MC0M-106 OE01-106 (A) Business Finance

Unit-I: Introduction
Business finance-meaning and concepts, characteristics, importance of
business finance, Scope of business finance, role of business finance, risk and
business finance, relationship between business finance and accounting

Unit-II: Sources of Business Finance

Short-term finance-its sources, ways of raising short-term sources, Long
term finance, equity capital, methods of raising equity finance, Preference share,
Debentures, Convertible loan notes, Warrants, Term loans, Asset-backed
finance(securitization), Leasing

Unit-III: Finance Functions

Financial decision, Liquidity decision, Investment decision, Dividend
decision- factors affecting finance functions.

Unit-II : Sources of Business Finance

Short-term finance-its sources, ways of raising short-term sources, Long
term finance, equity capital, methods of raising equity finance, Preference share,
Debentures, Convertible loan notes, Warrants, Term loans, Asset-backed
finance(securitization), Leasing

2.1 Short-term finance-its sources,

2.2 Ways of raising short-term sources,
2.3 Long term finance,
2.4 Equity capital,
2.5 methods of raising equity finance,
2.6 Preference share,
2.7 Debentures,
2.8 Convertible loan notes,
2.9 Warrants,
2.10 Term loans,
2.11 Asset-backed finance (securitization),
2.12 Leasing
2.1 Short term finance refers to financing needs for a small period normally
less than a year. In businesses, it is also known as working capital financing.
This type of financing is normally needed because of uneven flow of cash into
the business, the seasonal pattern of business, etc. Short-term
finance is used to help a business maintain a positive cash flow. For example, it
can be used to: get through periods when cash flow is poor for seasonal reasons,
eg during a rainy summer for an ice cream seller. its benefit as short term loans
need to be paid off within about a year, there are lower total interest payments.
Compared to long term loans, the amount of interest. Interest is found in the
income statement, but can also paid is significantly less.

2.2 The main sources of short-term finance are as follows:

1. Trade credit
2. Commercial banks or bank credit
3. Public deposits
4. Accrual accounts
5. Factoring.
6. Advances from customers

Short-Term Source of Finance:

1. Trade Credit:
Trade credit is the credit extended by the seller of goods to the buyer as
incidental to sale. It is also known as merchantile credit. It arises out of transfer
of ownership of goods. Trade credit is available in the ordinary course of
business without any security. The volume of trade credit available to a firm
depends upon the reputation of the buyer, financial position of the seller,
volume of purchase, terms of credit, degree of competition in the market, etc.
Trade credit may take two forms –
(i) an open account credit arrangement, and
(ii) acceptance credit arrangement.
In case of open account credit, the buyer has not to sign a
formal instrument of debt. Under acceptance credit, on the other
hand, the buyer is required to sign a debt instrument e.g. a bill
of exchange or a promissory note as an evidence of the amount
due by him to the seller. In both the cases, credit is made
 available to the buyer on an informal basis without creating any
charge on assets.
Merits:
(i) Trade credit is easily and readily availability because no legal formalities are
involved.
(ii) Credit is available on a continuing and informal basis. The concern has not
to approach anybody and tell that it is short of working capital.
(iii) No charge is created on the assets of the buyer.
(iv) Trade credit is a flexible source of working capital. Wherever necessary, the
buyer can delay payment because the seller normally accepts a genuine request.
The concern can earn cash discounts by making payments before the expiry of
the credit period.
Demerits:
(i) While fixing prices, the seller takes into account the interest, risk and
inconvenience involved in selling goods on credit. Therefore, the cost of trade
credit may be very high.
(ii) Availability of liberal trade credit facilities may induce a concern to over-
trading which can be harmful.
Thus, trade credit is a discretionary source of financing working capital with no
explicit costs.

2. Commercial Banks:
Commercial banks are the single largest source of short-term finance for
industry.
They provide working funds in the following forms:
(i) Loans:
Loan is an advance with or without security. A lump sum is given to the
borrower at an agreed rate of interest. The borrower has to pay interest on the
total amount whether he withdraws the full amount of the loan or not. The loan
may be repaid in lump sum or in instalments.
Loan may be term loan or demand loan. A ‘term loan’ is allowed for a fixed
time period whereas a ‘demand loan’ is payable on demand and is, therefore, for
a short period.
(ii) Cash Credit:
It is an arrangement under which the borrower is allowed to borrow money up
to a specified limit. Cash credit limit is fixed after taking into account the
paying capacity and credit worthiness of the client. The credit is given in the
form of cash usually against some security or guarantee.
Cash credit is a very flexible source of working capital. The borrower can
withdraw money as and when required. He has to pay interest on the amount
actually withdrawn rather than on the total unit sanctioned.
(iii) Overdraft:
It is a facility allowed by a bank to its current account holders. The account
holder is allowed to withdraw up to a certain limit over and above the credit
balance in his current account. It is for a very short duration, generally a week
and is used occasionally.

