City Law in Practice: Raising funds
7 March 2007
There are a number of methods by which companies can raise capital. Lawyers working on corporate transactions must be aware of them.
Companies have a range of financing tools available in the form of both bank debt and the increasingly sophisticated securities markets. The two basic methods of financing for companies are raising equity (share capital) and raising debt (loan capital).
Within each of these categories there is a number of different types of instrument available. The instrument used will depend on the size and credit profile of the company, its financing needs and the investor base likely to be most interested in the investment. In addition, companies are increasingly entering into a range of hedging instruments in the derivatives markets to mitigate some of the risks to which they are exposed from factors outside their control.
Equity instruments range from ordinary shares to hybrid debt/equity instruments, such as preference shares, convertible bonds and bonds with warrants. Ordinary shares are the instruments that grant the holder a fundamental ownership share in the company itself. In exchange for the chance to receive dividends, an ordinary shareholder puts up the basic share capital in a company. The holder of ordinary shares ranks last in the order of distribution of assets upon the liquidation of the company and hence takes a significant risk. However, because they actually own a part of the company, they have the potential to receive very significant capital growth in the value of their shares (over and above the receipt of income by way of dividends) if the company performs well. In larger companies, a shareholder is able to realise that growth by trading the shares. Ordinary shares are not by their terms redeemable by the holder.
Preference shares are shares that rank ahead of the ordinary shares in a liquidation of the company. They often pay a preferential dividend ahead of dividends on the ordinary shares and may or may not be redeemable at a later date. The downside is that they do not usually carry some of the ownership benefits that ordinary shares carry, such as voting rights. In this way they begin to behave commercially rather more like debt than equity and so are classed as hybrid instruments even though they are still, as a matter of legal form, equity.
Equity raising is a method of raising long-term capital for the company and is, at least for buy-to-hold investors, a long-term investment. There are statutory restrictions on reductions of share capital, although there will generally be no specific restrictions on the use to which the company may put the funds. Contrast the position in relation to debt which can, subject to its terms, be paid back at any time and which may be lent for certain specified uses only.
One of the plus sides of raising share capital, however, is that dividends are payable only to the extent that a company has cash available for payment and no default occurs just because it has not the investors must just wait.
The second method of financing a company is by raising debt. Loans may be provided by banks or by the issue of debt securities to investors in the capital markets in much the same way that shares are issued. Debt financing may or may not be secured on assets of the company. It is generally a more flexible tool for a company than equity financing in that the terms of any loan are freely negotiable between the lender(s) and the borrower, although many terms have of course become pretty standard as a matter of market practice.
Raising debt is a shorter-term method of financing than raising equity. Lenders expect the full amount of principal lent to be paid back to them (with interest) within a foreseeable time and, depending upon the type of facility or instrument concerned, this is likely to be in the short term (less than a year) to medium term (say five to seven years).
Longer-term debt is rare, although it is sometimes seen in relation to the financing of, for example, infrastructure projects, or more rarely in the issuance of long-term bonds (of perhaps 30 years or more). The downside for companies is that lenders of debt financing expect to receive interest and payments of principal in accordance with a pre-agreed schedule whatever the financial performance and future cashflows of the company. These payments must be made by the company ahead of the payment of dividends to equity investors and, upon the liquidation of the company, the lenders must be paid back in full before any amount is paid out to equity investors. The ratio between equity and loan capital in a company is known as leverage, and because loan capital ranks ahead of equity capital and because the costs of debt service are unavoidable whatever the current performance of the company, high leverage puts a strain on the company. Loan capital is often used for capital expenditure by the company or, depending on the flexibility of the instrument or facility, for shorter-term working capital or other cashflow requirements.
Financing by way of bank debt is open to most companies whatever their size and credit profiles. Methods range from an overdraft facility provided by a high street bank to a small local company to large multimillion-pound facilities provided to international companies by a syndicate of investment banks.
Large international companies with investment-grade credit ratings from the main credit rating agencies are able to tap the domestic and international capital markets, and such companies regularly raise funds by issuing debt securities such as eurobonds, domestic bonds or short-term money market instruments, such as commercial paper. The biggest issuers establish note and commercial paper programmes to be able to issue quickly and efficiently. The most active issuers are raising debt several times a week under such programmes. The main investors for debt securities of this type are the major institutional investors such as pension funds, insurance companies and investment funds, although in Continental Europe in particular there is a thriving and growing retail market as well.
Hybrid instruments are also an option. In addition to preference shares, convertible bonds and bonds with warrants are examples of these. Essentially, these latter instruments allow investors to invest in a relatively safe debt instrument with guaranteed and regular (if somewhat low) interest payments, but with the possibility, at a later date, of the option to cash in on the upside of capital growth in the equity of the company, either by conversion of the instrument into equity in the case of convertible bonds or the exercise of the warrant (or option) in the case of bonds with warrants.
It was also stated that companies are increasingly entering into derivative contracts to help them manage their cashflows more predictably, or just to take advantage of particular market conditions to borrow at advantageous rates. A company raising bank debt at, for example, a floating rate of interest might elect to protect itself from exposure to an increase in interest rates by entering into an interest rate swap (otherwise known as hedging). Under the terms of such a swap, the company would pay amounts equal to an agreed fixed rate of interest to a swap counterparty, which would in turn pay to the company amounts equal to the floating rate of interest it is due to pay to the lender in respect of the loan. In this way the company has hedged its exposure to a rise in interest rates and knows the exact amount of interest it will have to pay in future years. Of course, if interest rates fall rather than rise it is not such a good deal, but it has nevertheless achieved certainty as to its future liabilities. Similarly, companies that receive most of their revenue in US dollars, but which have raised finance in pounds sterling, might enter into a currency swap to hedge their exposure to an adverse movement in the dollar-sterling exchange rate.
The debt markets are evolving continually and ever-more sophisticated financing techniques are emerging. For example, companies with less than an investment-grade credit rating are increasingly able to tap the wholesale debt securities markets by issuing high-yield bonds, which are debt securities much like eurobonds, but with a covenant and security package from the issuer closer to that more commonly seen in bank financings. Companies with suitable businesses with regular cash receipts, such as mortgage lenders or credit card companies, are increasingly tapping the securitisation markets.
They sell off their income-producing assets to a special-purpose company that issues bonds to investors funded by the cash receipts from the pool of assets, thus funding money now for the company to reinvest in business expansion. The financial markets is an exciting and innovative area of legal practice.
Kate Lamburn is the director of Ashursts professional development (international finance), securities and structured finance group