City law in practice Debt v equity

Public companies that have shares listed on the UK Listing Authoritys (UKLA) Official List can access additional cash by completing either an equity or a debt financing. But as
the slump in the equities market continues, companies are increasingly turning to debt financing as a way of raising extra cash. So what is the difference between debt and equity financing, and what are the advantages and disadvantages of each method of fundraising?

Equity financing
Public companies can raise additional cash by offering further shares to shareholders. This is known as a rights issue (see Lawyer 2B, December 2002, Case Study 6: Rights Issues).

The main advantage of obtaining additional cash by offering shares is that a company does not have to pay shareholders a regular dividend. In stark contrast, a company is obliged to pay regular interest on all its debt regardless of its financial performance.

But equity financing has several disadvantages in terms of risk. It is also the most expensive form of fundraising, as the company will have to pay fees to its lawyers and investment bankers for their advice on the rights issue.

Because a company does not have to declare regular dividends, it is subject to stringent disclosure rules. Consequently, in order to complete a rights issue a company must produce a prospectus, which is a lengthy document setting out the purpose of the fundraising, facts about its business and detailed financial information. The purpose of these disclosures is to enable investors to determine the companys health and future prospects.

The UKLA has the power to impose severe penalties on the companys directors if the information disclosed in the prospectus is misleading or inaccurate.

Allen & Overy partner Simon Gleeson says: The real liability is
that, if theres a misstatement in the prospectus, then [the directors] are personally liable to pay the shareholders out of their personal assets.

Debt financing
Debt financing varies depending on a number of factors, such as:

• The type of lender.
  
• How much interest a company must pay for the borrowed sum (commonly known as the principal).
  
• Whether the borrowed sum is secured against the companys assets.
  
• The date on which the principal is due for repayment.

Convertible bonds
Convertible bonds, currently very fashionable, are unusual creatures as they start life as debt but end life as equity.

As the name suggests, convertibles convert into the companys shares after a period of time and at a predetermined conversion rate. The conversion typically happens at the option of the bondholder, although after a period of time (typically between five and seven years) the bond automatically converts into shares.
From the bondholders point of view, so long as the conversion rate is higher than the price at which the companys shares are being traded, they wont want to convert, explains Gleeson.

Convertibles are attractive because investors get the upside of equity (ie a stake in the company) as well as ensuring the certainty of a return in the form of interest. But the downside is that the interest payable to the bondholders is much lower than on an ordinary bond, often known as a vanilla bond, issued by the same company.

Subordinated debt
Subordinated debt will almost invariably be in the form of bonds, and because they rank below senior debt (see Hierarchy box) bondholders will typically receive a higher rate of interest.
Bonds are usually listed on the Lon-don or Luxembourg Stock Exchange. Therefore, when a company issues bonds, it needs to produce a listing document (or information memorandum).
The contents of the listing document are broadly the same as the disclosures made in a prospectus. The difference is that the listing document relating to a bond issue does not attract the same level of liability for misstatement. The liability relating to the sale of bonds is no different to the liability attached to selling a second-hand car, explains Gleeson.

Bond issues are underwritten by a lead manager. As in the case of share issues, the lead manager undertakes to take up any bonds that are left over in return for a commission.

A company issuing bonds must obtain a credit rating from a rating agency. Gleeson says getting and obtaining a credit rating is complicated and typically costs 50,000. Having a ratings agency in is more nerve-wracking than having the auditors in, says Gleeson. Unless a company has a good, or a very good, credit rating, the bond market wont be the most efficient way for it to raise money.
Standard & Poors, the leading ratings agency, publishes credit ratings on its website. Most investors would not take up bonds from a company that has a credit rating below BBB. The highest rating is AAA.

Senior debt
Senior debt can be in the form of either bonds or loans. Today, almost every loan will be obtained from a syndicate of banks. The loans obtained by companies are broadly similar to those obtained by individuals in that the amount borrowed is repaid over a period of time.

The principal advantage of syndicated loans is privacy, as the company does not have to produce a listing document. Consequently, though, the banks expect the company to enter into certain covenants.

The most important covenants relate to financial ratios. The company must covenant that its cashflow will cover its total interest over X number of times, and that its total interest payment is not more than a third of its total cashflow. The company will also covenant that all of its borrowings will not exceed 40 per cent of its gross asset value.