University of Calgary

Financing Your Business

In order to carry on business a company needs money to acquire necessary assets, pay bills, reimburse staff, and so on. To obtain the required funds, the company will often sell securities. These securities have a value because they are claims on the company's assets. A security may be either a debt instrument (outstanding loan) or an equity instrument (shares). In either case funds are generated to finance the business.

Key Questions

i.          WHAT IS THE DIFFERENCE BETWEEN EQUITY AND DEBT FINANCING?

ii.         HOW DO YOU FINANCE THROUGH DEBT?

iii.        WHAT SHOULD BE INCLUDED IN A LOAN AGREEMENT?

iv.        WHAT ARE SOME COMMON DEBT INSTRUMENTS USED TO SECURE A LOAN?

v.         WHAT IS THE DIFFERENCE BETWEEN A SECURED AND UNSECURED DEBT INSTRUMENT?

vi.        WHAT OTHER METHODS ARE AVAILABLE TO FINANCE A BUSINESS?

vii.       EQUITY FINANCING.

viii.      WHAT ARE SOME COMMON FORMS OF EQUITY INVESTMENT?

i.          WHAT IS THE DIFFERENCE BETWEEN EQUITY AND DEBT FINANCING?

Equity means ownership in the business. In the case of a corporation, equity financing would include the issue of common, and sometimes preferred shares, to the shareholders in return for their investment in the corporation. The common shareholders of a corporation are its owners. They have a right to anything the corporation decides to distribute after the creditors have been paid. The common shareholders also have ultimate control of the company's affairs since they elect the Board of Directors.

Many corporations also issue preferred shares as a means of raising additional capital for the corporation. Preferred shares, in many cases, are just a form of debt giving the holders extra privileges; for example a right to fixed dividend payments. Since the dividends must be paid out of after-tax income - this often makes preferred shares less popular than debt from the corporations perspective. Preferred shares may or may not be entitled to vote and the shareholders may or may not participate in the profits if the corporation is wound up.

Debtholders (e.g., those who give the company a loan) are usually entitled to a fixed regular payment of interest and repayment of principal. Persons receiving debt instruments are the creditors of the corporation. If the company cannot pay its debts, it can file for bankruptcy. The usual result is that the debtholders take over and operate the company's assets. Where all debts cannot be paid off, the shareholders will receive nothing and lose the capital they contributed as equity.

Interest payments made to creditors are deductible from income for tax purposes; dividends are not. In effect, the government provides a subsidy on the use of debt in the form of interest write-offs, which it does not provide for equity.

ii.         HOW DO YOU FINANCE THROUGH DEBT?

The traditional approach to financing a business is with a business loan from either a bank or from a commercial finance company. Private loans may also be available through friends or family, or by borrowing additional funds from the shareholders. Regardless of the source of the loaned funds, an agreement must be reached between the lender and borrower about the loan. Most banks will have their own loan agreements the terms of which they are very inflexible about negotiating. This document should be reviewed carefully to ensure you understand it.

iii.        WHAT SHOULD BE INCLUDED IN A LOAN AGREEMENT?

Some of the essential terms that should be included in any loan agreement are:

  • When the loan proceeds will be available
  • When the interest is payable
  • When the principle is payable
  • How the interest rate is to be calculated
  • Is there a penalty if the loan is repaid early
  • Any provisions to extend the term of the loan, to renew it or to convert it to a different type
  • Any reporting requirements
  • Any restrictions on the use of the loan proceeds
  • Any restrictions on incurring other debts, selling major assets or changing business lines
  • Any circumstances which will allow the lender to declare the loan in default and demand immediate payment
  • Events that will trigger a default
  • Any insurance provisions
  • The restrictions on the use of any property used as collateral for the loan
  • Any events that will allow lender to accelerate the due date of loan payments or principle
  • The total cost of the loan
  • Other loan fees, commitment fees, placement fees, points, etc., that will be charged in addition to the interest rate.

 

iv.        WHAT ARE SOME COMMON DEBT INSTRUMENTS USED TO SECURE A LOAN?

a)         Promissory Note

A promissory note is simply an unconditional promise in writing made by one person to another, signed by the maker, agreeing to pay on demand or at a fixed or determinable future time, a sum certain in money, to a specified person, or to the bearer.

The form of a promissory note is basically quite simple but it will lose its character unless it complies with the requirements of Section 176 of the Bills of Exchange Act. The requirements of this federal legislation are basically that the note be an unconditional promise to pay a sum certain at a fixed or determinable time.

A promissory note is not a "security" in the common sense of that word. No assets can be seized or taken in the event of non-payment. The holder of the note must, in the event of non-payment, sue on the note and then hope to realize on any judgment obtained.

