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Raising capital in business: The Companies Act 1985

A company, according to the Companies Act 1985, constitutes a separate legal entity (Companies Act 1985, s1). Once a company has been formed (that is, has been incorporated by registration with the Registrar of Companies at Companies House), it will usually need to spend money in order to get its business going. The amount of initial investment will of course depend on the background of the company. If it is a brand new enterprise, there will be far more initial capital outlay than if the company is incorporated from a former partnership of sole trader. In this event, many of the initial costs will already have been met, and the enterprise will be able to carry on trading as before, simply as a company rather than whichever business media it was previously. If it is a new enterprise, however, which has decided, for whatever reason (be it tax advantages, increased security for the entrepreneurs, more professional image, or whatever), to incorporate from the start as a company, initial outlays will be required before even the company can begin trading. Incorporation itself, for example, requires certain fees, although these are generally nominal and low. This would include the fee which must accompany the registration documents to Companies House. After this, the company will need to finance its business premises (which will probably involve the purchase of a freehold or, more likely, commercial leasehold in a suitable property. It will need to stock the premises with suitable equipment and, if applicable, machinery. Initial overheads will need to be considered. Who will be on the first payroll of the company? Finally, of course, stock and raw materials will need to be purchased. All of these outlays depend upon the nature of the business to be transacted by he company (which in turn will be reflected in the company’s ‘constitution’; the generic name for the company’s articles and memorandum of association as stipulated in the Companies Act 1985, ss2-3).

This initial outlay will acquire for the company, hopefully, assets including premises and machinery, sufficient staff, distributorship and supply contracts and other essentials for the operation of a successful business. As the business matures, various factors will come into play which will require the company to build on its reserves of finance, or capital. Such developments might include, for an expanding company, a requirement that the operation be moved to larger premises, or new assets be acquired, or perhaps more staff be taken on. Throughout a company’s life, right from its inception, finance is required for a whole host of aspects of its existence. The aim of the company is to be profitable and to make money. In order for this to happen, however, finance is required.

There are a number of different ways in which a company can raise capital, or finance. The two principal ways are through equity and through debt. These provide, by far, the most common ways of a company raising finance for projects or acquisitions or purchases. Each method will be looked at in turn, with its relative advantages and disadvantages considered. The first, and perhaps the favoured method, is equity finance. Broadly speaking, this involves the company, assuming it is authorised to do so in its articles of association, issuing what are known as shares in the company to members of the public. From point of view of the buyers of the shares, they will become investors in the company, speculating with their own money and hoping to see a return on their investment if the company performs well and increases its net worth. From the company’s point of view, it must attract investors to invest in the company by offering good returns. This basically means that they must always strive to perform as best they can, with the ultimate aim of increasing the value of the company.

A company is, of course, owned by its shareholders. The directors of the company have a duty to these shareholders to run the company in the best interest. When investors purchase shares in a company, depending on the company, they will acquire certain rights. The most significant of these rights, from an investment point of view, is a right to a dividend. This is how the company will attract the vast majority of its smaller shareholders. A dividend is a payment (usually annually) out of the company profits made to its shareholders. It can be seen as a reward for investing in the company. Although the shareholders will often have a ‘right’ to a dividend, the precise amount payable each year will be at the discretion of the directors (see Wood v Odessa Waterworks Co). As a member of the company, however, the shareholder will also have a degree of power over the company, depending on the value and number of shares which he or she owns. This can, perhaps, be seen as a disadvantage of raising finance through equity; it hands a degree of control of the company to others. In extreme cases, under the rule in Foss v Harbottle, a shareholder can sue the company for a wrong committed by it. The protection of shareholders in a company is further protected in statute, in section 459 of the Companies Act 1985. This provides that ‘a member of a company may apply to the court by permission for an order … on the ground that the company’s affairs are being or have been conducted in a manner which is unfairly prejudicial to the interests of some parts of the members…’

