Business finance - Funding options: debt and equity

Learning Outcomes

This article examines debt and equity financing for companies, including:

• The distinction between debt and equity financing and how each affects corporate balance sheets and funding strategy for SQE1 scenarios
• Legal and practical implications of each funding method, including contractual obligations, shareholder rights, and regulatory limits
• Effects of funding choices on ownership, risk, control, and directors’ decision‑making duties
• Companies Act 2006 requirements for share issues and debt arrangements, with emphasis on directors’ authority and necessary resolutions
• Comparative advantages and disadvantages of equity and debt for SQE1-style problem questions and multiple-choice analysis
• Mechanics of allotment versus issue of shares and the required filings, registers, and share certificates
• Statutory pre-emption rights: scope, exceptions, and methods of disapplication in private companies
• Filing and registration requirements for equity transactions and security interests at Companies House and, where relevant, the Land Registry
• Consequences of unlawful distributions and of unregistered or late-registered charges, including impacts on validity, priority, and potential liabilities
• Creditor priority for fixed and floating charges on insolvency, including preferential debts and the prescribed part
• The role and effect of personal guarantees, negative pledges, and covenants in shaping creditor protection and commercial risk
• How hybrid instruments such as preference shares and convertible loans are classified and examined in SQE1-style questions

SQE1 Syllabus

For SQE1, you are required to understand business finance funding options, including debt and equity, with a focus on the following syllabus points:

• 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.
• Allotment vs issue of shares; the return of allotment (SH01) filing and internal updates to the register of members and share certificates.
• The statutory regime for pre-emption rights on cash issues and methods of disapplication in private companies.
• Restrictions on distributions and consequences of unlawful dividends; capital maintenance rules.
• Registration of charges at Companies House and, where applicable, the Land Registry; consequences of late or non-registration.
• Fixed vs floating charges, crystallisation, negative pledge clauses, and setting aside floating charges on insolvency.

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. Separate legal personality and limited liability underpin corporate finance decisions, but those benefits can be constrained in practice by personal guarantees, security granted to lenders, and statutory regimes that prioritise certain creditors over shareholders. Private companies are also restricted from offering their shares to the public (s.755 CA 2006), which influences how they access equity markets compared to public companies.

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

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

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. In a public company, issuing shares can occur via listing and public offerings, whereas private companies cannot offer shares to the public.

Key Term: allotment of shares
The creation of an unconditional right for a person to be entered in the register of members in respect of shares (s.558 CA 2006), preceding the actual issue.

Key Term: share premium
The excess paid over the nominal value on an allotment; recorded in the share premium account and subject to capital maintenance rules.

Key Term: paid-up share capital
The portion of nominal value that has been paid by the shareholder; shares may be partly paid with the remainder subject to calls.

Directors must have authority to allot shares (s.550 or s.551 CA 2006). In a private company with only one class of shares and subject to any article restrictions, directors may allot without member approval under s.550. Where multiple classes exist or for public companies, directors need authority in the articles or by ordinary resolution under s.551, which must state the maximum number of shares and the period (up to five years) for which the authority is granted.

Existing shareholders may have statutory pre-emption rights (s.561 CA 2006), meaning they must be offered new equity securities for cash first, pro rata to their holdings, on terms at least as favourable. This protects against dilution. The offer must specify a minimum acceptance period of 14 days (s.562 CA 2006). Private companies can disapply pre-emption rights by special resolution (s.569–571 CA 2006), either generally or in relation to a particular allotment. Pre-emption does not apply to non-cash consideration, bonus issues, or certain employee share schemes.

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).

Once shares are allotted, the company must file a return of allotment (form SH01) within one month (s.555 CA 2006), update the register of members promptly (s.113 CA 2006), and issue share certificates within two months (s.769 CA 2006). If the allotment creates a new class or varies rights, class rights variation procedures (s.630 CA 2006) may be engaged.

Key Term: return of allotment (SH01)
The filing that notifies Companies House of new shares allotted; must be filed within one month of allotment (s.555 CA 2006).

