Let’s say, you and your friend have started a chai & vada pav shop in an MNC area. Your shop takes off, and there are many customers’ day in and day out. Now that the business is doing well, you and your friend decide to expand your outreach.
You want to set up more shops in different places in the same city. To set up more shops, you need to hire more people to sell chai & vada pav at the new shops, and you will have to make sure there is a place for customers to sit, buy fresh ingredients every day, etc. In other words, you will have to spend your money on new machinery, new staff, and daily expenditures.
All this requires a lot of money, but you have just started out. You do not have enough money to finance all these requirements. What will you do?
The most common solution would be to go to the bank and take a loan. However, as a new company, raising money through banks would be very difficult.
Banks take months to give loans. They also have many procedures like filling lots of paperwork. Banks might also ask you to provide collateral for your loan. Collateral means when you take a loan from a bank, and they ask you to keep an asset like your home as a security against the loan. If you do not pay the loan back, the bank can take your house and sell it, to try and recover the money they gave you.
The other way to get funds for your business is by listing your company on the stock market. You can raise money by issuing either equity securities or debt securities like debentures. Inequity securities, investors can own a share in your company. However, most companies prefer to use debt securities like equity shares to reduce their holdings in the business.
You can get funds from investors by issuing an instrument called debentures. Debentures are debt instruments. Debt means the money that needs to be paid back by the company to its investors.
When investors buy your company’s debentures, they are lending you money. You have to give them a promissory note which says that you will repay the amount with a fixed interest rate in the future. This is called debentures.
Types of debentures:
Now that we know what debentures are let us look at the different types of debentures. Debentures can be classified based on four categories. They are :
1. Security
2. Tenure
3. Convertibility
4. Registration
We can discuss each of the above categories in detail now:
1. Security
We can classify debentures based on their security. They can be secured and unsecured.
A] Secured Debentures:
Debentures that are issued against collateral are called secured debentures. Collateral means when you pledge an asset like your home against the loan, and in case you do not repay your loan, the asset can be taken from you. This asset can be sold to recover the money of the investors. This is the principle of secured debentures.
B] Unsecured Debentures:
Unsecured debentures are those debentures where you do not have to provide any collateral as security. If your company is credible, investors will invest based on that. Since you do not have to provide any asset or collateral against unsecured debentures, the interest you will give to your investors will be higher.
2. Tenure
The next classification of debentures is based on tenure. It means whether debentures are repayable on a specific date in the future or not. They are of two types, Redeemable and Irredeemable debentures.
A] Redeemable Debentures:
Like the name suggests, redeemable debentures are those which are repayable on a specific date. When issuing a debenture, your company will give a promissory note to the investors that will mention the date on which the debenture will be repaid. Redeemable Debentures are paid either at par or at a premium. Debentures at par means that the debenture is repaid at its face value. Face value means the price printed on the promissory note. Debentures at a premium means when the repayment is more than the face value.
B] Irredeemable Debentures:
Irredeemable Debentures are those with no redemption or repayment date is written on them. So, the company is under no compulsion to repay the money back to its investors on any particular date. It is also called Perpetual Debentures.
3. Convertibility
Here, debentures are classified on the basis of their convertibility. Convertibility means when debentures or any other financial instrument can be easily changed into other forms like shares, etc. Debentures can be convertible and non-convertible.
A] Convertible Debentures:
If an investor holds convertible debentures, then they can convert the debentures into other forms like equity shares. Convertible debentures allow the investor to turn their debenture assets into stocks. There will be a specified date and duration after which the debentures can be converted.
They can be partially or fully convertible. In partially convertible, only some amount of the debenture can be converted into shares and is fully convertible, and the entire debenture can be converted. These types of debentures allow investors to enjoy the benefit of both equity shares and debentures.
An example of convertible debentures: Let us say you bought debentures of XYZ company, and the company has issued a convertible debenture. According to the rules stated in the promissory note, the debenture can be converted into stock only after one year in the ratio of 12:1
After a year, the company stock price has risen from 40 to 50. Now, you can convert your debenture to stock in the ratio 12:1. Here, one debentures’ worth will be,
New Stock Price * Conversion Ratio (Here, * stands for multiplication)
50 * 12 = INR 600
So, the worth of your one debenture after a year when it is converted into shares is INR 600.
