Difference between the Equity Financing and the Debt Financing with discussion on the Security after Company Registration Hong Kong


There are various sources of corporate financing in practice such as bank loans, trade credits, venture capitalism, equity crowdfunding, short-term financing and long-term financing after new company registration in Hong Kong. But, in legal context there are only two broad categories of corporate financing such as:

  • Equity Financing.
  • Debt Finance.

Most of the above-mentioned source of corporate financing can be grouped with either of these two broad legal categories after new company registration in Hong Kong. For example, financing through equity covers the capital provided by the shareholders of the company or if company is a newbie in the corporate sector then this shall be provided by the founding members of the company. Also, the capital raised as the result of shares issued to the business angels, venture capitalists, IPOs, right issues and private share placements also comes within these grouped categories.

Debt financing covers most of the above-mentioned borrowing and types of loans as well as it includes the debt instrument and debt securities, issued or imply by the company. These all are those financing source which could fit in within two broad categories of corporate financing after establishing a business in Hong Kong and thus rest of the sources do not coincide or can be grouped with either of them. Let’s clear this matter by referring to an example which says that; we are familiar with the financing through sale of receivables but legal commentators communicate it to be the type of transaction which although puts company in the commercial transaction as similar to the loan but the legal nature of such transaction would still be an outright sale.

Equity finance is the type of financing after establishing a business in Hong Kong which is provided by the founders or proprietors of the company for the initial or continuing corporate operations of the company. Not just the proprietors of the company but any other person(s) who wish to be the members of the company, also contribute to the capital of the company through share capital. Whereas if we look into the financing through debt finance then it is the finance raised by the company through borrowings. External lenders, creditors of the company or the shareholders of the company would be the ones who shall supply the debt finance to the company so that corporate operations of the company shall go on uninterrupted and smoothly.

Although share capital is the way to raise capital of the company but if we see this with the perspective of the investor or financer then this is the high-risk capital. Share capital is the risky investment because in the situation where company goes default or business do not run up to the expectation then all the stakes of the investors would be lost. Hence there will be nothing left for the investor to get out of his/her invested money. In the situation of the winding up of company, investor would only get what would have been left after making full payment to the creditor(s) of the company and this return is not expected to much in proportion to what he/she has invested in. If we talk about the fate of the shareholder, then shareholders would not be able to grab any return against their acquired shares, if company is not earning any profit. But if after company registration Hong Kong the company is earning profits, then shareholders would get their due share through dividend payments. Usually shareholders are called the residual claimants of the company because if there are any surplus assets left even after making full payments to the creditor(s) of the company then shareholders would be entitled to have their share in these surplus assets, in proportion to the shares they possess in the company. Situation of company’s creditor(s) is entirely different from this because claims of the creditors are fixed, and company is liable to discharge the debt obligations it owes to the creditors, irrespective of the prospect or success of the company. This is the reason that lender or the one from whom company borrowed some capital for the business is entitled to receive periodical interest payments, irrespective of the success of the company.

You may now be thinking that why creditors enjoy such favourable position and why shareholders would have to suffer in case of winding up of company. The corporate reason of this is quite simple which says that; shareholders are the members of the company while creditors are not the members of the company. Thus, on account of being the members of the company, shareholders are entitled to exercise their control over the internal matters of the company. As per the legislative script, shareholders of the company are entitled to exercise their control in the company, over the matters such as; control over the management of the company, control over the economic surplus and control over the constitution of the company. On contrary creditors do not have any control over the internal matters of the company, hence to make them protect their stakes in the company, creditors are given the control over the loan documentation of the company so that they may be able to control the further borrowing of capital. Other controlling authority of the creditors include the appointment of receiver and manager. All these external controlling power or you can say that protective authorities are conferred only because of the reason that as creditor facilitate company in the hour of need, hence to facilitate their stakes it sounds legitimate to confer them some authoritative control. In special circumstances it is possible for the lender to appoint nominee of him or her into the board of directors of the company so as to protect their loan investment by acquiring contractual rights of the company. However, this can be done in exclusive circumstances, subjected to the size of the loan and the term for which loan is provided.

