Critical things to consider when raising loan finance or selling shares
PROS AND CONS OF A BUSINESS LOAN OR SELLING SHARES
In the current economic conditions, more businesses are raising finance. There are two ways for a company to raise finance. Either via loan finance or issuing share capital.
Deciding which option to take can be a head-scratching moment.
This article will give you an insight into what you need to consider when borrowing or selling shares in your Company.
There are several reasons why a Company will raise finance, including:
a. Pay unpaid invoices
b. Marketing
c. Business expansion
d. Hire more employees
e. Improve cash flow
f. Get new offices or move office
However, why loan finance and not issuing shares?
The following is a brief practical legal guide to why a company will raise loan finance instead of selling shares and why you need a lawyer.
When considering whether to raise finance through a business loan or by selling shares, it's essential to weigh the pros and cons of each option carefully. Opting for equity investment can provide your business with added credibility and expertise from shareholders who bring valuable skills and industry connections. This infusion of capital allows for flexibility in setting share prices and rights, potentially paving the way for future share issuances or buy-backs. Unlike loans, equity investment does not require immediate repayment and offers investors dividends rather than interest payments, although it involves giving up some ownership and control.
However, selling shares comes with its challenges. It can dilute your ownership stake, potentially reducing your influence over company decisions or even leading to a hostile takeover if precautions aren't taken. Valuing shares can be complex and may favor investors, especially in private companies, while subsequent funding rounds could further dilute your stake. Moreover, the process of selling shares involves extensive legal and financial considerations, including shareholder agreements, administrative compliance, and potentially navigating public company regulations if going public. This can be time-consuming and may distract from core business operations.
Pros of equity investment
Businesses gain more trust and confidence from the public and institutions if they can secure investment from a well-known stakeholder in the Company's industry. That Shareholder(s) expertise will boost the business's credentials. Additionally, the shareholders can bring their skills, knowledge and contacts to help the Company succeed.
When selling shares, you can dictate how many shares you wish to sell, at what price and the rights that attach to those shares.
You can decide when to seek a listing from a third-tier exchange like Ofex, then to AIM, and then to the London Stock Exchange, if you are ready for the big leagues. The Company can also issue more shares in future, and buy back shares already issued.
When selling shares, there are usually no restrictions on the use of the investment.
Unlike loans, there are no specific requirements to repay the investment. Shareholders receive dividends, and companies will suspend dividends under certain circumstances.
The investor takes no security for the money invested for the shares. For a substantial loan, there will usually be a charge taken over property or other assets, a debenture over the shares and other assets belonging to the Company, and a personal guarantee from one or all of the Company's directors. With a loan, if the Company fails to repay, the bank or other lender can make it bankrupt or exercise other enforcement rights over the Company's assets. None of these risks applies to a share purchase.
Cons of raising finance via shares
Selling shares in your Company can reduce your ownership and control. If you have not thought it through well enough, you might not only lose the ability to make decisions but might end up being forced out of the Company altogether. Being forced out is called a hostile take-over, and there have been many examples of this, both in well-known https://www.gobankingrates.com/money/business/5-examples-of-hostile-takeovers-that-actually-worked/ and even in small companies.
You have to come up with a valuation of your shares. Often evaluation of share price favours the investor, particularly in private companies. There are usually not enough funds raised in the first round, and the second and third round means more share dilution. With public companies, the market sets the share price.
With selling shares, you will need more advice from a solicitor and an accountant. Several critical issues include administrative and contractual matters, financial assistance, share buy-backs, shareholder agreements, and much more. If you are going public, then welcome to the tsunami of legal and administrative compliance. You will not have this with raising loan finance.
Much time is needed to deal with a share sale, whether you are a private or a public company. However, public companies require far more time. You can save this time away from managing your business with borrowing.
You cannot deduct tax for dividends nor finance used to re-purchase shares. Interest paid to creditors for a loan is tax deductible.
There is no requirement to release public information about your Company when borrowing money, although there will be a charge - MR01- at Companies House.
What is needed when you raise loan capital?
If you raise loan capital, you will require independent legal advice in some circumstances before signing a mortgage or personal guarantee.
In the case of Royal Bank of Scotland v Etridge (No 2), several borrowers argued successfully that a charge and personal guarantee taken by the borrower was not binding. The reason was that the borrowers had not independently advised them.
Lenders must ensure that the borrower does not feel pressured into agreeing to provide a guarantee or a mortgage, as they could be set aside based on undue influence or coercion. For example, there is a presumption of undue influence if there is a 'non-commercial' relationship between the borrower and the lender. This concept of undue influence is based on one of the principles set out in Royal Bank of Scotland plc v Etridge (No 2).
It would be wise if you are a lender always to ask the borrower to seek independent legal advice.
Getting legal advice on the loan agreement before lending is also good practice.
Alternatively, opting for a business loan offers certain advantages. Loan agreements typically allow you to retain full ownership and control of your company while deducting interest payments from taxes. Unlike equity investment, loans do not require public disclosures or face the complexities of shareholder management. However, securing a loan requires thorough legal scrutiny, including independent legal advice for borrowers to ensure terms are fair and avoid potential challenges such as undue influence or coercion, as highlighted in legal precedents like the Royal Bank of Scotland v Etridge (No 2) case.
What do I need to do if I am a lender or borrower?
If you are a lender, you need to ask the borrower to find a solicitor that is experienced in giving independent legal advice. Specific requirements are required to discharge the duty of providing independent legal advice that an experienced solicitor will already know. Any lender would also be wise to ask an experienced solicitor to draw up the Loan Agreement, Personal Guarantee;p and any mortgage. Naturally, the solicitor that gives independent legal advice should not also draft the loan agreement, guarantee or mortgage as there is a conflict of interest.
However, it is standard practice for the same solicitor to act for the borrower and lender to give independent legal advice (ILA) and sign the certificate of execution.
Lenders typically require the borrower to pay legal fees for independent legal advice.
Whether you choose loan finance or selling shares, seeking expert legal advice is crucial to navigating the complexities and ensuring compliance with regulatory requirements. At PAIL® Solicitors Limited, we specialize in providing comprehensive legal guidance on financing options, helping you make informed decisions that support your business's growth and stability.
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Let us know if you're considering raising money by loan or selling shares. We will advise you on which route to take and deal with all the legal requirements.
We are experienced with giving independent legal advice for surety for loans and regularly represent borrowers and lenders.
At PAIL® Solicitors Limited, we will give you experienced practical advice that will benefit your Company.
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