B] Non-Convertible Debentures: Non-convertible debentures are those that do not allow the investors to convert their debentures into shares. They will function as a normal debenture where the company repays the principal amount with a fixed interest rate on a specified date in the future.
4. Registration
Debentures can also be classified on the basis of their registration. They can be registered debentures or Bearer Debentures. Registered Debentures are where investors have to provide necessary details like their name and address. Bearer debentures are those where the investor does not have to give any personal information.
A] Registered Debentures:
Here, the investor has to give out details regarding himself to the company. These details include his name, bank details, address and other important information. In case the investor transfers the rights of the company debentures to someone else, then he has to inform the company regarding the same
B] Bearer Debentures:
Bearer debentures are those which do not need to be registered with the company. They do not require specific details of the investors, such as their name or bank details. They can be transferred, and the company pays to whoever is holding the debenture currently.
Debentures vs Shares
Debentures, shares and bonds are all popular methods to raise funds from the public. Though they have the same goal of raising capital for the company’s business, there are many differences between shares and debentures. Some of these differences are written below:
➔ In shares, the company is raising funds by selling parts of their shareholdings. This means that investors who buy a company’s shares are also tiny owners of the company. This will dilute the management’s shareholding in their business.
➔ In Debentures, the company is raising funds by borrowing money from the public. Here, a promissory note is issued to the investors where the company promises to pay the amount that the investors have given along with a fixed interest rate in the future. Here, the investors do not own any shares of the company.
➔ In shares, investors own tiny shares of the company. It is possible that the company might not give investors a return on their shareholdings. The decision to give dividends depends on the management of the company and whether the company is making a profit.
➔ In Debentures, the company has to repay the borrowed sum along with fixed interest to the investors regardless of whether they are making a profit or a loss.
➔ In shares, investors are shareholders and have ownership rights in the company. Hence, they have voting rights in the managements’ decisions.
➔ In Debentures, investors do not own any part of the company and cannot control managements’ decisions.
➔ In shares, investors are shareholders in a company and in debentures, investors are creditors to a company.
➔ Shares cannot be converted into any other assets. In comparison, debentures can be converted into equity shares after a particular duration.
Advantages vs Disadvantages of Debentures:
Just like every other financial instrument, debentures have certain advantages and disadvantages. Some of them are:
Advantages of Debentures:
➢ For a company, debentures are a better option than equity shares to raise funds.
➢ Debentures allow companies to raise funds from investors without diluting the hold of the company on its shares.
➢ For investors, it is better to invest in debentures as they will get a fixed rate of interest which is higher than the interest they receive on fixed deposits.
Disadvantages of Debentures:
➢ For a company, debentures are compulsory payments to be made to the investors. So, even if the company is making a loss, they still have to pay back the money guaranteed.
➢ If the company is unable to pay back the money to its investors, its credit ratings can get affected. This, in turn, can affect their ability to raise funds from investors in the future, as investors will be hesitant to invest in unreliable businesses.
➢ For investors, they cannot get more than the principal amount and the fixed interest written on the promissory note.
Conclusion:
Debentures are an excellent way for a company to raise funds. It is economical and a better option than equity shares. Companies that do not want to dilute their shareholdings can rely on debentures. For investors, debentures provide a new and diversified opportunity for investment. However, they are not without risks. If a company starts defaulting on its payment, then investors can face a loss. Hence, it is important to analyze a company’s credibility before investing in it.
Frequently Asked Questions Related to Debentures:
1. What is the need for debentures when there are other financial instruments?
Debentures provide diversified investment options to investors and an economical way to raise funds for companies; hence there is a requirement for debentures.
2. What is the companies’ (share capital and debentures) rules of 2014?
The companies share capital and debentures rule of 2014 was enacted by the Central Government in 2014. It provides rules related procedures for share capital and debentures. These rules apply to listed, unlisted and private companies.
3. What is the interest rate of debentures, and how is it calculated?
Debentures have fixed interest rates. Non- convertible debentures have higher interest rates. The interest rate is calculated based on the face value of the debenture.
4. How is a debenture redeemed?
Debentures are promissory notes given to the investor. On the promissory note, the method of repayment is given by the company. Repayment can be made on a fixed date in the future, in lump-sum amount, annual instalment or investors can get their payment before maturity through call and put option.
5. What is the relevance of debentures in accounting?
Debentures are recorded in the transaction book of the company and are issued under the seal of the company. It is essential in accounting as it acknowledges the long or medium-term debt owed to the investors.
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