It is important to remember that the note is fully negotiable by the holder. It is this negotiability and the fact that its use is governed by federal statute that makes it of considerable importance to a lender when used in conjunction with other forms of security, like chattel mortgages. In certain situations it may not be possible to recover all outstanding loan amounts under a security document like a mortgage because of provincial limitations but by use of a promissory note any deficiency may be recovered by an action on the note.[1]

The promissory note can be a dangerous device for a purchaser to place in the hands of a vendor, because the vendor could negotiate the note (ie) sell it and a new holder could sue on that note even if the original vendor had breached some of the terms of the purchase agreement, e.g. warranties under a sale of shares. For this reason it is good practice to refrain from giving promissory notes for the unpaid purchase price under an agreement. The covenant to pay contained in the agreement itself should be sufficient for any vendor.

Sample promissory note

Where the loan is to a corporation, the bank will also attempt to secure a personal obligation on the part of the shareholders to pay any amounts not received from the corporation. This will be a matter for negotiation with the lender. If a personal guarantee is signed however, the signing shareholders will be liable to the full extent of their personal assets for any amounts not paid by the corporation.[2]

b)         Real Property Mortgage

A mortgage is defined in Backs Law Dictionary as "an interest in land created by a written instrument providing security for the performance of a duty or the payment of a debt". Real property or land generally includes the land, and whatever is erected on, growing upon or affixed to the land (i.e., buildings). As already mentioned, in some provinces where the mortgage is between a bank and individual, there is no action against the individual on a personal covenant for payment under a real property mortgage.[3] In other words, the bank can seize the real property for non-payment, but cannot seize any other assets. The personal assets of a mortgagee can, however, be pursued to satisfy any outstanding mortgage amount in other provinces, ie. in Ontario.

c)         Personal Property Mortgages and Personal Property Securities Legislation

In Alberta, the Personal Property Securities Act (PPSA) came into force in October, 1990 and created the Persona Property Registry. The Act also contains provisions which determine the priorities among creditors in a competing claim situation and provides for rights and remedies that arise from a security agreement, or any breach of such agreement.

The PPSA applies to "every transaction that in substance creates a security interest, without regards to its form". A "security interest" includes interests of a creditor in the personal property of a debtor, in order that the creditor is able to secure payment or performance of an obligation by the debtor.

Through the Registry, creditors can give notice to the public of their claims to interests in personal property of their debtors. The Act defines personal property as "goods, chattel paper, a security, a document of title, an instrument, money or an intangible". Each of these terms have specific definitions in the Act. Under the Act, a secured creditor and debtor are free to make their own security agreement, which is enforceable under the terms negotiated between the parties, subject to the provisions of the PPSA and other Acts (for example consumer protection and banking legislation). Thus, the PPSA allows one party to provide a form of financing to another party, and to have repayment of the debt secured, by way of registration. If a security agreement is unregistered, while it may be an enforceable agreement, it will not have priority over a registered security agreement.

d)         Conditional Sales Agreement

A conditional sales agreement is one in which until the purchase price is paid in full, the right to the property remains in the seller notwithstanding actual possession of the goods passes to the buyer. If the amount owing under the conditional sales agreement is not paid, the goods or chattels could be reclaimed by the seller. It is also quite common to utilize a promissory note in conjunction with a conditional sales agreement in order to place the seller in a position to sue on the note if full recovery is not made by seizing the property. Some provinces have legislation requiring a court order before seizure is made if a substantial amount of the purchase price has been paid.[4]

e)         Assignment of Book Debts

This is a fairly common form of security given by a business. It is frequently required by banks and nearly always requested by them on the formation of a new business to secure advances made to that business. The assignment permits the bank to notify the business's customers or debtors that their outstanding accounts should be paid directly to the bank and not to the business. Generally this notice is not given to customers by the bank unless the bank is concerned about repayment. The most common form of assignment is a general assignment of book debts although assignments are sometimes given for specific obligations. The general assignment usually covers all present and future indebtedness to the company.

f)          Debenture

"Debenture" is defined in Black's Law Dictionary as: "A promissory note or bond backed by the general credit or a corporation and usually not secured by a mortgage or lien on any specific property."

It is common practice of corporations to raise funds by issuing "debentures". In a broad sense a debenture is simply a written instrument evidencing indebtedness of the corporation. The debenture can be either secured or unsecured, and is usually negotiable. The usual practice is to issue debentures which are secured by either a floating charge on assets or property or by both a floating and specific charge.