We have assessed the debt financing with the perspective of the creditor and the shareholders, hence ascertained the risk factor for both. But, if we see debt financing from the perspective of the company then we will find that; debt financing is the cheaper and less risky source of financing and this is due to the corporate comfort as creditor do no participate in the profits of the company. Debt financing would become risky only in the case when company’s profit is inadequate enough to discharge the debt obligations of the company. However, there is the advantage involved in the debt financing because company would not need to make dividends payment, in the condition when company is not in the position to make dividend payments.

Financing through the share capital is considered to be the permanent or long-term financing while debt financing is considered as the short-term financing, medium term financing as well as long term financing, as it depends on the circumstances in which company is obtaining debt financing.

Modernisation and newness are the factors which drives the innovation in the corporate sector because some of the corporate financing instruments are basically the hybrid of debt financing and equity financing. Such type of financing possesses the security characteristics of both debt financing and equity financing. Some of the examples of such hybrid financial instrument includes:

  • Financing through the Preference Shares.
  • Financing through the Convertible Preference Shares.
  • Financing through the Convertible Bonds.

Let’s get to know all of these hybrid modes of financing in detail so that we may be able to understand that, what uniqueness makes them hybrid and different from the rest of financing methods.

Financing through Preference Shares

Preference shares have the feature similar to the debt instruments because preference shareholders are entitled to receive fixed amount of dividends against their shares, every year. Although such obligation is subjected to the adequate profits of the company but still they are entitled to receive so. Other rights of the preference shareholder include:

  • Preference shareholders holds the right to receive dividends before the ordinary shareholders of the company.
  • Preference shareholders would enjoy the priority over the ordinary shareholders of the company on account of return on their share capital, in case company is subjected to the winding up.

However, they lack the right to vote in the general meetings of the company, but they would be allowed to vote in the matters where it seems that; the subjected matter is being the one which effects the rights of the preference shareholder. Preference share is called hybrid of the debt financing and the equity financing because while determining the gearing ratio of the company, preference shares would be accommodated as being equivalent to the money borrowed at the fixed rate of interest. This is so because preference shareholders are entitled to receive fixed rate of dividends each year.

Financing through the Convertible Preference Shares

As the name implies, these shares possess the convertible nature. Now take some moments and think that what type of conversion would that be? Came up with sound economic and legal logic? No? don’t worry we will hack this for you. Basically, convertible shares are those, the holder of whom has the option to convert them to ordinary shares, any time in the future. Convertible debentures give holder of the shares, the liberty to get the securities of their debt redeemed against their shares for the issuer of the shares.  Debt security can be mandatory or optional on account of being convertible security. It must be kept in mind that this convertible nature of the debt security is only confined to convertible preference shares only. In case debt security is mandatory then company would convert them irrespective of the wish of the shareholder. While in case debt security is optional then conversion would be made upon the discretion of shareholder.

What does corporate sector mean by the word “Security”?

We have heard about the word security many times in the corporate literature. Now let’s shed some light to know that what does this word mean for the corporate world?

Although concept of security is to provide the protection to the creditors of the company, but protection is not its only purpose. Incorporate HK company usually borrows from various creditors and businesses with them. Hence, each of the creditor would want that his/her interest should be protected and should be given priority over the other creditors. Basically, this is where, need of security was felt. Most of us think that tangible properties such as lands and goods are the most important sources through which security can be provided to secure loan or any interim relief. But intangible properties such as; document of titles to the goods, negotiable securities and book debts are some of the famous intangibles securities which are provided as the form of security in the modern corporate financing. Now the question arise that which security should be called as the “secured protection to the creditor”? Creditor shall consider having the secure protection if;

  • Extent of security amounts to the attachment to the subjected property.
  • Extent of the security is perfect and there is no question on the legitimacy of the provided security.
  • Provided security is of the extent where it would have preference over other creditors and form of securities.

But this is not something, company can provide on its own because corporate sector is driven by the rules and regulations. Therefore, extent of any such security would be subjected to the legal standing and character of the conferred rights to the creditor.