Most Start-up founders use multiple avenues to raise funding for their businesses. These sources of funding are generally classified either as equity or debt financing. Equity financing involves raising funding through a share of ownership from new or existing shareholders (owners). On the other hand, debt financing occurs when a business borrows or secures funding to be repaid at a future date with interest.
Commonly, a debt financing arrangement for a start-up could be in the ordinary course of its business involving the purchase of goods and services on a credit arrangement, bank loans, overdrafts, and other financial supports like bank guarantees or letters of credit, etc.
Mostly, these arrangements are extended to start-ups based on their creditworthiness, ability to provide acceptable collateral, cash flow projections, short-term liquidity/profitability, among others. However, due to the stringent eligibility requirements, only a few start-ups are able to access these short-term debt financing facilities, either from banks and other financial institutions or third-party lenders.
Alternatively, an important long-term debt financing option for start-ups is the use of debentures. Therefore, the purpose of this article is to assess the legal regime for debentures, their creation, and enforcement conditions in Ghana.
What is a debenture?
Although the Companies Act, 2019 (Act 992) does not define a debenture, it provides an extensive list of obligations on a company as constituting a debenture. Examples include a bond or an obligation, a loan stock, an unsecured note, or any instrument executed, authenticated, issued, or created in consideration of such a loan or existing indebtedness, among others.
Essentially, a formal written instrument creating or acknowledging a loan or indebtedness of the start-up will qualify as a key defining feature of a debenture. This indebtedness could be as a result of a loan granted or to be granted to a start-up. Further, a debenture recognises the existing indebtedness of a company, whether constituting a charge on any of the assets of a company or not.
To qualify as a debenture, the indebtedness must be in writing, on terms indicating the company’s obligations to repay, and concerning a debt relating only to the company. Typically, a debenture will be a deed under seal and will set the terms of the loan, such as the amount borrowed, the rate of interest, the date of repayment, and if the loan is secured, the assets subject to the security and the circumstances under which the security may be enforced.
The repayment obligation could be created as convertible or non-convertible, perpetual or redeemable, secured or unsecured, with each having its inherent advantages and disadvantages.
Taking into consideration the nature of start-ups and small and medium-sized businesses, debentures offer the most preferred option for raising long-term funds as they offer the opportunity to negotiate flexible repayment terms and conditions.
Rights of debenture-holders
It must be stated that the legal relationship between the company and its debenture holders is simply the contractual relationship of a debtor and creditor. In contrast with a shareholder, a debenture holder is in law, not a shareholder of the company having a right in the company, but a creditor having rights against it. Therefore, the debenture holder is not entitled to attend and vote at a general meeting of the company, entitled to the payment of dividends, among other rights of shareholders.
Nonetheless, the rights of debenture holders are strictly defined by the terms of the agreement creating the relationship. For instance, the most obvious right of a holder of a convertible debenture is the right to convert the due debt into equity shares at a pre-determined conversion rate. The conversion rate may be set at a premium to the market value of the shares, providing an incentive for the holder to convert instead of making demands for repayment. When such an option is triggered, the start-up has an obligation to convert the debt into shares, diluting the existing ownership of the start-up.
A debenture-holder also has the right to recoup the principal amount and the accrued interest on maturity as per the terms of the debenture. Further, a debenture holder may also exercise the right to secure the debt by creating a charge over the company’s property, and in turn, creating a secured debenture – either as a fixed charge or a floating charge.
Where a fixed charge is created, it usually precludes the company from dealing with the related asset by way of disposal without the consent or permission of the debenture holder. This form of security grants the lender the right to sell the property or to appoint a receiver of the property if there is a default in payment of the due amount. The holder of a fixed charge takes precedence over all other creditors, and so the enforcement of this type of charge usually creates little or no challenge for its holder.
On the other hand, where a charge is floating, it is created over the entire asset book of the company and does not affect any specific asset. However, on crystallisation following the occurrence of agreed events, this type of charge becomes specific or fixed and the company loses its right to deal with its entire asset.
A floating charge crystallises either upon the commencement of the winding up of the company, where there is a default by the company and the holder, pursuant to a right appoints a receiver or manager, or where a receiver is appointed by the court on the application of the holder. The resulting process places the payment of the due debenture liability in priority over any other debts.
In other words, the entitlements in respect of debt repayments and interests are a priority consideration over all other payment commitments, including the payment of dividends.