A specific charge contained in a debenture can be against both personal and real property. For the purpose of enforcement it operates, insofar as real property is concerned, the same way as a real property mortgage and insofar as personal property is concerned as if it were a chattel mortgage or assignment of book debts.

g)         Bond

A bond is a certificate of evidence of a debt in which the issuing company promises to pay the bondholders a specified amount of interest for a specific length of time, and to repay the loan on the expiration date. Commonly, bonds are secured by a mortgage.

h)         Section 427 (Bank Act) Security

The Bank Act is federal legislation. It provides for a specialized form of security which is available only to banks which may be taken by the bank from certain classes of borrowers. The classes are wholesale or retail purchasers, shippers or dealers, manufacturers, farmers, fishermen, and forestry producers. The assets that would be covered by section 427 security include inventory, finished goods, and work-in-process. The security could also extend to receivables generated by sales of inventory. Upon default by the borrower, the bank acquires limited statutory rights of seizure and sale. These rights might be supplemented by an agreement between the borrower and the bank, which permits the bank for example, to occupy the company's premises and use its equipment.

i)          Pledge

In addition to the assets of the business, a lender may wish to acquire as security certain rights that are held by the borrower or its shareholders. For example, the bank may want to control the corporation itself in the event of default. In that case the bank would ask the borrowers to pledge their shares in the company as security for the loan. Upon default, the bank could acquire rights to sell or otherwise deal with the shares in accordance with the terms of the pledge agreement.

v.         WHAT IS THE DIFFERENCE BETWEEN A SECURED AND UNSECURED DEBT INSTRUMENT?

A secured instrument is one in which the debtor has provided some type of collateral as security for the repayment of the amount owing. If the debtor defaults in his obligations under the instrument, the secured creditor has first priority vis-a-vis any other unpaid unsecured creditors in any collateral in which the security was taken. For example, a lender who has registered an assignment of book debts as security for an operation loan will be the first to recover any amounts owing to him from the accounts receivables of the debtor. The unsecured creditors divide any surplus once the secured creditor is paid.

With an unsecured instrument, the creditor has no priority to any of the debtor's goods, and must compete with any other unpaid creditors for recovery of any amounts owed.

vi.        WHAT OTHER METHODS ARE AVAILABLE TO FINANCE A BUSINESS?

Some other methods of financing include:

a)         Equipment leasing (Hire Purchase Agreements)

This is an arrangement where a long-term lease is entered rather than the outright purchase of business equipment. At the end of the lease, the equipment will generally belong to the business owner usually after a nominal purchase option is exercised.

In many cases, the lease is structured so that the cash flow the equipment generates is tied into the amount of lease payments due. Another advantage of using the lease method of equipment financing is that the lessor effectively finances a greater percentage of the equipment's cost than what would be available in the usual loan situation.

Some of the matters that should be considered before using the lease financing method include the allocation of tax benefits, depreciation, the risk of obsolescence of equipment, the residual value of the equipment at the end of the lease, and the allocation of risk of any loss regarding the equipment itself.

b)         Limited partnership Interests

A limited partnership arrangement is another financing method that enables a business owner to obtain needed funds. This arrangement offers investors the advantages of current tax deductions and potential capital gains. Its advantage to the business owner is that limited partners don't have a voice in the management of the partnership. A limited partnership is sometimes used in the takeover of an existing business. The method is fairly straightforward. The new business owner would form a limited partnership with the previous business owner. Once the new business owner gained financial strength from the business, he or she would buy out the previous owner.

c)         Factoring

Factoring is an unconventional method some businesses use to obtain additional financing. Generally, factoring isn't an appropriate method to finance a new business but it can be used to provide added cash for an existing one. Basically, factoring is the selling of accounts receivable. If a business has a large volume of accounts receivable, it can turn them into ready cash by factoring or selling them to a third person or a bank. A hybrid type of factoring is one in which the bank lends a percentage of the value of the accounts receivable to the business, and in turn, takes a security interest in the accounts receivable.

vii.       EQUITY FINANCING

Equity financing is financing through the issue of shares in a corporation. Seven provinces and the federal government have Business Corporation Act legislation.[5] Restrictions may be imposed by provincial securities legislation regarding the issuance of shares.

The Articles of the corporation must state the number of classes of shares which can be issued, and the maximum number of shares which can be issued in each class. Three rights must be available to shareholders:

a)         the right to vote at shareholders meetings;
b)         the right to receive dividends declared by the corporation; and
c)         the right to receive the remaining property of the corporation on dissolution of the corporation

The shares to which all three rights attach are usually referred to as common shares, although this is not a legal term.

If there is more than one class of shares, not all shares need to have all three rights nor do they have to share equally in the rights. The only rule is that all three rights must be represented between all the classes of shares.

All rights, privileges, restrictions and conditions which attach to each class of shares are set out in the Articles of Incorporation.

Nova Scotia, Newfoundland and British Columbia operate under a registration system which requires the filing of a Memorandum of Association and Articles of Association with the Registrar of Companies for the province. The Memorandum or Association would outline the capital or share structure and the rights attaching to the shares.

