders’ ownership and may reduce their control, but does not require repayment or create fixed obligations.
• Debt finance allows owners to retain control, but creates a legal obligation to repay and increases financial risk if the company cannot meet its commitments.

Key Term: pre-emption rights
The statutory right of existing shareholders to be offered new shares before they are issued to outsiders (s. 561 CA 2006).

Key Term: debenture
A written acknowledgement of a debt by a company, which may be secured or unsecured.

Worked Example 1.3

A company needs £500,000 to expand. The directors are considering either issuing new shares or taking out a secured loan. What are the main legal and practical considerations?

Answer: Issuing shares will dilute existing shareholders’ ownership and may require pre-emption offers. No repayment is required, but new shareholders gain voting rights. A loan will not affect ownership, but the company must make regular repayments and may have to grant security. Failure to repay could lead to enforcement of security and insolvency.

Hybrid and Alternative Instruments

Some companies use hybrid instruments, such as convertible notes or preference shares, which combine features of debt and equity. These can provide flexibility but may involve complex terms and require careful legal compliance.

Key Term: preference shares
Shares that give holders preferential rights to dividends or capital on winding up, usually with limited or no voting rights.

Summary

Key Point Checklist

This article has covered the following key knowledge points:

• Equity finance involves issuing shares, giving investors ownership and voting rights.
• Debt finance involves borrowing, creating repayment obligations and creditor rights.
• Directors need authority to allot shares and must respect pre-emption rights.
• Debt may be secured by fixed or floating charges, which must be registered.
• Equity dilutes ownership but does not require repayment; debt preserves control but increases financial risk.
• The choice of funding affects company structure, risk, and legal obligations.

Key Terms and Concepts

• equity finance
• share capital
• debt finance
• fixed charge
• floating charge
• pre-emption rights
• debenture
• preference shares