A debenture is a legal document that acknowledges debt between a borrower and a lender. Often referred to as a security document, it outlines how a company’s assets will be used to secure funding. Debentures play a vital role in business finance, offering lenders clarity and security while allowing businesses to access necessary funding.
Here, we break down everything you need to know about debentures, their types, and how they can impact your business.
How does a debenture work?
In the UK, a debenture is filed at Companies House and provides security to the lender. If the borrower defaults on repayments, the lender has defined rights to the company’s assets. This means the lender can recover their money by selling those assets, which places them ahead of other unsecured creditors in the queue for repayment.
Debentures are commonly required in the following situations:
- Full-book invoice finance facilities: Lenders often insist on a debenture to secure the funding provided.
- Construction businesses: Given the industry’s higher insolvency rates, debentures are required for invoices exceeding £50,000.
However, for selective invoice factoring below £50,000, debentures are typically not required.
Types of debentures
Debentures come in several forms, depending on the terms of the agreement and repayment structure:
1. Secured debentures
These are the most common type in the UK. Assets such as property, equipment, or intellectual property are used as collateral. If repayments are not met, these assets can be sold to recover the debt.
2. Unsecured debentures
Rarely used in business finance, unsecured debentures rely solely on the borrower’s creditworthiness. Without collateral, these carry higher risks for lenders and usually require personal guarantees or higher interest rates.
3. Redeemable debentures
This type resembles a fixed-term loan, where the borrower must repay the debt by a set date. Payments can be made in instalments or as a lump sum, as outlined in the agreement.
4. Irredeemable debentures
Unlike redeemable debentures, these have no fixed repayment date. Borrowers continue to pay indefinitely until the company enters liquidation or decides to repay the debt. Business overdrafts are a common example of irredeemable debentures.
Types of charges in a debenture
A debenture may include different types of charges on the borrower’s assets:
Fixed charge
This applies to specific assets, such as property or machinery. These assets cannot be sold or transferred without the lender’s permission, and any proceeds from their sale must go to the lender.
Floating charge
A floating charge applies to a group of assets, such as inventory or receivables, which may change over time. The borrower can continue using or selling these assets during normal business operations. However, if the company defaults or enters insolvency, the floating charge “crystallises” and becomes fixed, restricting further transactions involving those assets.
Advantages and disadvantages of debentures
Advantages
- Secure funding: Debentures provide lenders with security, making it easier for businesses to access funding.
- Cost-effective: Compared to other unsecured financing options, secured debentures often come with lower interest rates.
- Business control: Unlike equity financing, debentures allow businesses to raise funds without giving up ownership or decision-making power.
Disadvantages
- Asset control: Borrowers lose control over secured assets, which could be sold by the lender in case of default.
- Mandatory interest: Regular repayments are required, regardless of the company’s financial position.
- Risk of liquidation: If repayments cannot be met, the company may face liquidation.
Debentures in the UK vs. the USA
The term “debenture” has different meanings across regions. In the UK, debentures typically involve secured loans backed by company assets. However, in the USA, a debenture is an unsecured corporate bond used to raise capital. These bonds depend on the borrower’s reputation and do not involve collateral.
American debentures may be:
- Convertible: These can be converted into equity shares over time, offering lower interest rates.
- Non-convertible: These remain as loans and typically carry higher interest rates.
Debenture vs. personal guarantee
For unsecured financing arrangements, lenders may require a personal guarantee instead of a debenture. This means company directors pledge their personal assets as security. However, in invoice finance, personal guarantees are rarely called upon due to the reliability of customer payments.
Is a debenture right for your business?
If your business needs funding and you’re comfortable securing it against your assets, a debenture can provide a straightforward and cost-effective solution. However, it’s essential to understand the terms and ensure you can meet the repayment obligations.
Consulting a finance expert or broker can help you navigate the complexities of debentures, ensuring you make the best decision for your business.