Business organisations and procedures - Finance

Learning Outcomes

After reading this article, you will be able to explain the main forms of business finance for organisations in England and Wales, compare equity and debt finance, outline capital maintenance requirements, understand shareholder pre-emption rights, and describe the essentials of company security and the impact of insolvency on business finance. You will also be able to answer SQE2-style questions on these issues and apply these rules to typical client scenarios.

SQE2 Syllabus

For SQE2, you are required to understand business finance concepts and their practical relevance to organisations. Focus your revision in particular on:

• the main methods of raising business finance (share/equity and debt/loan finance)
• pre-emption rights when companies issue new shares
• the principles of capital maintenance and lawful dividend/payment of capital
• differences between secured and unsecured borrowings
• the purpose and practicalities of company charges and security (fixed and floating)
• how insolvency and liquidation procedures affect business finance, security, and creditor priorities

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. Which type of finance allows shareholders to vote at general meetings—equity finance or debt finance?
2. What is the legal requirement for a company when issuing new ordinary shares for cash—must it first offer them to existing shareholders, or can the board allocate freely?
3. What is the main difference between a fixed charge and a floating charge?
4. When can a company lawfully pay a dividend to its shareholders?
5. If a shareholder's shares are fully paid and the company is wound up, what is their maximum financial liability for company debts?

Introduction

When advising business clients, you must know the practical legal implications of raising and managing finance. This section explains the main sources of business finance—equity and debt—the central importance of capital maintenance for companies, the rules and procedures on issuing and transferring shares, and what happens to business finance when a company faces insolvency.

Types of business finance

Most organisations require start-up and ongoing capital. Finance for business may broadly be divided into equity finance (shares) and debt finance (loans and borrowings).

Equity finance (shares)

Equity finance means raising money by issuing shares. Those who buy shares become owners of the company and may be entitled to vote at meetings and receive dividends. Share capital is the foundational finance for a company.

Key Term: equity finance
The process of raising business capital by issuing shares to owners/members, who become shareholders of the company.

Key Term: share capital
The total nominal value of shares issued by a company, representing ownership and the sum invested by shareholders.

When a company is incorporated, subscribers agree in the Memorandum of Association to take at least one share each. Later, the board of directors may resolve to issue more shares as needed, provided they have authority.

Debt finance (loans and borrowings)

Debt finance is raising finance by borrowing. This can take the form of loans from banks, overdrafts, or issuing debt securities (like debentures or bonds). Debtholders do not become owners of the company, but are creditors owed repayment with interest.

Key Term: debt finance
Raising money for a business by borrowing, where the company becomes legally obliged to repay the loan or debt plus interest.

Worked Example 1.1

A small company has no cash for a warehouse purchase. The directors want to preserve existing shareholder ownership, yet secure property. Should the company issue new shares to raise funds or negotiate a bank loan?

Answer:
If the owners want to avoid diluting shareholder control, borrowing might be preferable. However, the company would be subject to repayment obligations and probably need to grant security over assets.

Issuing shares: authority and pre-emption rights

A company must have directors' authority (either from the articles or an ordinary resolution of shareholders) to allot (issue) new shares after incorporation.

Where a company proposes to issue new ordinary shares for cash, it must first offer them to existing shareholders in proportion to their holdings (the statutory pre-emption right). This protects existing shareholders from dilution of voting and economic rights unless the right is disapplied by special resolution.

Key Term: pre-emption rights
Existing shareholders' legal right to be offered new shares first, on a pro-rata basis and for cash consideration, before the shares are offered to outsiders.

Worked Example 1.2

A company has 10,000 existing shares owned by five shareholders. The company wants to issue 1,000 new ordinary shares for cash. What must it do before allotting shares to an outside investor?

Answer:
The new shares must first be offered to the existing shareholders in proportion to their current holdings, at the same price and on the same terms. Only if the shareholders decline wholly or partly can shares be offered to the outsider, unless the shareholders have waived or disapplied the pre-emption right.