(iv) Bills Discounted/Purchased:

The customer having a bill of exchange arising out of trade can discount the
same with a commercial bank. The term ‘discounting of bills’ is used in case of
time bills whereas the term, ‘purchasing the bills’ is used in respect of demand
bills.

While sanctioning credit, commercial banks take into account the following
factors:
(a) Promoters background, managerial competence, credit-worthiness and
integrity.
(b) Technical feasibility of the project in terms of location, size-infrastructure,
raw materials, skilled labour, manufacturing process, etc.
(c) Economic viability of the enterprise in terms of future demand and supply
position for the product, marketing arrangements, etc.
(d) Financial feasibility and profitability in terms of cost of the project sources
of finance, breakeven point, projected profits, cash flow.
(e) Security and guarantee offered.
(f) Role of the enterprise in the nation’s economy—priority sector or otherwise,
employment generation, export promotion, etc.
Merits:
(i) Bank credit is generally a cheaper method of raising working capital.
(ii) Bank credit is flexible because banks offer different schemes of financing
working capital.
(iii) Under the directives of Reserve Bank of India, banks provide finance to
small scale and cottage industries at concessional rates of interest.
(iv) Commercial banks serve as a friend, philosopher and guide to their clients
in respect of the most appropriate method of financing and utilisation of credit.
Demerits:
(i) In order to raise funds from commercial banks several documents have to be
submitted and signed. It is a time-consuming and expensive process.
(ii) Commercial banks generally require hypothecation or pledge of assets for
granting credit.
(iii) Commercial banks generally take a very serious view of delay in repayment
and interest.

3. Public Deposits:
Many companies invite and accept deposits for short periods from their
directors, shareholders and the general public. This method of raising short term
finance is becoming popular due to increasing cost of bank credit. Deposits are
generally invited for a period ranging from 6 months to five years. Government
has prescribed rules and regulations which must be followed by companies
inviting public deposits.
Merits:
(i) It is a very simple method of financing as very little formalities are involved.
A company has only to advertise and inform the public that it is interested in
and authorised to accept public deposits.
(ii) Public deposits are a relatively less costly source of short-term finance.
(iii) No charge is created against the assets of the company as public deposits
are unsecured loans.
(iv) The rate of interest on public deposits is fixed. Therefore, the company can
take advantage of trading on equity.
Demerits:
(i) Public deposits are not a reliable source of finance. It is not available during
depression and financial stringency. Only well reputed firms can raise public
deposits.
(ii) This mode of financing can put the company in serious financial difficulties.
Even a rumour that the company is not doing well may lead to a sudden rush of
public demanding premature repayments of deposits.
(iii) Widespread use of public deposits may reduce the supply of industrial
securities and thereby adversely affect the growth of the capital market.

4. Accrual Accounts:
There is a time lag between receipt of income and making payment for
the expenditure incurred in earning that income. During this time lag, the
outstanding expenses help an enterprise in meeting some of its working capital
needs. For example, wages and taxes become due but are not paid immediately.
Wages and salaries are paid in the first week of the month next to the month in
which services were rendered. Similarly, a provision for tax is created at the end
of the financial year but tax is paid only after the assessment is finalised.

Merits:
(i) Accrual accounts are a spontaneous source of finance as these are self-
generating.
(ii) Financing through accruals is an interest free method and no charge is
created on the assets.
(iii) As the size of business increases the amount of accruals also increase.
Demerits:
(i) An enterprise cannot indefinitely postpone the payment of wages/salaries and
taxes. Therefore, it is not a discretionary source of finance.
(ii) This source should be used only as a matter of last resort.

