Advantages and Disadvantages of Shares and Debentures
What are the advantages and disadvantages of shares and debentures? Most businesses raise capital by issuing shares in the company or by borrowing from lenders.3 min read
What are the advantages and disadvantages of shares and debentures? Businesses usually raise capital by issuing shares in the company or by borrowing from lenders. A debenture is one of the ways a business can borrow money. The company agrees to repay the debt plus interest. The main disadvantage of being a debenture holder is that they have no control over the decision-making process of the company because they don't control any shares in the business.
Introduction to Debentures
A debenture is a bond or promissory note that is issued by a business to a creditor in exchange for capital. The repayment and terms of the loan are completed based on the general creditworthiness of the business and not by a lien, mortgage, or any specific property.
Most companies don't have the luxury of operating solely on the ownership capital of the business. Many investors don't like to risk their capital in stocks and prefer the safety of bonds. Debentures were created to attract low-risk investors. These types of securities are known as "creditorship securities." Creditorship securities are also known as "debt finance."
What Is a Debenture?
The lack of liquidity in the market, as well as the aversion of many banks to take on potentially burdensome administrative tasks, has resulted in many directors lending funds to their own organizations. A debenture is considered a more secure way to invest in a business than purchasing shares, because the company must pay the interest on the debenture before any dividend payments can be made to shareholders. For example, if a company declares bankruptcy, the debenture holders will receive payment before shareholders.
When a company is looking to raise capital but doesn't want to issue shares to the public, it may instead decide to issue certificates that cover a specific period of time and provide a fixed interest rate. These loan certificates are referred to as "debentures." Similar to equity shares, debentures are issued to the public for subscription.
The company acknowledges the receipt of funds from the investor under the common seal of the organization. A debenture will summarize the terms of the loan and must be logged with the Registrar of Companies. The debenture will include the following:
- Loan amount
- Repayment amount
- Interest rate
- Whether it's a secured or unsecured loan
- How it will be repaid, whether on a fixed date or on demand
Directors may protect their investment by securing a floating or fixed interest rate on the debenture. Generally, the principal is paid on the date that the debenture matures, and interest is paid annually. Fixed charges will include tangible assets such as land, property, machinery, and the plant. When the loan is secured, the company is not able to sell any of the assets assigned to the debenture until the loan has been repaid, unless consent has been given by the debenture holder.
Floating charges cover a specific class of asset, such as shares in the company, which may be sold without the lender's concession. However, the debenture should document what will occur with the floating charges if a loan defaults or the company goes bankrupt. When this threshold has been met, the company will now need the permission of the debenture holder to sell these floating charges assets.
Advantages of Using a Debenture
- Debentures are categorized as a creditor and therefore receive privilege in repayment.
- The directors receive reassurance and financial protection.
- May be a way to grow the business over a long period of time at a fixed low cost
- Debenture holders must be reimbursed before dividends can be paid to stockholders.
- Ownership of the company is not increased, and therefore, profit-sharing remains the same.
- Debentures are a form of debt financing and consequently provide a tax-deductible expense.
- Ownership is not diluted in the company.
- A debenture provides a disciplinary effect because the interest payments are fixed regardless of the amount of profit.
Disadvantages of Using a Debenture
- No flexibility in making the payments to the debenture holder
- If the debenture is secured the business may not have the freedom to sell certain assets.
- Debenture holders are not allowed to vote or share in profits.
- Not a good investment choice in low inflationary periods
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