Capital maintenance

A company must protect and maintain its share capital, as this forms a fund for creditors in insolvency. Maintenance of capital means a company cannot return capital to shareholders except via strictly controlled processes (e.g., dividends, redemption or buy-back out of distributable profits, or capital reduction procedures).

Key Term: capital maintenance
The legal principle that a company must preserve share capital and can return it to shareholders only in accordance with statutory rules and not at will.

A key aspect of capital maintenance is that dividends may be paid only out of distributable profits—not out of capital. Paying otherwise can result in liability for repayment or for breach of duty by directors.

Key Term: distributable profits
Profits realised and available under company law for paying dividends to shareholders.

Loans, security, and charges

Lenders may lend to a company on either a secured or unsecured basis.

Secured finance: Fixed and floating charges

A lender may require the company to grant a security interest (charge) over some assets. Security can take the form of:

• Fixed charge: attaches to a specific asset (e.g., land, machinery); the asset cannot be sold or dealt with without the lender's consent.
• Floating charge: hovers over a changing class of assets (e.g., stock, receivables), crystallising into a fixed charge on certain events (e.g., insolvency).

Key Term: fixed charge
A security interest over a specific asset, preventing the company dealing with it without lender consent.

Key Term: floating charge
A security interest over a shifting class of assets (e.g., inventory), allowing the company to use them in the ordinary course of business until crystallisation.

A charge must be registered at Companies House within 21 days of its creation or it is void against a liquidator or creditor in insolvency. The order of priority of security is determined by creation and registration.

Worked Example 1.3

A supermarket grants a bank a floating charge over its present and future stock in exchange for a loan. The company continues to buy and sell goods day to day. What happens if the company goes into liquidation?

Answer:
The floating charge crystallises over all stock held at the date of liquidation. The lender becomes a secured creditor with priority to the charged assets after the liquidator's costs and statutory ring-fenced sum for unsecured creditors.

Dividends

A company may only pay dividends out of distributable profits. Directors who recommend unlawful dividends or shareholders who knowingly receive them can be required to repay.

Key Term: dividend
A distribution of realised profits to shareholders, authorised by directors and declared by ordinary resolution of shareholders.

Insolvency and creditor priority

If a company is insolvent and wound up, assets are distributed according to statutory priority:

1. Costs and expenses of liquidation
2. Fixed charge holders (to the value of secured asset)
3. Preferential creditors (e.g., certain employee claims)
4. Floating charge holders (subject to ring-fencing for unsecured creditors)
5. Unsecured creditors
6. Shareholders (if anything remains; rare)

Secured creditors usually get paid ahead of other creditors, and floating charge holders are paid after fixed charge holders and preferential creditors.

Worked Example 1.4

A company is insolvent and its assets are realised. There are three creditors:

• A bank with a £50,000 fixed charge
• Employees owed £10,000 in wages
• A supplier owed £5,000 with no security

If the company assets realised £70,000, who is paid and in what order?

Answer:
Out of the £70,000: First, liquidator’s expenses; then £50,000 to the bank (fixed charge); then £10,000 to employees (preferential creditor); the remaining funds, if any, would go to unsecured creditors (the supplier), probably by percentage.

Summary

Key Point Checklist

This article has covered the following key knowledge points:

• The fundamental differences between equity and debt finance for business organisations.
• The rules on authority to issue shares, shareholder pre-emption rights, and the process for allotment and transfer of shares.
• The capital maintenance principle, including lawful dividends and buybacks.
• Requirements for security over assets: fixed vs. floating charges, registration, and priority in insolvency.
• The order of repayment for creditors and shareholders in insolvency.

Key Terms and Concepts

• equity finance
• share capital
• debt finance
• pre-emption rights
• capital maintenance
• distributable profits
• fixed charge
• floating charge
• dividend