Issuing dividends is not automatic. A company may only make distributions out of accumulated, realised profits (s.830 CA 2006). Directors typically recommend a final dividend requiring an ordinary resolution under the articles (model articles reflect this), while interim dividends may be declared by the board alone. Paying dividends out of capital is unlawful.

Key Term: dividend
A distribution of profits to shareholders; must be paid only out of accumulated, realised profits (s.830 CA 2006).

Key Term: capital maintenance
The principle that share capital should not be returned to shareholders except in prescribed ways (e.g., lawful buybacks, reductions of capital), protecting creditors.

Tax and cost considerations also influence equity choices. Dividends are not deductible for corporation tax; new equity may be seen as cheaper if cash is tight because there is no mandatory periodic interest, but equity dilutes ownership and future profit shares.

Directors’ duties intersect with allotments. The duty to act within powers and for proper purposes (s.171(b) CA 2006) is often tested where shares are allotted to affect voting control. Allotments should be exercised to raise capital or pursue the company’s interests, rather than to entrench management or disenfranchise particular members.

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.

Issuing shares below nominal value is prohibited (s.580 CA 2006). Where shares are partly paid, calls may be made according to the terms of issue and the articles; unpaid amounts remain a potential source of funding if the company needs to call them.

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

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

Worked Example 1.2

A private company plans a quick cash raise by allotting equity to a new investor without offering shares to existing shareholders. How can it lawfully avoid statutory pre-emption?

Answer:
The company should pass a special resolution disapplying pre-emption rights under s.569–571 CA 2006 (either generally or for the specified allotment), ensuring the resolution’s scope and duration are clear. The allotment can then proceed without making a pro rata offer to existing shareholders. Filing the resolution (ss.29–30 CA 2006) and SH01 is required, and internal registers and certificates must be updated.

Unlawful distributions can have serious consequences. Members who knew or had reasonable grounds to believe a distribution was unlawful may be required to repay (s.847 CA 2006), and directors who authorised an unlawful dividend may be liable to repay if they knew or ought to have known it was unlawful, subject to a defence where reasonable care is taken (case law: Bairstow v Queens Moat Houses plc; Burnden Holdings v Fielding). Auditors may be liable in negligence if erroneous accounts caused the unlawful distribution.

Worked Example 1.3

A company had significant losses for three years, then made a profit this year. The board proposes a large final dividend. Is this lawful?

Answer:
Only accumulated, realised profits net of accumulated, realised losses can be distributed (s.830 CA 2006). The board must consider prior years’ realised losses when assessing profits available. If profits do not cover those accumulated losses, paying the proposed dividend would be unlawful. Directors should obtain up-to-date accounts, consider interim vs final dividend mechanics under the articles, and ensure lawful capacity to distribute.

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 commonly require security over company assets to mitigate risk. Security can be a fixed charge (over specific assets) or a floating charge (over classes of assets that change, like stock). Security increases lender priority on insolvency.

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.

Key Term: crystallisation
The event upon which a floating charge ceases to float and attaches to specific assets (e.g., insolvency, cessation of trade, appointment of a receiver/administrator), as specified in the instrument.

Key Term: secured creditor
A creditor with security over company assets, giving priority over unsecured creditors on enforcement or insolvency.

Key Term: unsecured creditor
A creditor without security; ranks behind secured and preferential claims on insolvency.

Secured creditors rank ahead of unsecured creditors on insolvency. Fixed charge holders are typically paid from the sale proceeds of the charged asset, followed by insolvency expenses and certain preferential creditors; floating charge holders rank behind preferential debts and any ring-fenced “prescribed part” for unsecured creditors. Charges must be registered at Companies House within 21 days (s.859A CA 2006), or they may be void against a liquidator, administrator, or any creditor (s.859H CA 2006). Registration is by filing form MR01 with a certified copy of the instrument; a certificate of registration is issued (s.859I CA 2006). A legal mortgage over land must also be registered at the Land Registry. The company should maintain a register of charges (if kept) and retain copies at the registered office or on the central register.

