What are the factors that affect the choice between debt and equity financing after starting a business in Hong Kong?

Debt Financing

Company may need surplus funds to meet its corporate needs and the method of obtaining required sum of money through lending is called debt financing. There are two basic types of debt financing, namely sale credit and loan credit. The type of debt financing where debtor is liable to repayment in relation to acquired item or product in future to the creditor, is called the loan credit. For the situation where understanding exist between the company and the creditor that payment for acquired product will be made in future, is called sale credit. To ensure the smooth running of business operations, company needs supplementary finances and for such needs, loan credit is the most appropriate one. Credit loan is the appropriate and the most common one because it provides immediate relief to the company or entity borrowing the loan, from the one who is providing loan credit.

Equity Financing

Equity is analogous to the shares in the company, thus it can be said that person holding equity in the company refers to the number or percentage of shares possessed by a person in the subjected company. If company possess the share capital, then any person can become the member of such company by acquiring one or more shares of the company, and thus stands eligible to have their name listed in the company member’s register. Section 2 of Cap. 622 defines share as:

Stakes or contribution of any person to the share capital of the company.

Any person can acquire the shares of the company by acquiring the issued shares by the company in name of person who is demanding them. Person can also become the shareholder of the company if existing shareholder of the company either transfers or transmits the shares to the subjected person.

People usually confuse members of the company as the shareholders of the company. Hence, to clear this misunderstanding it is suggested that one should refer to the constitution of the company or the legislative framework under which company was registered, to know who the shareholder of the company would be and who will be the member of the company. But, generally it can be said that shareholder having contribution to the share capital of the company is called the member of the company. Any person would be called member of the company if name of the specific person is listed in the company’s register of members. There is no statutory definition which defines the status of the company’s shareholder, instead this term refers to any such person who holds the legal association and title to the shares. Holder of company’s bearer shares is called the shareholders of the company but would never been called the members of the company because they would not have their names, listed in the company’s register of members. One must note that after the enforcement of the Cap. 622 it is restricted and neither possible to issue the bearer shares in Hong Kong.

Factors affecting Debt and Equity Financing

There are certain factors which are supposed to affect the choice of company to go for either debt financing or equity financing, for capital raising of company after create a company in Hong Kong. Hence, it is very important for the manager or controller of the company to ascertain the pros and cons of their financing decisions, because such decision would decide the prospect and future standing of the company. Now, one may wonder that how corporate prospect of the company would be dependent upon the choice of financing? Company go for the financing methods when it is in dire need of extra funds to meet their corporate needs, and obviously if someone is financing them, then he/she would do so by keeping in mind his/her interests. So, terms of the agreement would decide that what company would be made liable of? Still not sure on the vulnerability of the situation? Ok, let’s make this interactive, suppose that after create a company in Hong Kong lender agrees to finance the intention of the company such as business expansion on terms such as high interest rate, equity in the business returns etc. Obviously on such terms although company would get financing for their anticipated goals but such transaction may cost company a lot if anticipations does not come true or meet the anticipated goals. On contrary, if financing is provided on soft and favourable terms, then obviously company would be in a better position to streamline its financial standing and corporate prospects. Now, let’s shift our discussion towards the factor upon which decision such as either to adopt equity financing or debt financing depends:

Size of the Company

Size of the company is the foremost criteria to select the suitable mode of corporate financing after opening a business in Hong Kong as a foreign or local, because liabilities for the acquired financing would most likely to be trickled down to the members or shareholders of the company. This is the reason that small private companies usually operate through the economic reality of partnership and reluctant to involve new equity providers because they themselves want to keep their control over the corporate affairs of the company. While on contrary, large listed companies arrange corporate financing through the mode of equity issuance and they issue the sizeable amount of debt securities so that world would realise and affirm confidence in their business, thereby attracting the investors to invest in their business.

Small private companies or the closely held companies are not able to exercise such showcase of their business or project success as first, they are not listed and not large enough to afford such use of economic instrument. So, it can legitimately be said that after opening a business in Hong Kong as a foreign or local, the size of the company is the important factor and is lethal enough to make or disturb the capital structure of the company.

