Private Limited Company — Debt Financing

By CA Ashok Kumar

In this article we would like to share our knowledge on the various ways which are open to a Private Limited Company to raise Debt Funds and majorly by issuing debentures.

Raising of funds by a Company can be broadly classified in 2 ways, one is Equity funds and Debt Funds.

Equity funds includes amount raised through Equity shares & Preferential shares in general and Loan funds includes, amount raised through Debentures, loans, Bonds etc.

Equity financing: As per the Companies Act 2013, a Pvt. Ltd. Company cannot reach out public at large seeking to invest in its shares, as a result this route of reaching out public at a large for equity financing is not open to Pvt. Ltd. Company. Further, existing share holder may not have sufficient funds to invest in the company.

To get around Private Limited Companies / Startups usually do preferential allotment / rights issue to add investors as equity holders in the Company. However, the same is a tedious exercise with lot of paperwork around the same.

Below table would provide overview for the mode of raising funds by a Pvt. Ltd. Company:

Without further delay, let us get into the details of Debenture Issue by a Pvt. Ltd. Company.

Firstly, let us understand Debentures meaning, types and benefits of raising money by Issuing Debentures:

1. Meaning: In simple terms, a Debenture means an instrument acknowledging debt issued in favour of Investor by the companies for receiving money. The definition under the Companies Act 2013 can be seen below:

As per section 2(30) of Companies Act, 2013, Debentures includes Debentures Stocks, Bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the Company or not provided that

(a) The instrument referred to in chapter III-D of RBI act. 1934; and

(b) Such other instrument as may be prescribed by the Central Government in consultation with the RBI, issues by a Company, shall not be treated as debentures

2. Types of Debentures: The broad types of Debentures are as below and most of them are self-explanatory as a result, we are not going in depth for their definitions.

3. Benefits: Below are some of the benefits that a Company may enjoy by issuing debentures.

· Debenture financing results in interest expense for the company, which is tax deductible expense which is not the case with Equity funds.

The above can be better understood with the below example:

· Generally, debentures are issued for a longer period say 10 years and even these can go without any security (unsecured Debentures).

· Issuing of debentures does not dilute the control of existing shareholders.

· Issue of debenture is a cheaper form of finance as compared to other borrowings/Equity.

Since we have overview about the basics about debentures, let us get into the more technical aspects of the same.

It is impossible to cover all kinds of debentures in this few mins read, we would like to cover most commonly used debentures i.e., Convertible debentures, Redeemable debentures & Zero-coupon debentures.

Convertible Debentures: Means the debentures which are convertible into Equity shares of the issuing Company at a later point of time.

Redeemable Debentures: As the name suggests, these are kind of debentures which are repayable to Investors after specified period of time. Eg: A redeemable debenture with period of 5 years, should be redeemed at the end of 5th year from the date of their Issue.

Zero Coupon Debentures: Means debentures with payment of Zero interest. Generally, zero coupon debentures are either issued at discount (less than their face value) or will be tied with an option to convert them into equity shares on a later date.

FAQs

Ø Can Debentures be listed by Pvt. Ltd Company?

Yes, a Private Limited Company can list its debentures under the private placement and also list the same in BSE or NSE under the debt segment after complying with the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015

Ø When is it a good idea to choose a debenture as a source of finance?

It varies with entity to entity but in general under below circumstances issue of debentures can be explored:

I. When the owners does not wish to dilute their ownership and at the same time company needs funds for their growth.

II. When a company is sure that it can yield more return that what it will shell out by way of interest.

III. When a company wishes leverage on it’s funds and to get the tax savings on the interest paid on debentures.

Ø Is Debt Cheaper than Equity?

When comparing the cost of debt (e.g., a loan) to the cost of equity (e.g., selling a stake of the company) we need to consider how much the interest a company would pay over the lifetime of the loan compares to the portion of profits an owner sacrifices over the lifetime of the company. If the interest paid on the loan is less than an outside investor’s cut of the company’s profits, then debt would be less expensive, and vice versa.

As the cost of debt is finite and the company will not have any further obligations to the lender once the loan is fully repaid, generally debt is cheaper than equity for companies that are profitable and expected to perform well. In other words, the more profitable a company is or will be, the more costly it is to sacrifice equity, as it is more beneficial for an owner to simply keep the profits and pay interest.

Ø Is it true that debentures are always preferable to equity?

No, it cannot always be said that debentures are always better option than equity because regardless of profitability of the company, debenture interest is always payable, on the other hand it is at the discretion of the company to distribute its profits to equity holders.

Ø How startups use debentures?

Since the startup’s may not generate revenue in their initial years of operations, they could issue a Zero-Coupon redeemable debenture, so that at end of maturity term the debentures are redeemed by paying cash.

Let us now see the statutory compliance's under

1. The Companies Act 2013;

2. Foreign Exchange Management Act 1999; &

3. Income tax Act 1961;

1. The Companies Act 2013: Besides many other points to highlight as per Companies Act 2013, below are major intricacies to keep in mind.

Permissibility for Convertible Debentures: As per Section 71(1)[1] read with The Companies (Acceptance of Deposits) Rules 2014[2], Company can issue debentures with an option to convert into Equity shares. However, such issue requires members approval by way of special resolution and with a cap for compulsory conversion period of 10 Years from the date of Issue.

Voting Rights: No Company shall issue debentures carrying any voting rights, meaning the company cannot give right to Debenture holder to participate in the meetings and to vote for the decisions of members.

Debenture Redemption Reserve (“DRR”): In simple terms DRR is the amount that required to be kept aside by a Company for the purpose of meeting the repayment of debentures maturing in the next year. It is capped at 15% of maturity value and the amount kept aside should be invested in specified modes.

Debenture Trustee: Company cannot issue a prospectus or make an offer or invitation to the public or to its members exceeding 500 for the subscription of its debentures, unless it has, before such issue or offer, appointed 1 or more debenture trustees.

2. Foreign Exchange Management Act 1999:

Under FEMA, FDI regulations, an Indian Company can receive funds by issuing Debentures which are “fully, compulsorily and mandatorily convertible” which are treated as Capital instruments.

Raising of funds by Issuing Debentures other than “fully, compulsorily and mandatorily convertible” will not be treated as Capital Instruments and thereby it requires compliance of External Commercial Borrowing (“ECB”) guidelines issued by RBI.

Note: Raising of funds through Compulsorily convertible Debentures will be subjected to the sectorial cap applicable, if any, as it is predetermined that they will be converted into common equity shares at a future date.

3. Income tax Act 1961:

· Interest paid on Debentures will be allowed as expenditure for the purpose of arriving Taxable Income

· Further, premium payable on redemption of debentures is allowed over the period of debentures (CIT Vs M/s Apollo Tyres Ltd (Kerala High Court))

· Discount on issue of Debentures will also be allowed as expenditure.

· Interest on Debenture payment between associated enterprise may be subject to arm’s length price calculation.

Information in this blog is intended to provide only a general outline of the subjects covered It should not be regarded as comprehensive or sufficient for making decisions, nor should it be used in place of professional advice.

Nitin Jogad & Associates | Chartered Accountants accept no responsibility for loss arising from any action taken or not taken by anyone using this blog.