5. Factoring:
Factoring is an arrangement under which a financial institution (called
factor) undertakes the task of collecting the book debts of its client in return for
a service charge in the form of discount or rebate. The factoring institution
eliminates the client’s risk of bad debts by taking over the responsibility of book
debts due to the client. The factoring institution advances a proportion of the
value of book debts of the client immediately and the balance on maturity of
book debts.
Merits:
(i) As a result of factoring services, the enterprise can concentrate on
manufacturing and selling.
(ii) The risk of bad debts is eliminated.
(iii) The factoring institution also provides advice on business trends and
other related matters.
(iv) It helps in avoiding overtrading.
(v) It helps in balancing cash requirements.
(vi) It helps to improve operating margin.
(vii) It helps to reduce overheads involved in credit and collection
activities.
Demerits:
(i) A substantial amount of discount or rebate has to be paid to the
factoring concern.
 (ii) If the factoring institution uses strong arm tactics to collect money it
mill spoil the image and relations of the firm with its customers.
a. Factoring is a service whereby the provider, known as the factor, offers to
take up the accounts receivable – in the form of invoices – on behalf of a seller,
for a fee
b. It’s beneficial for small and medium businesses who may not have adequate
working capital to work with large corporate buyers
c. There is absence of clearly defined regulations that recognize factoring. The
comfort level of buyers is another issue that factors have to contend.

6. Advances from Customers:

Manufacturers and suppliers of goods which are in short supply usually
demand advance money from their customers at the time of accepting their
orders. For example, a customer has to make an advance at the time of booking
a car, a telephone connection, etc. Similarly, contractors constructing buildings,
etc. require an advance form the client.
In some businesses it has become customary to receive advance payment
from the customers. This is a very cheap source of short term finance because
either no interest is payable or the rate of interest payable on advance is
nominal.

2.3 Long term finance

Long-term finance can be defined as any financial instrument with

maturity exceeding one year (such as bank loans, bonds, leasing and other forms
of debt finance), and public and private equity instruments, Its used for
Coincides with Long-Term Strategy – Long-term financing enables a
company to align its capital structure with its long-term strategic goals,
affording the business more time to realize a return on an investment.
A major drawback of long-term debt is that it restricts your monthly
cash flow in the near term. The higher your debt balances, the more you
commit to paying on them each month. ... It also limits your ability to build up a
safety net of cash savings to cover unexpected costs of doing business.

Advantages of Long Term Financing

 Align specifically to the long term capital objectives of the company

  effectively manages the Asset-Liability position of the organization

 Provides long term support to the investor and the company for building

synergies.

 Opportunity for equity investors to take controlling ownership in the

company.

 Flexible repayment mechanism

 Debt diversification

 Growth & expansion

Limitations of Long Term Financing

 Strict regulations laid down by the regulators for repayment of interest

and principal amount.

 High gearing on the company which may affect the valuations and future

fund raising.

 Stringent provisions under the IBC Code for non-repayment of the debt

obligations which may lead to bankruptcy.

 Monitoring the financial covenants in the term sheet is very difficult.

Long-term financing sources can be in the form of any of them:

 Share Capital or Equity Shares.
 Preference Capital or Preference Shares.
 Retained Earnings or Internal Accruals.
 Debenture / Bonds.
 Term Loans from Financial Institutes, Government, and Commercial Banks.
 Venture Funding.
 Asset Securitization.

1. Share Capital or Equity Shares

The Company raised their capital by offering shares is known as equity
share or Share Capitall. It is the money that company owners and investors
direct towards a company's capital and use to develop or expand the operations
of their venture.
Equity or shares are a unit of ownership in a company, and equity
capital is raised by issuing shares to shareholders. It is also referred to as share
capital. Shareholders are the owners of a business, and bring in capital, take
risks and directly or indirectly run the business.

2. Preference Capital or Preference Shares

Preference shares are the shares which promise the holder a fixed
dividend, whose payment takes priority over that of ordinary share dividends.
Capital raised by the issue of preference shares is called preference share
capital.
Preference share or preferred equity is similar to the common share of a
company in terms of ownership. ... For example, a 5% preference share with a
face value of Rs. 100 will pay Rs. 5 as dividends every year
Preferred shares are a hybrid form of equity that includes debt-like features such
as a guaranteed dividend. The four main types of preference shares are callable
shares, convertible shares, cumulative shares, and participatory shares.

3. Retained Earnings or Internal Accruals

Retained earnings or retained profits are the net income company
generates that are retained by company and not distributed to the owners.
Retained earnings are either reinvested in the company to assist with
stabilization and expansion or retained to strengthen the company's balance
sheet.
Internal accruals are nothing but the reserve of profits or retention of
earnings that the firm has created over the years. They represent one of the most
essential sources of long term finance since they are not injected into the
business from external sources.