Corporate Nature of the Business

Corporate nature of the business is an important factor in determining the capital structure of the company. It can be assessed through the “debt to value ratio”, which is related as:

Value of the company= debts of the company + equity of the company

The debt to value ratio for banking corporations is expected to be above 95%. While the debt to value ratio for companies having business nature that of the life sciences, biotechnology and pharmaceuticals, is expected to be less than the 10%. If we look in to the corporate structure of companies having nature of business such as like real estate firms, their debt to value ratio is expected to be around 50%.

Tax Deductions

Tax deduction is another factor which must be kept in mind while seeking finance for meeting the corporate needs of the business. It is counted as the quality of the decision maker, if he/she evaluates all the pros and cons of expected decisions and take the decision which although is not perfect but must be good enough so that if due to any circumstances, company has to suffer, then it should not suffer much. For example, assume the situation where food chain wants to open a franchise at the place where managers or controllers of the company think that it shall be beneficial and profitable for the company to open up a franchise in this locality but being short on finance they seek the financial help from the financers. Suppose it require about $10,000 to establish a new franchise, then it would be a bad decision if borrower, borrows exact $10,000 from the financer because loan finance is not exempted from taxes and thus cost for incurring loan finance is tax deductible. This is the reason it is said that, certain portion of the debt finance must be allocated for the tax deductions so that overall corporate structure of the company could help in increasing shareholder’s returns.

Matters related to the Insolvency and Financial Distress

Corporate sector is full of uncertainties and risks because every step of the manager, controller, agents and directors of the company is linked directly with the prospect of the company. Hence, on account of this uncertainty it can be legitimately said that; likelihood that company would experience financial distress and may become insolvent is proportionally correlated with the debt capital of the company. This situation is so alarming that, in case company has to fold its business operations, then all the stakeholders and employees of the company would lose their jobs. It is said that company’s insolvency is also costly because once company becomes insolvent, then hiring of financial, legal and other relevant professionals would incur a great cost. In Hong Kong company setup service, a company would have to considered in the condition of financial distress if it is seen having trouble in keeping its key employees intact in the company and thus, company holds the clear likelihood that it is soon going to lose its suppliers and customers. Situation of financial distress will lead to the liquidation or if not liquidated, then even restructuring of the company would cause negative ramifications on the interests and stakes of the shareholders.

Restrictions on the Debenture

To protect the investment, it is most likely that lender would impose certain conditions on the debenture notes so that company could not secure further borrowings on the assets, upon security of which lending was made. Let’s clear this by constituting the situation, consider the situation where lender agrees to lend $50,000 on security of company’s property. To ensure that his/her investment would remain safe, he/she would most likely impose restriction, as per which company would not be allowed to borrow more finances on the property or assets, it gave as the security to the lender to finance $500,000 for its corporate operations or any other corporate matter.

Disclosure Cost

Cost of disclosure can help managers or decision makers of the company to decide that, should they get financing through debt financing or equity financing? To raise the equity financing or debt financing, company is expected to bear cost of disclosure such as the preparation of prospectus.

For the situation where company thinks that it would be able to raise the required funds through privately procured finance either through right issues or through placements, then probability that company would raise funds publicly, is near to zero.

Variation in the Interest Rate

Company can determine the cost it is required to bear, so that financing could be obtained either from equity finance or from debt financing, by ascertaining the present interest rates in the market and the present condition of the financial markets. If market offers low interest rate, then this condition would oblige company to increase the size of anticipated debt finance.

Gearing Ratio of the Company

In Hong Kong company setup service, gearing ratio of the company is defined as:

Company’s relationship between its equity capital and indebtedness as well as relationship of company between available earning and the interest charges.

Relation between equity capital of the company and indebtedness is known as the capital gearing. Relation between the available earnings of the company and interest charges is known as the income gearing. Basically, gearing ratio is the measure of the company’s indebtedness. Gearing ratio shows the extent of the company’s borrowing in relation to the equity held by the assets of the company. It can also be regarded as the debt to equity ratio which shows the total debt or total equity held by the company. If we call gearing ratio as the debt to equity ratio then it can be said that, gearing ratio indicates the credit rating of the company and this rating furthermore affects the cost of debt finance.

Lenders and corporate financer use gearing ratio as the tool to determine the borrowing capacity of the company. Legal commentator thus suggests companies to adopt such capital structure which would result in high gearing ratio of the company. Risk factor is inversely proportional to the gearing ratio of the company. Therefore, higher the gearing ratio of the company, more will be the risk associated with the company.