Key Term: negative pledge
A covenant by the company not to create further security over specified assets (or to ensure any later security ranks behind the existing lender), commonly found in debentures.

Key Term: personal guarantee
A promise by an individual (often a director/shareholder) to meet the company’s obligations to the lender if the company defaults.

Sole proprietors and ordinary partnerships cannot grant floating charges, although LLPs and companies can. Security priorities are determined by type and date of creation (and, for land, date of registration). Floating charges created shortly before insolvency may be set aside in certain circumstances (e.g., s.245 Insolvency Act 1986), and preferences (s.239 IA 1986) may be challenged.

Loan documentation often includes covenants (e.g., financial ratios, information undertakings, restrictions on disposals), events of default, and remedial rights such as acceleration, enforcement of security, or appointment of a receiver/administrator. While debt preserves equity control, it imposes cash flow obligations and can constrain operational flexibility.

Worked Example 1.4

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.

Worked Example 1.5

A company created a fixed and floating charge but forgot to register the instrument within 21 days. What is the effect?

Answer:
The charge is void against a liquidator, administrator, or any creditor (s.859H CA 2006). The debt becomes immediately payable but is unsecured as against those parties. The company (or any interested person) should consider applying for a court extension where available (s.859F CA 2006), though relief is discretionary and priority will only run from the eventual registration date. Any land mortgage must also be addressed at the Land Registry.

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. It may be attractive where cash flow is unpredictable, where control dilution is acceptable, or where raising debt on favourable terms is not feasible. Dividends are discretionary (subject to profit availability), but equity can be more expensive overall due to dilution of future profits and lack of tax deductibility.
• 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. Interest is generally tax-deductible for corporation tax purposes, making debt cheaper on an after-tax basis, but cash interest and covenant compliance must be sustained. Security may be required, and high indebtedness may reduce flexibility and increase insolvency risk.

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

Worked Example 1.6

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.

Additional considerations include: directors’ authority to allot (s.550/551), SH01 filing and register updates; the pre-emption regime and possible disapplication; dividend policy and capital maintenance; loan covenants, events of default, and negative pledges; tax treatment (non-deductible dividends vs deductible interest); and market access constraints (private companies cannot offer shares to the public).

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 align investor and company interests, allow deferred valuation (convertibles), or trade voting dilution for economic priority (preferences).

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

Key Term: convertible loan note
A debt instrument that may convert into equity (typically on a future financing or maturity), combining fixed-income characteristics with potential ownership.

Hybrid instruments often contain complex terms (conversion mechanics, anti-dilution, caps/floors) and must be checked against the company’s articles and statutory rules (e.g., pre-emption where equity securities are issued for cash on conversion, capital maintenance if redeemable). They can provide flexibility but demand careful legal and accounting treatment.

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 (s.550/551) and must respect statutory pre-emption rights unless disapplied.
• Allotments require timely SH01 filing, register updates, and issuing share certificates.
• Distributions must be paid only out of accumulated, realised profits (s.830); unlawful dividends can lead to repayment and director liability.
• Debt may be secured by fixed or floating charges; security must be registered within 21 days (s.859A), or it is void against insolvency officeholders and creditors (s.859H).
• Fixed charges rank ahead of floating charges; floating charges crystallise on specified events and rank behind certain preferential claims.
• Negative pledges and covenants can restrict further borrowing and disposals; personal guarantees can negate limited liability in practice.
• Equity dilutes ownership but does not require repayment; debt preserves control but increases financial risk and imposes cash flow obligations.
• Hybrid instruments (e.g., convertibles, preference shares) combine features of debt and equity and require careful compliance with articles and statutory rules.

Key Terms and Concepts

• equity finance
• share capital
• allotment of shares
• share premium
• paid-up share capital
• pre-emption rights
• return of allotment (SH01)
• dividend
• capital maintenance
• debt finance
• debenture
• preference shares
• fixed charge
• floating charge
• crystallisation
• secured creditor
• unsecured creditor
• negative pledge
• personal guarantee
• convertible loan note