There are various types of accrual accounts. The most common

include accounts payable, accounts receivable, goodwill, accrued interest
earned, and accrued tax liabilities. Accounts payable refers to debts a
company incurs when it receives goods or services from its vendors before it
has actually paid for them.
4. Debenture / Bonds
Bonds are a kind of Debt-instrument which are backed up by specific
physical assets and are issued with the intention of raising Capital through
borrowings. A bond is a contract between two parties viz. the issuer and the
issue with a fixed maturity date and in most of the cases, a Bondholder is
benefitted with a fixed rate of interest periodically. Debentures, on the other
hand, is not backed up by any assets or security, rather it’s issued only by the
issuer’s promise. Like bonds, a debenture is also treated as a loan instrument.
A debenture is a type of bond or other debt instrument that is
unsecured by collateral. Since debentures have no collateral backing, they
must rely on the creditworthiness and reputation of the issuer for support. Both
corporations and governments frequently issue debentures to raise capital or
funds
A debenture is a bond issued with no collateral. Instead, investors rely
upon the general creditworthiness and reputation of the issuing entity to obtain a
return of their investment plus interest income. Examples of debentures
are Treasury bonds and Treasury bills.

What is the difference between debenture and loan?

Debentures are capital raised by a company by accepting loans from general
public. Debentures are transferable while loans are not. • Debentures do not
need any collateral from the company whereas loans need collateral

5. Term Loans from Financial Institutes, Government, and Commercial Banks.

A Term loans is a form of debt incurred by an individual or other
entity. The lender—usually a corporation, financial institution, or government
—advances a sum of money to the borrower. In return, the borrower agrees to a
certain set of terms including any finance charges, interest, repayment date, and
other conditions.
Financial institutions are very important in an economy to grow. ... Commercial
Banks refers to that financial institution who accepts deposits, does checking
account services, makes various loans arrangements and offers other financial
product and savings accounts to individuals and other small businesses.

6. Venture Funding
Venture capital (VC) is a form of private equity financing that is provided by
venture capital firms or funds to startups, early-stage, and emerging companies
that have been deemed to have high growth potential or which have
 demonstrated high growth (in terms of number of employees, annual revenue,
scale of operations.
Venture capital (VC) is a form of private equity and a type of financing
that investors provide to startup companies and small businesses that are
believed to have long-term growth potential. Venture capital generally comes
from well-off investors, investment banks, and any other financial institutions.

Following are the institutional sources of venture capital:

 All India Financial Institutions.
 By State Finance Corporation.
 By Banks.
 Private Sector Companies.
 Equality capital.
 Conditional Debt.
 Income Note.
 Establishment of Shares in the Market.

7. Asset Securitization

Asset securitization is the structured process whereby interests in

loans and other receivables are packaged, underwritten, and sold in the
form of “asset- backed” securities. ... Asset securitization began with the
structured financing of mortgage pools in the 1970s.
Securitization is the process of taking an illiquid asset or group of assets
and, through financial engineering, transforming it (or them) into a security. A
typical example of securitization is a mortgage-backed security (MBS), a type
of asset-backed security that is secured by a collection of mortgages.
Any company with assets that generate relatively predictable
cash may be securitized. The most common asset types include corporate
receivables, credit card receivables, auto loans and leases, mortgages, student
loans and equipment loans and leases. Generally, any diverse pool of accounts
receivable can be securitized.

The primary benefit of securitization is to reduce funding costs. Through

securitization, a company that is rated BB but maintains assets that are very
high in quality (AAA or AA) can borrow at significantly lower rates, using the
high quality assets as collateral, as opposed to issuing unsecured debt.

2.4 Equity capital

In finance, equity is ownership of assets that may have debts or other

liabilities attached to them. Equity is measured for accounting purposes by
subtracting liabilities from the value of the assets. Equity capital is funds paid
into a business by investors in exchange for common or preferred stock. This
represents the core funding of a business, to which debt funding may be added.
Common stock capital is an example of equity that a corporation obtains from
owners and other parties. A company issues shares of common stock in
exchange for cash. ... For instance, if you and two family members each put in
$50,000 to start a corporation, you would each get an equal number of shares of
common stock.

Companies borrow debt capital in the form of short- and long-term loans
and repay them with interest. Equity capital, which does not require
repayment, is raised by issuing common and preferred stock, and through
retained earnings. Most business owners prefer debt capital because it doesn't
dilute ownership

Equity and Capital are different as Equity, as mentioned above, only

refers to the shareholders' rights in a company or owners' rights in a business.
Similarly, capital only represents the investment made in the company or
business directly. ... Therefore, capital is also a term used to describe both
the equity and debt of a company.