The issue of shares involves a complex legal procedure governed in part by statute, in part by case law, and in part by the company’s individual constitution. The rules governing the issue of shares will also depend on whether the company is a private or public company, and whether it is a companied limited by shares or by guarantee. Whichever is applicable, however, equity finance remains one of the most popular and useful ways in which a company can raise finance. The advantages of this method include the fact that it may be easier, especially for a relatively new company with limited resources, to attract investors rather than convince a bank to issue a loan. Secondly it is at the directors’ discretion how much will be paid out to the shareholders by way of a dividend. This can be contrasted with a bank loan which will come with an already agreed (and usually high) interest rate which the company are obliged to pay to avoid defaulting which carries serious consequences. The negative side of this method of raising finance, as mentioned above, is that certain duties are owed to the shareholders, and if the holding of an individual, or group of shareholders is sufficiently large, it may well mean that effective control of the company has been handed away.

Companies have the power to alter their capital. In the event that the company requires more finance, section 121 of the Companies Act 1985 gives the company the power ‘to increase its share capital by new shares of such amount as it thinks expedient.’ alternatively the company can consolidate or subdivide existing shares.

The alternative method available to companies looking to raise finance or capital, is by debt. This essentially means taking a loan from a commercial bank. The company gets the finance, but finds itself in debt to the bank. Although this sounds less attractive from the outset, there are certain advantages with this method over equity finance. It is an established rule of company law that a company has an implied power to borrow money for the purpose of its trade.[1] Accompanying this is an implied power to grant security for the loan to the lender. Many lenders, especially of large sums, are reluctant simply to rely on the borrower’s contractual duty to repay the loan. If the company defaults because, for example, it runs out of money, or becomes insolvent (the procedure for which is set out in the Insolvency Act 1986), the lender will have no recourse. They will often demand, then, security for their loan, which essentially guarantees the recovery of the value of the loan in the assets of the company. A company can give the lender a legal right to take possession, and to sell, certain of the company’s assets in the event of default. Security can be granted by way of three different legal devices; a mortgage, a fixed charge or a floating charge.

When companies borrow money through debt, that is, from a lender, they will often enter into a debenture agreement with the lender. This is simply a formalised agreement containing the terms of the loan. The debenture document will usually contain the amount of the loan (and whether this is a fixed or variable amount), a formal promise by the company that it will repay the amount of the loan on a fixed date, or on the happening of certain stipulated events, a promise by the company that it will also pay in interest on the amount of the loan, the relevant charges (whether fixed or floating or by way of a mortgage) over the company’s assets, and certain clauses which will afford extra protection to the lender, such as a power to appoint a receiver (something else which is dealt with in the Insolvency Act 1986). When a company grants charges over its assets as security for loans, the company is required to register these charges at Companies House (Companies Act 1985, section 395). The company itself must also keep a register of all the charges which it has granted (Companies Act 1985, section 407).

The advantages of borrowing money from a lender (usually a bank); that is, through debt, has certain advantages for the company which is, perhaps, more established, with more assets and resources at its disposal. It is often quicker and easier for such a company to approach a bank and get a loan, than to go through the complex procedure of issuing shares. The down side to this, however, is that most banks will be unwilling to make loans if they cannot get security for that loan over the assets of the company. In the case of a new, young, or small company, there may be insufficient assets to grant security over. In this case, borrowing from a lender will perhaps not be an option.

How a company raises finance, whatever the purpose of this is, depends on the circumstances of that particular company. All options will need to be considered, and the most appropriate can then be selected.

BIBLIOGRAPHY

Statutes

Companies Act 1985

Companies Act 1989

Insolvency Act 1986

Cases

Foss v Harbottle(1843) 2 Hare 461

Wood v Odessa Waterworks Co (1889) 42 Ch D 636

Secondary sources

Scott Slorach, J., and Ellis, J., Business Law (Oxford, 2005)

Walmsey, K., Butterworths Company Law Handbook, 19th edition (LexisNexis, 2005)


Footnotes

[1] See, for example, Scott Slorach, J., and Ellis, J., Business Law (Oxford, 2005), p106


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