How to Raise Fund by Issuing Debentures
What is a Debenture?
A debenture is an instrument issued by a company that acknowledges its debts to the holder under its seal.
A debenture is a loan certificate issued by the company to its holders. Instead of borrowing entire funds from an individual, a company can divide the funds into certain small denominations or parts (i.e., debentures).
Debentures carry interest at a certain percent (e.g., 8%). As it is a loan taken by a company, it is repaid after a specified period or at the option of the company as per the terms of the issue.
There are no legal restrictions on the price for which debentures are issued. Debentures may be issued at par, at discount, or at premium, as in the case of shares.
Debenture holders are a company’s creditors. They regularly receive interest on their debentures at a fixed rate. It is usual practice to prefix the rate before debentures (i.e., 12% debentures).
In the event of the dissolution of the company, debenture holders have priority over shareholders as to their interest, as well as of their loan.
Debenture holders are not concerned with the management of the company. Also, they are not involved in the administration and control of the company.
Suppose that a company is seeking to borrow $1,000,000 as a loan by issuing debentures. To do so, it can issue debentures of $100 each (i.e., 10,000 debentures will be issued). For $1,000 debentures, only 1,000 debentures will be required for the loan of $1,000,000.
Types of Debentures
Debentures are classified as:
1. Redeemable Debentures
The amount of the debentures is to be repaid within the period specified in the terms of their issue.
2. Irredeemable Debentures
These are perpetual debentures. The company has no right to make the payment of the principal of these debentures during its lifetime. These debentures are repaid in case of the company’s closure.
3. Bearer Debentures
These debentures are transferable by mere delivery. The name of the holder is not registered with the company.
4. Registered Debentures
These debentures are not transferable by mere delivery. The names of the debenture holders are registered with the company.
5. Naked Debentures
6. Secured or Mortgaged Debentures
These debentures are secured by a charge on the company’s assets. This charge may be fixed or floating.
7. Collateral Debentures
If the company does not pay loan interest and the principal security falls short, lending institutions can exercise their right as debenture holders.
Difference Between Shareholders and Debenture Holders
The main differences between shareholders and debenture holders are summarized in the table below.
|Point of difference||Shareholders||Debenture holders|
|Meaning||The subscribers to the shares are shareholders. Shares are the parts of share capital.||Debenture holders are the subscribers to debentures. Debentures are parts of a loan.|
|Status||Owners of the company.||Creditors of the company.|
|Return||Shareholders are paid dividends on their holdings.||Debenture holders are paid interest on the debentures they hold.|
|Regularity of return||Dividends are paid when there is sufficient profit. The dividend rate is not fixed. Dividends are not a regular source of income.||Interest on debentures is paid at a fixed rate regularly.|
|Security||Shares are not secured.||Debentures are ordinarily secured.|
|Right to attend meetings||Shareholders are invited to attend the annual general meeting of the company.||Debenture holders are not invited to attend the annual general meeting of the company unless a decision affecting their interest is being made.|
|Repayment||Share capital is not returned except in the case of redeemable preference shares.||Debentures are the loan repaid by the company.|
|Priority of refunds||In the event of the dissolution of the company, shareholder funds are refunded after every claim is settled.||Debenture holders have a priority of the refund of their loan prior to shareholders.|
|Restriction on issue||There are certain restrictions on the issue of shares at discount.||There are no restrictions as to the issue of debentures at discount.|
|Control||Shareholders control the affairs of the company. It is managed by the board of directors, which consists of the elected representatives of the shareholders.||They are not involved in the management and control of the company.|
Evaluation of Funds Raising Through Debentures/Loans
Advantages/Merits of Fundraising Through Debentures/Loans
1. Availability of necessary funds: The company can raise funds by the issue of debentures if funds are not available by the issue of shares.
2. No interference in management: Debenture holders do not have voting rights, which means they cannot participate in the management of the company.
3. Fixed rate of interest: The company has to pay interest at a fixed rate even if its rate of earnings and dividends is comparatively higher.
4. Ability to return loan: The company can return funds to debenture holders as per agreement and relieve itself from the burden of the loan.
5. Regular source of income: Investors receive fixed and regular interest at the agreed rate, irrespective of whether the company earns a profit or suffers a loss.
6. Safe and secured investment: Debentures are issued against assets as security, meaning holders have charge of the firm’s assets. Hence, the investment is safe because if the company is dissolved, funds may be realized by the disposal of assets pledged.
Disadvantages/Demerits of Fundraising Through Debentures/Loans
Debentures may be disadvantageous for the following reasons:
1. Disadvantageous for financially unsound companies: The company will be required to pay interest regularly at a fixed rate, even if it has been suffering losses.
2. Pledging assets: Funds are available, after pledging assets as security, which would have been available without mortgaging assets by issuing shares.
3. No participation in management: Debenture holders do not have voting rights. They cannot participate in the company’s management despite supplying funds to the company.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.