What are the Advantages and Disadvantages of Debentures?
The reluctance of some banks in offering business loans, as well as a potentially onerous administrative procedure, has resulted in more directors lending to their own company.
Without the security of a debenture, however, it is often too late to call in the loan if the company becomes insolvent. As a result, directors can find it very difficult to recoup their money.
A debenture outlines the terms of lending, and has to be lodged with the Registrar of Companies when the loan is agreed. It generally details the total loan amount, interest rate, repayment amounts, the charges securing it (if any), and whether the loan will be repaid on demand or on a fixed date.
Securing a charge on the debenture
Directors can further protect their money by securing a fixed or floating charge on the debenture. Fixed charges involve tangible assets such as property, land, or plant and machinery. These assets cannot be sold without the company either repaying the loan in full, or obtaining consent for sale from the debenture-holder.
A floating charge covers a class of asset, such as stock, and can be traded without the lender’s agreement. The debenture should specify that the floating charge will ‘crystallise’ upon certain conditions, however, such as loan default or insolvency.
This is when it becomes a fixed charge in essence, and from then on, the company needs the lender’s permission to trade or otherwise deal with the asset.
Some of the advantages of using a debenture
- Debentures ensure a higher position in the ‘pecking order’ for repayment as a creditor. Otherwise, the loan is unsecured - the position of unsecured creditors near the bottom of the payment hierarchy means a significantly lower chance of recovering any money.
- Valuable financial protection and reassurance is provided for directors as regards their personal funds.
- The use of debentures can encourage long-term funding to grow a business. It is also cost-effective when compared with other forms of lending.
- Debentures usually provide a fixed rate of interest for the lender, and this has to be paid before any dividends are issued to shareholders.
- Control of the company by existing shareholders is not reduced, and profit-sharing remains in the same proportion.
Are there any disadvantages?
- As far as the company is concerned, there is no flexibility in their obligation to make interest payments on the debenture. In times of financial difficulty this can compromise business growth, and even force insolvency in some cases.
- Restrictions imposed by securing the debenture with an asset or asset class, takes away the management’s freedom to control or use the assets at will.
- By holding a debenture, the lender loses their right to vote and take a share of company profits.
For more guidance on the advantages and disadvantages of debentures for company directors, contact Begbies Traynor and a member of our expert team will be able to advise.