Advantage:

1. No Repayment Requirement

When you use equity capital, you have no obligation to make interest
payments or to repay equity investors’ initial investment. Debt capital, on the
other hand, requires periodic interest payments and repayment of the borrowed
principal. Although you might distribute some of your profits as dividends to
equity holders, you can skip these payments if necessary. This advantage helps
your small business keep more of its profits and allows more spending
flexibility.

2. Lower Risk

In general, a business that uses more equity than debt has a lower risk of
bankruptcy. If a business suffers a setback and fails to make its interest
payments, its creditors can force it into bankruptcy. Equity investors have no
such rights. They must wait out any potential downturns to be able to benefit
when a business prospers. For example, assume you finance your small
business with all equity and have a bad year. Investors might be disappointed,
but their only option is to hope for improvement.

3. Bringing in Equity Partners

While the money is a definite advantage of new equity, the partners that
you'll work with also have a vested interest in seeing your business succeed. If
these partners have a good deal of expertise, connections and influence, this
could make all the difference between a struggling or thriving business.
Additionally, having good equity partners can make increase the odds of
securing more attractive debt if needed in the future.

Disadvantage:

1. Ownership Dilution

Various share capital pros and cons exist, but one of the worst negatives
as an owner is the loss of control over the company. The advantages of owners
capital investments typically include a certain amount of control over the
enterprise through the ownership of a large percentage of the company's shares
of stock.

With every share of stock you sell to investors, you dilute, or reduce,
your ownership stake in your small business. Because equity investors
typically have the right to vote on important company decisions, you can
potentially lose control of your business if you sell too much stock.

For example, assume you sell a majority of your company’s outstanding

stock to raise money, and investors disapprove of the company’s progress. In
this case, because of your choices and your reduced ownership percentage,
they might have the power to vote you out of a leadership position and bring in
new management.
2. Higher Cost

Although equity does not require interest payments, it typically has a

greater overall cost than debt capital. Stockholders shoulder more risk from
their perspective compared to creditors because they are last in line to get paid
if the company goes bankrupt. Consequently, equity investors demand a higher
rate of return on their investment. You typically must give up more stock for a
lower price when you raise equity to compensate investors for this risk.

3. Time and Effort

It takes a good deal of time and effort to get a loan, from getting through
the loan application to getting through the underwriting process. However, the
process to secure equity funding can be even more time-consuming and
arduous. It typically takes the right connections and a powerful pitch deck to
get the equity you need.

2.5 Methods of raising equity finance

There are various sources of equity finance, including:

1. Business angels
Business angels (BAs) are wealthy individuals who invest in high growth
businesses in return for a share in the business. Some BAs invest on their own
or as part of a network. BAs are often experienced entrepreneurs and in addition
to money, they bring their own skills, knowledge and contacts to the company.

Business angels (BAs) are private individuals who invest in start-ups and
young companies with good growth prospects, in exchange for a share of the
company's equity. Most BA investments range between £5,000 and £150,000.

BAs are free to make investment decisions quickly and often specialise in
particular industrial sectors or local companies. Many take an active role in the
businesses they invest in by advising and mentoring the management.

2. Venture capital
Venture capital is also known as private equity finance. Venture
capitalists (VCs) look to invest larger sums of money than Business Angels in
return for equity. Venture capital is most often used for high-growth businesses
destined for sale or flotation on the stock market. Venture capital (VC) funding
is a form of private equity investment, where a business obtains long-term
funding in exchange for a share of its equity.
 VC funding is mainly sought by start-ups or new businesses with high
growth potential. Companies can also use it to expand, fund management buy-
outs or buy-ins, or develop new products.

3. Crowd funding
Crowd funding (also known as crowd financing or crowd sourced
capital ) is where a number of people each invest, lend or contribute small
amounts of money to your business or idea. This money is combined to help
you reach your funding goal. Each individual that backs your idea will usually
receive rewards or financial gain in return.

Crowd funding usually takes place through a website. The platform will
manage any online payments and may often offer services such video hosting,
social networking and enabling contact with contributors.

4. Enterprise Investment Scheme (EIS)

Some limited companies can raise funds under the EIS. The scheme
applies to small companies carrying on a qualifying trade.

