Debentures have become increasingly popular in recent years and are typically used as a means of securing debt. Investing in or lending to a business is never without risk, but debentures provide an element of protection for the investor/lender.
They can also be a useful tool to borrowers who would otherwise struggle to attract debt finance on reasonable commercial terms.
What is a Debenture?
A debenture is a legal agreement between an investor and a borrower, in which a loan is secured against some or all of the company’s assets. It is a form of charge, similar to a mortgage. The lender can expect to have a priority claim on the business’ assets in case of insolvency or defaults on payments of interest or capital.
In addition, a debenture awards the lender the rights of a mortgagee, giving them an element of control over the company’s assets. They must be consulted on the sale of assets outside of normal business transactions, and can require the borrower to obtain their consent before doing certain things that might change the risk profile of the investment.
If the company were to run into financial difficulty, the lender can ultimately assert their powers to appoint their own administrators to take over the business and realise the assets.
When is a debenture used?
A debenture is generally used in circumstances that may be deemed a higher risk for the lender. When investing in a business, the lender must rely on the creditworthiness and likely success of the business in order to get a return on their investment. A debenture provides a layer of protection for the investor. If things were to go wrong, the holder of a debenture takes a prior claim over company assets to any unsecured creditors, increasing the likelihood that the lender will be able to reclaim their debt if the worst were to happen.
Debentures will always be more attractive to a company’s directors than personal guarantees, because if the company runs into financial difficulty it will generally be the company’s assets (rather than the directors’) that the lender has the ability to enforce its security against. A debenture will also need to be registered at Companies House (where it will be publicly available) in order to be enforceable. Failure to register a legal charge can mean that the lender loses its first-ranking status in an insolvency.
Floating charge or fixed charge
Debentures can take the form of either a floating charge or a fixed charge, or both.
A fixed charge will generally be over assets whose value is unlikely to materially change in the course of day to day business, such as land. The company cannot sell an asset that is subject to a fixed charge without the consent of the lender.
A floating charge generally ‘floats’ over all of the company’s assets and will then ‘crystallise’ when there is an event of default. This is a lower-ranking form of security than a fixed charge, but a much more practical one as the value of stock or work in progress may be constantly changing.
In reality, many debentures will create fixed and floating charges over the various assets of the borrower’s business.
Using a debenture within your own company
As a business owner, you are able to use a debenture to secure assets within your own business. This would give you first rights to them ahead of any unsecured creditors, thereby protecting them in an instance of insolvency. You can take out a debenture at the same time as issuing a loan to the company, for example by choosing not to withdraw a dividend or when granting a directors’ loan, to secure that loan against the assets of your company.
However, it’s worth noting that any third-party lender will want their security to take priority over this kind of debenture, so where commercial borrowing is required it may have limited value.
What are the main advantages of a debenture?
There are various advantages of a debenture, including:
•Security for the lender - the underlying loan is secured against the assets of the business.
•Finance opportunities for higher risk companies – because lenders know that the risk profile is reduced by the security that they are granted in the form of a debenture.
•Control - the lender has an element of control over the secured assets, as well as taking priority over unsecured creditors in case of insolvency.
•Protection for the business owner – as the debt is secured against the assets of the company rather than against their personal assets.
What are the risks of a debenture?
As with any case where there is money being borrowed, there is always an element of risk. Some of the risks involved for the parties when a debenture is granted to a lender are:
•Giving away control: as a business owner, entering into a debenture may limit your ability to make certain business decisions without first obtaining the consent of your lender.
•Default on the loan: from a lender’s perspective, there is the risk that even though the lender’s interests will rank higher than unsecured creditors, the borrower may not have sufficient assets to cover the underlying debt in an insolvency event. This risk will usually be factored into the terms of the loan.
Choosing to use a debenture
As with any loan, it is important to weigh up the risks of entering into a debenture. However, in many instances debentures prove a very useful form of security to lenders issuing loans in higher risk situations. They may open up borrowing opportunities for businesses, and give lenders more confidence in their investment.
Given the complexities around the use of debentures – and the risks for both parties should things go wrong – it is always worth seeking expert legal advice before using this kind of security arrangement.
The contents of this article do not constitute legal advice and are provided for general information purposes only.
The Legal Stop provides fixed fee legal services and legal and business document templates for individuals and businesses. Our services include:
We aim to make the law and provision of legal services accessible and transparent to people and businesses alike!
Expertise: Legal Services
The Legal Stop is a straightforward online business using information technology for the public good. We aim to make the law and provision of legal services accessible and transparent to people and businesses alike!