Before issuing shares the applicable provincial Securities Act should be reviewed. This is important since corporations are required to file a prospectus when issuing shares unless they remain private. Generally a private company is required to have restrictions on the transfer of its shares, cannot have more than 50 shareholders, and is prohibited from making an invitation to the public for the purchase of its shares. To remain a private company shares must therefore be offered privately to friends, relatives, etc. and not more than 50 people in total can purchase the shares.

The three rights, dividends, voting and winding up are not the only rights or restrictions which may attach to shares. For example, shares may also be subject to a condition that this may be repurchased at some specified later date at the option of the shareholder or the corporation (called retractable or redeemable shares). The rights and restrictions placed on the shares can be set out to suit the parties needs bearing in mind that the more restrictive the rights the tougher it is to find people to purchase the shares.

viii.      WHAT ARE SOME COMMON FORMS OF EQUITY INVESTMENT?

a)         Common Shares

Common shares represent true equity or "risk capital" in the sense that the holders bear most of the risk for the "down side" of corporate misfortune. In return common shareholders will participate in the "upside" of corporate success. Common shares also have the distinction of being the only true "permanent capital" usually available to corporations. In other words, the holders of common shares generally have no expectation of receiving a return of the original capital invested in the company. In the absence of a liquidation of the company, the only way in which the holder of common shares will usually realize on his investment is by way of a sale of his shares to a third party, or through the payment of dividends.

In summary, Common shares have the following principal advantages:

  1. They are considered permanent capital. They usually do not entail any obligation on the part of the corporation to repay the capital paid on common shares at any time in the future while the corporation is a going concern.
  2. In all but the most unusual of circumstances common shares do not carry a mandatory dividend requirement and, unlike indebtedness and most preferred shares, entail no drain on the corporation's cash flow. Thus, in terms of economic cost, common share financing is "cheap" to corporations and to the extent that common share capital is available, the proceeds may be advantageously applied in reduction of indebtedness or retirement of fixed dividend preferred shares.
  3. Banks and other lending institutions will require corporate borrowers to have a sufficient equity base (as reflected in the "debt to equity" ratio) to provide creditors with a sufficient margin of comfort in respect of debt service and return of principal in the event of winding up. Thus, a strong common share base will increase the borrowing capability of most corporations.
  4. In addition to its being "cheaper" than debt or preferred share financing, common share financing has the advantage of avoiding unwieldy and onerous covenants which the issuing corporation will be forced to accept in debentures, trust indentures and preferred share conditions.

Some of the disadvantages associated with the issuance of common shares are as follows:

  1. Because of voting rights usually associated with common shares, the owners will be giving up some measure of control (although, depending on the relative size of an issue, this may be rather insignificant).
  2. The participation feature of common shares will dilute the per share value of the common shares held by the existing owners of the company.
  3. The issuance of equity to "outsiders" may necessitate periodic and timely public disclosure of financial and operating information about the corporation and require that the affairs of the corporation be conducted with due regard for the minority interest of the new investors.

b)         Preferred Shares

Although preferred shares are equity instruments, in many instances they bear a much stronger similarity to long term debt than they do to common shares. This is particularly true in the case of a preferred share, if it has neither voting or participation rights or the right to convert into shares having voting and participation rights. The only real expectation of the holder of such a preferred share is to obtain a current and pre-determined income yield on his investment in the form of dividends.

Although many preferred shares can be viewed as a form "quasi debt", they often take on characteristics which make them more like equity than debt. For example, they may have a participation feature (i.e. a right to participate in the earnings and assets of the corporation in conjunction with the holders of common shares, over and above the right to a fixed dividend and return of capital) and/or a right to vote generally or in respect of specific matters or circumstances.

This flexibility to "tailor" preferred shares to the particular requirements of the corporation and purchaser is one of the principal attractions of preferred share financing. Indeed, subject to certain rather minimal statutory requirements, the only limitation of the attributes to be attached to preferred shares is the creativity of the individuals designing them.

c)         Warrant

A warrant gives its owner the right to buy shares for cash. For example, the owner pays to buy a warrant today. That warrant entitles its owner to purchase a share (or shares) at a set price at, or just before, a specified future date. The warrant price is usually adjusted to account for dividends and stock splits.

 

[1]           In Alberta, acquisition of the real property from an individual is considered to be full satisfaction for a mortgage. However, in Ontario you can sue for any deficiency.

[2]           See FN 1 from prior page

[3]           Alberta is exceptional in that no guarantee by a shareholder has any effect unless appears before a notary public and acknowledges, to the notary public that he has executed a guarantee (The Guarantees Acknowledgement Act).

[4]           See, for example, British Columbia's Sale of Goods on Condition Act which prohibits seizure by the seller if two-thirds of the purchase price has been paid.

[5]           Alberta, Saskatchewan, Manitoba, Ontario and New Brunswick all have Business Corporations legislation. Nova Scotia, British Columbia and Newfoundland have Legislation referred to as the Company Act.