Companies have various options of raising funds. It may be debt, equity, preference, bonds, or any other method. Debentures play a vital role in sourcing the funds of the Company at a lower rate of interest with a periodic commitment to payment of interest. The Indian market has now increased its interest in debt instruments.
Contents of this article
- What are Debentures?
- Types of Debenture
- How Debentures are Useful to Investee?
- How Debentures are useful to Investor?
- Issue of Debentures
- Procedure To Issue Debentures Under Companies Act
- SEBI Regulations for Issue of Debentures
- Redemption of Debentures
What are Debentures?
One needs to understand the basic difference between debt and equity. Debt may be unsecured or secured. Debtholders carry interest rate risk, inflation risk, and liquidity risk. For these risks, they demand risk premiums accordingly. Say the return demanded is 12%.
Now, on the other side, equity holders are the ones who take forward the business of the Company and are actually concerned with the survival of the company. Thus, they carry a higher risk than the debt holders. Thus, the rate of return “required” by the equity holders would be higher than that required by the debtholders.
Definitions of Debenture:
- A debenture is a financial instrument issued by a company for the purpose of infusion of capital in order to expand the current operations of the Company or to explore new market or for any operational reason, wherein the lender (i.e., investors) provides the loan normally without any charge on the assets of the borrower company.
- The terms of debentures are specified in a binding contract made between the issuer company and the debt-holders.
- The said contract specifies features of the debenture such as:
- – Frequency of payment of interest (monthly, quarterly, semi-annually or annually, or any other appropriate manner)
- – Date of maturity (date on which the principal amount will be repaid by the issuer company)
- – Rate of interest to be applied on the face value of debentures
- – Other specific features such as convertibility, non-convertible, or options, etc.
- Debentures usually have a longer period of time say 10 years. These are source of long-term funds of the company with a stated rate of interest on the date of issue.
- At the point no.1 in the above diagram, the issuer issues debt instruments and the lenders provide funds to the issuer. At point no.2, the issuer needs to pay periodic interest to the debenture holder until the maturity date. At point no. 3, the issuer repays the principal amount to the lenders.
- However, not all companies are eligible to issue debentures. Only those corporates with good credit rating by authorized agencies, are eligible for issuance of debentures.
Types of Debenture:
Primarily, Debentures are of two types:
- Non-Convertible Debentures
- Convertible Debentures
Let us first discuss about Non-Convertible Debentures.
So, Non-Convertible Debentures are those who remain as debt and are therefore termed as “fixed income” instruments in the finance world. These investors do not have any ownership rights in the Company. Of course, they are eligible to receive the interest amount irrespective of whether the company makes profit or loss. Thus, there is fixed inflow of cash for the investors.
From Company’s perspective. The Company is obliged to serve the interest at all points of time and this is required to be paid before payment to equity holders.
These debentures are hybrid instruments which are convertible into equity shares. The ratio of conversion is number of equity shares to be issued for 1 debenture instrument.
This ratio is specified in the agreement with the debenture holders. The said conversion is made on the basis of predetermined price, which is specified in the agreement entered into between the parties.
A part of the instrument is equity, the interest rate is lower. The reason for lower risk is connected with the fact that the debenture-holders will get the equity shares of the company at pre-determined rate.
Further the holder holds business risk and is thus, eligible for higher returns from the Company.
Convertible Debentures are further classified as Compulsorily Convertible Debentures and Optionally Convertible Debentures.
Compulsorily Convertible Debentures:
- These are by-nature compulsorily convertible into equity shares. Thus, the holders do not hold an option to opt-out.
- The issuer company is saved from cash outflows on the maturity date. The company only issue shares against the debenture certificates. Due to such restricting features, the company is required to issue the debentures at lower prices. At the time of conversion, the issuer company can demand a premium for the issue of equity shares.
- Such premium helps the Company expand the operations of the Company. Once the debentures are converted into equity shares. The interest meter stops and now the Company has no liability for the committed cost.
- Optionally convertible debentures are debt securities that allow an issuer to raise capital and in return, the issuer pays interest to the investor till maturity.
- The investor of such debentures has a right to convert the debt into equities of the issuing company at a price that is normally decided at the time of the issue.
- The debenture holder has an option:
- – Either to convert the debenture into equity shares or
- – Accept repayment in cash.
- Here, the debenture holder has the option to choose one of the options above on or before the maturity date.
How Debentures are Useful to Investee?
- The issuer Company can raise funds from the public for a specified period of time. The Company offers pre-determined interest commitment to the investors.
- The rate of interest offered by debentures is little lower than procured via a bank finance, wherein the Company needs to pledge its assets. Thus, the Company can save on the net interest cost.
- The debenture holders will not acquire any controlling interest in the issuer-company and hence, the company is not liable to report to the debt-holders.
- Due to higher level of financial leverage, the Company can scale up to massive possible possibilities. Of course, subject to the demand of the products in the market.
- The debentures are source of long-term funds of the company with lower cost of funding as compared to return required by preference shareholders and equity shareholders.
- Since the term of debentures if fixed, the company can plan the utilization of the funds.
