Debentures are a way for companies and government entities to raise money for long-term projects or to cover the costs of working capital as an alternative to taking a business loan by offering to pay the money back in increments with interest to the lenders or investors. It is similar to offering stock except the borrower does not give ownership of the company to the investor. Debentures are similar to loans in that the borrower makes regular payments with interest to the lenders and investors.
They’re appealing to a business owner because the business owner does not normally have to put down collateral and risk having their assets seized like they do with a traditional business loan. This is why the company must have a very strong business credit score and be able to show strong financial statements to qualify.
There are downsides to offering a debenture, like having restrictions on your ability to sell assets if the debenture is secured. Also, debentures require more administrative work than a business loan, which increases your operational expenses.
If you’re thinking about offering a debenture instead of stocks, bonds, or taking a business loan, we’re here to help you learn more about the types of debentures you can offer and what to expect as they come to term.
The Types of Debentures
There are four ways debentures can be offered. You can base them on the present goals of your company and how you plan on operating in the future.
Convertible and non-convertible
Similar to having investors or being a public company, you can use debentures to offer shares in your business. Convertible debentures allow the investors to turn the money owed into shares of equity or common stock (stake in the company) after a certain amount of time has passed, while non-convertible debentures do not allow the lenders to become stakeholders.
Convertible debentures are more appealing to both parties as they can mean lower interest payments than a short-term loan for the company. This option is appealing for the lender as it results in regular income through interest payments and an asset that can grow if the common stock increases in value.
Non-convertible debentures are better for businesses that want to retain control of the company without adding stakeholders, so they make higher interest payments instead of letting the debenture turn into stock. The lenders or investors in a non-convertible debenture benefit from the higher interest payments and stability of the payments vs. hoping the stock will appreciate in value in the future.
Secured and unsecured
Much like unsecured and secured business loans, debentures can have specific company assets tied to them like machinery, vehicles, and property. Secured debentures are not as common as unsecured debentures, as companies offer a debenture so that they don’t have to risk their assets.
If a company offers a secured debenture, there will likely be a covenant that restricts them from being able to sell off or trade in assets. If you’re a manufacturer and want to upgrade your machinery, you may not be able to because the current equipment is part of the debenture.
This is why you want to make sure you have a covenant that allows you to upgrade or sell specific assets, and why you should list the new equipment or assets if they are of equal or greater value. This is known as a fixed charge, the right of the lender to have a claim on the assets that secured the debenture. By adding this, you can keep upgrading your operations and growing without being restricted by the secured assets.
Floating charges are assets used as security that adjust in value. They may reference multiple assets (like inventory as a group) that eventually become fixed. Make sure to define these as best as you can when offering debentures. If you’re the lender, you’ll want to ensure that the stability of the assets is within your investing risk tolerance.
Unsecured debentures allow for you to operate your business and move assets around, assuming there are no clauses in the debenture agreement. This is more appealing as a business owner because you have the freedom to run your business as you see fit. In exchange for not having to put assets up for seizure if you do not make payments, you will likely need to pay a higher interest rate as there is more risk to the lender.
Redeemable and irredeemable
Redeemable means that the debenture must be paid off by a certain date or under specific circumstances unlike irredeemable (also known as perpetual) debentures, which are ongoing. Businesses tend to prefer redeemable debentures because the debt owed terminates at some point in time, while investors and lenders may prefer irredeemable debentures because they continue to receive interest payments in perpetuity.
Registered and bearer
Registered debentures are when the owner of the debenture is listed on the debt, and a bearer means there is no specified person or company the borrower owes money to, making it easier to transfer the asset to another party for the lender.
Some investors enjoy the anonymity of a bearer debenture and being able to sell off or exchange the asset. Borrowers enjoy simplicity and reduced paperwork when assets get transferred and when the debenture is issued the first time or sold to a new party.
The benefits for an investor of a registered debenture are the stability of the assets if the ownership is challenged and the ability to trade it in a secondary market. The downside is that investors cannot trade registered debentures in primary markets as they are not new securities (tradeable financial assets).
Other things to know about debentures
Debentures can be paid off early if your agreement allows for it. Some covenants allow for early repayment if you pay above face value, while others may have a prepayment penalty. You may also be able to add covenants for how much stock can be converted into a convertible debenture, helping you reduce the amount of ownership stakeholders can take in your business.
To offset the amount of stock the investors take, if the debenture is unsecured, you can offer higher interest rates and potentially a bonus as the term comes to maturity.
Any business, regardless of size and private or public setup, can offer debentures. It is about the trust that lenders and investors have in your business that determines if the debenture strategy will work. Newer businesses and start-ups that may not qualify for a small business loan but have a strong track record in business may be able to use this as a way to raise funds.
If you have a strong business credit score and third parties that are willing to invest in your business, and you want to retain ownership and do not mind adding administrative work to your team, debentures could be a great way to secure funding.
If this doesn’t sound like you, contact us to learn more about the types of business loans we can help you secure. Whether you’re looking for short-term or long-term funding options, we’ll match you with the right lender based on your needs and profile.
