Different Types Of Debentures And Their Use

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The foundation of a successful business is not built single-handed. Did you know Steve Jobs had to sell his asset (Volkswagen Bus) to fund Apple? The importance of money to a business cannot be overstated. To start a business, funds are most  Important that turn ideas into actions. Many companies raise capital through public offerings of shares. It's not viable for some companies, especially startups, to go public.

Looking at a half-full glass of water, you will never be empty-handed. Another effective method of acquiring funds is borrowing. Usually, companies borrow funds through bonds and debentures. Let’s understand with the help of this article what debentures and their types are.

What is Debenture?

A debenture is a financial term derived from the Latin word “debere” which simply means to borrow. It is a type of investment given by a business or other organizations to fund the small-caps, start-ups, and established organizations for their long-term operations and growth. The companies pay their debenture holders a fixed interest rate on these investments or securities which are repayable after a fixed period.

This form of capital is considered debt capital, so it appears as debt on the balance sheet of the issuing company.

In simple terms, it is just a legal document that shows how much the investor has invested (principal amount), how much interest will be paid, and when the payments will be made.

Who are Debenture Holders?

The debenture holders are called as “creditors” and solely lend to the company. The main difference between the shareholders and debenture holders is that shareholders actively get themselves involved in the decision-making process of the company. On the other hand, debenture holders have no voting rights and cannot participate in the decision-making process.

Let’s have an example and suppose that the government raises funds to build roads for the general public. Now what happens next is debenture holders are the creditors of the company regardless of a shareholder who is the owner.

Debentures are mostly considered unsecured loans where the investors have no right to allege on the company's assets if any mishap occurs. The authenticity, creditworthiness and integrity of the issuing company play a strong role because the repayment solely depends on them. Therefore, the issuing company secures the debt interest payments beforehand while paying stock dividends to its shareholders.

In liquidation, the company has the option of paying the creditors by liquidating their assets. Therefore, investors go through the credit ratings of these instruments before planning to invest in them.

A company can issue debentures to raise capital when it has pledged all of its assets as collateral. Through this, they hold for a longer period and pay lower interest rates. Thus, they can be more appealing instead of other types of long-term financing.

What are the types of Debentures?

There are numerous types of debentures that a company can issue based on its objectives and needs. Debentures are classified according to their security, coupon rate, tenure, redemption, convertibility, etc. Eventually, a Debenture is not like a standard product that is strictly configured. A debenture share is defined by the terms of an agreement between a corporation and its holders.

Let’s have a look at how many debenture types are there that companies can issue-

1). Convertible

Convertible Debentures are those debenture shares in which investors can convert their debenture holdings into equity shares of the company. Debenture holders' rights, conversion rates, and trigger dates for conversion are generally determined when the debentures are issued.

2). Non-convertible

Non convertible debentures are the exact opposite of convertible debentures. These types of debentures do not have the right to be converted into equity shares.

3). Registered

The company issuing the debenture enters information about its holdings details, including the number of debentures issued and the name and address of the investor are known as registered debentures. As a result, if the debenture holder transfers their holdings to another investor, the holder's details appear in both the debenture holder register and the transfer register.

4). Unregistered

Unregistered debentures are also known as bearer debentures defined as a company that does not maintain any records at all. The company pays the principal amount and interest to the bearer of an instrument regardless of who is named on the document. Furthermore, the benefit of an unregistered debenture is that it can easily be transferred to a new holder.

5). Redeemable

Redeemable is one of the types of debentures specifying the redemption date on the debenture certificate. A company is legally obligated to return the principal amount to a debenture holder when the redemption date comes.

6). Irredeemable

It is different from redeemable debentures, which have an expiration date; these debentures continue at any time, and the company is not bound by any deadline to pay the holder. It can only be redeemed if the company enters into liquidation.

7). Secured

When a charge is being imposed on the assets of the company, it is commonly known as secured debentures. Charges can either be floating or fixed.

A fixed charge is imposed on assets owned by the company and not used for sale purposes. It is only applicable to specific assets. While floating charge included all assets except those authorized to the secured creditors and is only applicable to the general assets of the company.

8). Unsecured

Unlike secured debentures, unsecured debentures do not have any charge over the company's assets. But a floating charge can be imposed on unsecured debentures by default.

What is the difference between Convertible Debentures (CD) and Non Convertible Debentures (NCD):

The major difference between convertible debentures and non-convertible debentures allows you to know which debentures are suitable for your requirements and why. Let’s understand the difference to get a clear understanding-

1). Rate Of Interest

Convertible debentures usually have a lower rate of interest as compared to non-convertible debentures. The reason behind the distinctive rate of interest is that convertible debentures have the right to convert into equity shares.
Non-convertible debentures are considered to be less risky because of higher interest rates.

2). Maturity Value

Convertible debentures' maturity is determined by the company's stock price at the time of providing debentures. Therefore, the higher the stock price, the more returns you get and vice-versa.                                                                                       Non convertible debentures' maturity value is always fixed because these types of debentures provide fixed returns on maturity.

3). Status

The term Status is used to differentiate between convertible and non-convertible debentures. As a convertible debenture holder, you can be a creditor or owner of the company.                                                                                                                       Whereas, if you are a non-convertible debenture holder, your status is reviewed as the creditor of the company.

What are the advantages and disadvantages of debentures?

Every coin has two sides. Similarly, debentures are beneficial yet they have negative sides too. Let’s discuss both the sides below-

Advantages-

  • The issuance of a debenture does not dilute the interests of equity shareholders, since the debenture holder has no voting right or to take part in management decisions
  • Debenture interest is a tax-deductible expenditure, so it results in tax savings
  • The cost of debentures is relatively lower than the cost of preference shares or equity shares
  • Debentures are advantageous when inflation is high
  • Debenture holders do not bear any risk because interest on debentures is paid even if losses occur.

Disadvantages-

  • For the company, there is no flexibility in the obligation to pay interest on the debenture. When a business encounters financial difficulties, it may be hampered, even brought to insolvency in some cases.
  • By securing a debenture with an asset or asset class, you take away management's freedom to use or control the assets at your whim.
  • Debentures do not confer voting rights on the lender, nor do they allow them to participate in company profits.

In this article, you learned about the debentures and other aspects of it. Debentures are a fruitful alternative to raising the company’s capital and can be financially rewarding for investors as they pay interest at a higher rate as compared to bonds or other investments.

FAQs

What are the different types of debentures in company law?

Ans: Debentures in company law refer to the different types of debentures issued by companies to borrow capital from creditors. Secured & Unsecured, Redeemable & Irredeemable, Registered and other types of debentures fall under this category.

What is the difference between debentures and bonds?

Ans: Government agencies, financial institutions, and large corporations issuing financial debt instruments backed by physical assets and collaterals are called Bond. When private companies issue financial debt instruments but without the backing of physical assets and collaterals, they are called debentures.

What does the term “Wimbledon Debenture” mean?

Ans: Wimbledon debentures are issued by The All England Lawn Tennis Ground plc where creditors are given the right to tickets to every day of the Championship. The best seats at the stadium are reserved for the creditors, in this case, debenture holders.

How much risk do debentures carry?

Ans: Debentures, if compared to Fixed Deposits, are a bit risky as the creditors cannot allege the missing company’s assets in case of any mishap. However, compared to investing in stocks, debentures are safer investments as their prices cannot be manipulated.