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Business Law and Practice Part 3 – Company Finance

Business Law and Practice Part 3 – Company Finance

Company finance is all to do with how companies raise money, be that through making a profit or by borrowing, and what they can do with it. A company’s funds are its life force, it is the reason the company exists in the first place and being insolvent could be the reason the company is wound up.

There are four ways in which a company can raise funds:

  • Profits
  • Grants from governmental bodies (I won’t be considering this type of finance; it is worth remembering in case your client has not explored this option.)
  • Borrowing – debt finance
  • Shareholders/shares – equity finance.

Profit

Profit is the money generated by the business that remains after all the overheads have been paid. This is true of all businesses but due to the account reporting required of companies, profit must be dealt with in certain ways and this recorded.

There are four ways to deal with profit:

  • Retain in the business i.e. reinvest it. It is wise to retain some profit for future expenditure and shareholders benefit in the long run as capital value of the business and therefore their share value will increase.
  • Pay interest and borrowings. This does take profit from the shareholders but loans are an alternate form of investment so could be seen as payment for the investment. In most cases the company may be obliged to repay.
  • Pay directors fees and bonuses. Some service contracts allow for the payment of bonuses. Payment to directors is treated as an expense, so is deducted pre-tax. In smaller companies, the directors are often the same people as the shareholders so this might be a more tax efficient way to pay the profit to the shareholders.
  • Pay dividends. These are direct payments to shareholders which are declared by the company. They are taxed twice – companies’ profits are taxed by corporation tax before dividends and dividends are taxed by income tax.

Dividends are the ultimate result of profit. It is how investors make money – if the company is profitable, those who have invested by buying shares will benefit from the dividends. However, if, as mentioned above, it is a small company where the shareholders and directors are the same people, there may be a more tax efficient way of distributing the profits to the business owners.

There are also restrictions on the sources of funds that can be used as dividends, in order to prevent investment being returned to shareholders to the detriment of creditors. Dividends can only be paid out of profits available for the purpose, which means accumulated, realised profits, so far as not previously used by a distribution, less accumulated, realised losses. A company must calculate all profits, but can elect to carry them forward through re-investment. Any realised losses must be carried forward, and satisfied, before any further distributions can be made. This means that profits can only be properly judged in relation to accurately and properly drawn up accounts (be nice to your accountants!).

As mentioned previously, dividends are taxed through income tax. However, the fact they have already been taxed through corporation tax is recognised. The shareholder receives a tax credit – this has the effect that the lower rate tax payer will pay nothing, and an upper rate payer will pay a reduced rate. In practice a dividend will be grossed up, so that all tax payers receive the same amount of cleared profit.

Debt vs equity

When a company wishes to raise funds, more than what it is being generated as profit or outside of the normal accounting period, it requires investment. Either the company can invest in itself, by borrowing money (debt finance) or it can sell more shares to new investors (equity finance). There are pros and cons of each and it will depend on the circumstance as to which is most appropriate

Equity finance

Equity finance has its own terms, so it is worth understanding what these mean before thinking about the issue of shares.

Definitions
  • Nominal/par value – the share value in constitution documents (usually written on the front of the share)
  • Share premium – amount over the par value paid, due to the increased value of share
  • Paid up – the amount of the nominal value that has been paid. If only partly paid up the shareholder is required to pay the balance on liquidation.
Types of share
  • Ordinary shares
  • Preference shares – have a right to a fixed annual dividend, potentially cumulative, could stand ahead of other shareholders in repayment of capital contribution on winding up but tend not to get voting rights
  • Redeemable shares – can be redeemed by the company
  • Convertible shares – can be converted into another kind of share.
Share capital

The share capital (the nominal value of the shares issued) must be maintained and cannot be returned to shareholders while the company is a going concerned. A company cannot be its own shareholder, so cannot directly own shares – a trustee will need to be appointed to hold them. Redeemable shares can only be issued if the constitutional documents allow it. If the company wishes to buy back redeemable shares it must do so out of profits or money raised through the issue of new shares.

Debt finance

Companies can only borrow money if it is permitted by its constitutional documents. Most do allow this for the purpose of its trade. Borrowing outside of the permitted scope is ultra vires and can be challenged. This should be checked before entering into any loan agreements, to ensure they are enforceable.

Many loans to companies will be in the form of a debenture – this document grants security or a charge over companies assets, often a mixture of fixed or floating charges. Fixed charges require identifiable assets, such as property or vehicles. A floating charge is one that only fixes over assets when the company defaults. These are used where there is a lot of movement over the kind of asset in question, such as traded goods.

To be valid, charges should be registered with Companies house within a set time of their creation. Unregistered charges are void against the company and any liquidator so it is crucial for the lender to ensure this aspect is completed. Lawyers need to be aware of this and have the registration forms ready to dispatch on completion of the loan in order to meet the deadline. Once a charge is registered, future lenders are deemed have knowledge of its existence and so loans take precedence in the order in which they are registered.

Each type of finance has its own benefits and implications and it is important to appreciate these  in order to advise your client appropriately.

Debt
  • Certain property will be restricted
  • Company itself unrestricted
  • Interest accrued
  • Money spent how they want to
  • Loan takes precedence over shareholders
  • Can manage and budget finances
  • Lender kept at arms length
Equity
  • Waters down voting rights
  • More shareholders = more dividends
  • Increases value of company
  • Do not have to pay money back

In the exam, a question about company finance is likely to revolve around the pros and cons of a particular type of finance and its appropriateness in the situation. You will also be expected to know the procedure to arrange a particular kind of finance, although this will be in your course materials. It helped me to set out each type of finance in a table to have an easily referable comparison. Most of company finance is common sense, once you understand the implications and motivations behind each type. Put yourself in the shoes of the company, which option is best suited?

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