"FUNDING" - Debentures: What Are They and How Do They Work?

What is a debenture?

Debentures are an instrument available to?business lenders, allowing them to secure loans against borrowers' assets. A debenture is a document granting lenders a charge over a borrower's assets, giving them a means of collecting debt if the borrower defaults.

Traditional lenders, such as banks, commonly use debentures when providing high-value funding to larger companies. To register a debenture, a lender must file it with Companies House. This can usually be done in a matter of days.

The different types of debenture charge

A debenture can grant two types of charge, with lenders tending to seek one or both of the following.

Fixed charge

With this charge, a lender can ensure it is the first creditor to recoup any outstanding debt if a borrower defaults on a loan. In essence, it grants the lender possession and ownership of a borrower's asset in the event of non-payment, with any subsequent sale being used to pay off the remaining debt. The most common form of fixed charge is against property.

As well as covering the freehold or leasehold of a property, a fixed charge can cover building fixtures, trade fixtures, fixed plant and machinery, and motor vehicles. With a fixed amount, the borrower would not be able to sell the asset without the lender's permission, and the proceeds would usually go to the lender or towards a new purchase, which the lender then places a fixed charge over.

Floating charge

A floating charge can be attached to all of a company's assets or specific classes of assets, including stock, raw materials, debtors, vehicles, fixtures and fittings, cash, and even intellectual property. The 'floating' nature of the charge means these assets might change over time, with the borrower able to move or sell any assets during the ordinary course of business.

Only when the lender looks to enforce the debenture in a default situation does the floating charge 'crystallize' and effectively become a fixed charge. From that point, the borrower will only be able to deal with the assets in question if they have permission from the lender. In insolvency or liquidation, a floating charge will prioritize a lender over unsecured creditors when it comes to the allocation of repayments.

Multiple debentures

It is possible for a lender – or lenders – to have multiple debentures on the same borrower. These can be various fixed debentures against different specific assets, multiple floating debentures, or a mixture of both. When the first lender places a debenture on the company, they often prevent a second lender from adding another without their consent.

Where multiple lenders with debentures have recourse against the same borrower's assets, they will agree on the priority of payments between themselves. This is usually documented between the lenders and borrowers through a Deed of Priority.

Debentures - good or bad?

In essence, debentures are necessary for raising money for a business. Some lenders will only lend above a certain amount with a debenture, so you should be prepared to offer up your assets as security regardless of how much you want to borrow.

If you're uncomfortable putting your company's assets on the line, an?unsecured loan?might be a better option for your business. However, it could mean borrowing less and paying a higher interest rate.

Debentures in the USA

If you're reading this article in the USA, you can only ignore the above if you found this page as part of your research into the UK finance industry.

Believe it or not, 'debenture' means something completely different in the United States. Rather than an instrument used to secure a loan against company assets, a debenture in the USA is an unsecured corporate bond that companies can issue to raise capital.

With no collateral, this debenture is backed only by the reputation and creditworthiness of the business that issued it. As such, anyone investing in a debenture in the USA does so on the belief that a company will have no trouble making repayments.

There are two types of debenture in the United States: convertible and non-convertible.

Convertible debentures

A convertible debenture can convert into equity shares of the issuing company after a certain amount of time. It's an attractive proposition for investors and offers low-interest rates for businesses looking to raise capital.

Non-convertible debentures

A non-convertible debenture doesn't convert into equity in the issuing company. However, it usually offers a higher interest rate than a convertible debenture, making it a more expensive form of capital for businesses.