Where the debenture-holder opts not to secure his/her debenture with a charge, such a debenture may be secured by a trust deed appointing a trustee(s) for the debentures, whether the debentures are secured by a charge over the company’s property or not. The trustee(s) serve as a liaison between the debenture-holders and the company. Such a trustee is responsible for organising meetings between the company and the debenture holders, and may bring an action on behalf of the debenture holders to whom he/she serves as a trustee to enforce the terms of the debenture.
Finally, the debenture agreement or trust deed may make provision for the convening of general meetings of debenture holders for the exercise of various rights, such as the right to vote on matters related to the debenture and to propose resolutions for consideration by other debenture holders at meetings.
The registration and enforcement regime of debentures
The registration and enforcement regime relates to the legal and regulatory requirements that must be complied with to make debentures enforceable. It must be noted that failure to register the debenture, whether fixed or floating, creates no rights in its holder; and such a holder will be regarded as an unsecured creditor of the company.
Once a debenture deed or agreement is executed, the next step is to perfect same – which provides legal validity for its creation. It involves the taking of additional steps to render the rights created under a legal document effective against the company, third parties, and/or to retain its effectiveness in the event of default by the start-up. Such perfection is necessary in order to render them valid and enforceable against the start-up and as notice to the world.
The required registration and enforcement processes include:
The first step in the perfection process is to stamp the executed debenture agreement. Stamping is the making of an impression on a legal document by a public authority in pursuance of law and for which a tax or duty is exacted. In Ghana, stamping is administered by the Land Valuation Division of the Lands Commission on behalf of the Ghana Revenue Authority under the Stamp Duty Act. Stamping must be done within two months from the date of execution of the debenture agreement. Failure to do so within the stipulated period attracts a penalty.
The stamping of an executed debenture is important for two main reasons. First, stamping is required to render the executed debenture admissible in evidence in court and enforceable by the debenture holder following defaults. An unstamped or insufficiently stamped debenture agreement will, therefore, not be admitted in evidence in court and a person cannot rely on same. Secondly, stamping is important because it is a precondition for the registration of the debenture with other registries. The debenture document, therefore, cannot undergo other forms of perfection unless it is fully stamped.
Next, the executed and stamped debenture must be registered with the appropriate registry body which, in the Ghanaian case, is the Office of the Registrar of Companies to serve as notice of the creation of the charge to the world. Under the Companies Act, 2019 (Act 992) all charges created to secure debentures by companies are required to be registered.
Failure to register the charges created over the assets of a company will result in the charge becoming void and all monies secured by the charge becoming immediately payable. It should be noted that the loan under the debenture remains valid, but the charge securing its repayment becomes void unless it is duly registered. The particulars of the charge created – with certified copies of the instrument creating the charge – must be delivered to the Registrar of Companies within forty-five (45) days of the creation of the charge. However, the courts may grant an extension of time for its registration on reasonable grounds.
Even though the obligation is on the company, nothing stops the debenture holder from registering the charge. If the debenture holder registered the charge, he/she is entitled to be indemnified by the company in respect of the cost involved in registration.
On successfully completing registration, the Registrar of Companies is required to issue a certificate of registration as evidence of registration. Registration of a charge constitutes actual notice of the creation of the charge – but not the contents of the charging document – to persons dealing with the company from the date of registration. In such a case, the debenture holder has priority over other creditors so far as the assets are concerned.
As stated earlier, there is a requirement for the charge securing the debenture agreement to be perfected through the process of stamping and registration in order to ensure its validity and enforceability. However, the fact that the charge has become enforceable is not enough. In order to realise the debenture loan secured by the charge, the holder must take positive steps to either get a receiver appointed, or enter into possession of the assets. It is only then that the charge will be regarded as having crystallised.
The default by the start-up or the occurrence of an event specified in the debenture securing the charge only means that the security has become enforceable. The debenture holder must then take one of the steps specified earlier in order to have the charge crystallised. In other words, the mere enforceability of a charge without crystallisation does not thereby vest any rights in the debenture holder. He, therefore, cannot defeat the claim of a judgment/execution creditor to the company’s assets if the company is wound up.
Debentures offer patient and long-term debt financing options for start-ups. However, as permission of regulation, debentures must be created in strict compliance with the requirements of the law, perfected – stamped, and registered in order to ensure their legal validity, and allow for their enforceability on defaults. Start-ups, in the attempt to secure this type of debt-financing arrangement, must appreciate and understand the full options and obligations associated with same; and this article provides some useful guides.
>>>The writer is a Trainee Associate at Sustineri Attorneys PRUC with its Corporate, Governance, and Transactions Practice Group, specialising in legal service provision for Start-ups/SMEs, Fintechs, and Innovations. He welcomes views on this article via [email protected]