- Debenture-holders get interested and the issuer is able to earn higher multiples of gross profits due to leverage.
- Further, the interest payments are tax-deductible thus, the actual cost of debt is much lower than the stated rate.
How Debentures are useful to Investor?
- Debentures usually provide a fixed rate of interest for the lender.
- Interest on debenture has to be paid before any dividend to shareholders.
- At the time of liquidation, Debentures holders are repaid before equity or preference shareholders.
The debentures may be issued through any of the following ways:
- At Par: It means the nominal value of the debenture, is the amount to be collected by the issuer-company.
- At discount: It means the issuer charges lower price than the nominal price of the debenture. The amount to be collected by the issuer-company is lower than the nominal price. This discount is a capital expense of the Company.
- At Premium: It means the issuer charges higher price than the nominal price of the debenture. The amount to be collected by the issuer-company is higher than the nominal price. This premium is a capital receipt of the Company.
The issuer is required to issue debenture certificate to the allotters within 6 months from the date of allotment, as required under section 56 of the Companies Act, 2013. If a company fails to issue the certificates within the time limit, the company is in default and liable to pay fine of minimum Rs. 25000 to maximum of Rs. 500,000. Further, the officer in default (i.e., the individual of the Company who was actually party to the default) is also liable to pay fine of minimum Rs. 10000 and maximum up to Rs. 100,000.
- Provisions of the Companies Act, 2013 provides following regulations to be observed by the Company intending to issue debentures:
- – Debentures should not be issued with voting rights.
- – Approval of the company accorded by special resolution is required in case of the issue of debentures which can be converted into shares (either wholly or partially).
- – In case the Company intends to issue debentures to more than 500 people, it can do so only by appointing a debenture trustee.
- – Such appointment of debenture trustee be made within 60 days of allotment.
- – Company is required to create a debenture redemption reserve.
- – In case of an issue of secured debentures, the periodicity should not exceed 10 years from the date of issue.
The issuer company needs to ensure the following:
- Company shall issue notice of Board Meeting to all directors of the Company. Such notice shall be given prior to 7 days of the scheduled date of meeting.
- The board, at the meeting, shall pass a resolution for such issuer.
- The company needs to pass a special resolution through an extraordinary general meeting in case the company requires to increase the borrowing limit.
- The company needs to file MGT-14 with the Registrar of the Companies within 30 days of passing the special resolution.
- The company needs to prepare a list of people to whom debentures are to be issued. The draft report needs to prepared in PAS-4 form.
- The company needs to open a separate bank account for receipt of funds from the proposed investors.
- The Board is required to make allotment of debentures within 60 days of receipt of funds, subject to closure of the offer.
- The Board needs to authorize the draft agreement for the creation of the charge. One of the directors should be authorized to sign on behalf of the Board.
- After approval of the agreement, it needs to file in Form CHG-9 within 30 days of the creation of charge
- In case of secured debentures, Board’s approval is necessary for the draft deed with the debenture trustee.
- The board shall further approve the issue of debenture certificates. Such certificates shall be issued within 6 months of allotment.
As per SEBI (Issue and Listing of Debt Securities) Regulations, 2008, the issuer company needs to ensure the following compliances, if Company’s shares are listed on Stock Exchange:
- The Company needs to obtain credit rating from one or more rating agencies. Even if the ratings are unaccepted, the said ratings need to be disclosed in the offer document.
- The company needs to obtain in-principal approval from one or more stock exchanges in order to list the debentures.
- Further, the Company needs to enter into a dematerialization agreement with the depository.
- The company needs to appoint one or more Merchant Bankers. Also, Company needs to specify the lead Merchant Banker.
- It also needs to create debenture redemption account as per provisions of the Companies Act, 2013
- The offer document is required to be placed on the website of the stock exchange and it should be available for download in PDF format or HTML format.
Redemption of debentures refers to repayment of the principal amount to the debenture holders on the date of maturity. Redemption allows a company to legally discharge its liability in respect of the debentures. Post such redemption, the Company is not liable to pay interest to the debt holders.
Redemption can be done in one of the following ways:
– It means the entire repayment is made in one shot at the time of maturity.
– Such method gives one shot hit on the cash flows of the issuer-company.
Redemption in Instalments
– In this case, the Company specifies the dates on which the instalments are to be paid.
– It simply means, total liability divided by a number of installments.
– Instalments can be staggered into years, monthly, or months depending on the terms of the issue.
– Here, the Company can manage the funds in appropriate manner.
Buy Back of debentures
– It means procurement of debentures from open market.
– After such procurement, the Company cancels out the debentures to extinguish the liability.
– Such procurement is generally made at a price higher than the market price.
– Such debentures are callable debentures. Company exercises the option in case the interest rates in the market has reduced significantly.
Redemption by conversion
– Such option is available in case of convertible debentures.
– Such conversion may be compulsory or optional. In the case of Compulsory conversion, there is no cash flow. The debt holders receive equity shares.
– In case of optionally convertible debentures, the outflow is involved only in respect of debt-holders who choose to get paid rather than accepting the equity shares.