There are potential tax advantages for individuals who invest in such
companies, such as:

 the buyer of the shares gets income tax relief at 30 per cent on the cost of
the shares
 Capital Gains Tax (CGT) on the sale of other assets can be deferred if the
gain is reinvested into EIS shares
Certain conditions must be met for a company to be a qualifying company and
for an investor to be eligible for tax relief.

5. Alternative Platform Finance Scheme

If your small business is struggling to access bank finance, there is now a new
government scheme in which the UK's biggest banks will pass on details of any
businesses they have rejected to three alternative finance providers. These are:

 Funding Xchange
 Business Finance Compared
 Funding Options

6. The stock market

Joining a public market or stock market is another route through which
equity finance can be raised. A stock market listing can help companies’
access capital for growth and raise finance for further development.
2.6 Preference Shares:
Shares which enjoy preference as regards dividend payment and capital
repayment are called “Preference Shares”. They get dividend before equity
holders. They get back their capital before equity holders in the event of
winding up of the company. The owners of these shares have a preference for
dividend and a first claim for return of capital; when the company is closed
down. But, their dividend rate is fixed.
Preference share can be of following types:
a) Cumulative Preference Shares:
Such shareholders have a right to claim the dividend. If, dividend is not paid to
them, then, such dividend gets accumulated, and, therefore, they are called as
“Cumulative Preference shares”.
b) Non- Cumulative Preference Shares:
They are exactly opposite to cumulative preference shares. Their right to get
dividend lapses if, they are not paid dividend and it does not get accumulated.
Thus, their right to claim dividend for the past years will lapse and will not be
accumulated.
c) Participating Preference Shares:
Such shareholders have a right to participate in the excess profits of the
company, in addition to their usual dividend. Thus, if, there are excess profits
and huge dividends, are declared in the equity shares, the holders of these all
shares get a second round of dividend along with equity shareholders; after a
dividend at a certain rate has been paid to equity shareholders.
d) Non- Participating Preference Shares:
Such shareholders do not have any right to share excess profits. They get only
fixed dividend.
e) Convertible Preference Shares:
Such shares can be converted into equity shares, at the option of the company.
f) Redeemable Preference Shares:
Such shares are to be redeemed, or, paid back in cash to the holders after a
period of time.
g) Non- Redeemable Preference Shares:
Such shares are not paid in cash during the life of the company.
Merits of Preference Shares
a) Fixed dividend.
b) First claim on company assets.
c) Cost of capital is low.
d) No dilution over control.
e) No dividend obligation.
f) No redemption liability.
Demerits of Preference Shares:
a) Not a very high dividend rate.
b) No voting rights.
c) Dividends paid are not tax- deductible.
d) Non payment of dividend affects firm.

2.6 DEBENTURES:
When borrowed capital is divided into equal parts, then, each part is
called as a debenture. Debenture represents debt. For such debts, company pays
interest at regular intervals. It represents borrowed capital and a debenture
holder is the creditor of the company. Debenture holder provides loan to the
company and he has nothing to do with the management of the company.
Kinds of Debentures:
A company can issue different kinds of debentures.
a) Registered and Bearer Debentures:
This classification of debentures is made on the basis of transferability of
debentures. Registered debentures are those in respect of which the names,
addresses, and particulars of the holdings of debenture holders are entered in a
register kept by the company. The transfer of ownership of such debentures is
possible through a regular instrument of transfer which is duly signed by the
transferee and the transferor. However, the transfers are freely allowed through
the execution of a regular Transfer Deed. Only formal approval of the Board is
necessary. Interest on such debentures is paid through interest warrants. Bearer
debentures are transferable by mere delivery. They are freely negotiable
instruments. The company keeps no records of the debenture- holders in the
case of bearer debentures. Such debentures are similar to Share Warrants; the
interest on them is paid by means of attached coupons which encashed by the
holder are as and when cash falls due. On maturity, the principal sum of Bearer
Debenture is paid back to the holder.
b) Secured and Unsecured Debentures:
This classification is made on the basis of security offered to debenture-
holders. Secured debentures are those which are secured by some safe charge on
the property of the company. The charge or, mortgage may be “Fixed”, or,
“Floating”, and thus, there may be “Fixed Mortgage Debentures”, or, “Floating
Mortgage Debentures” depending upon the nature of charge under the category
of Secured Debentures. Unsecured, or, Naked Debentures are those that, are
secured by any charge on the assets of the company. The holders of such
debentures are like ordinary creditors of the company. The general solvency of
the company is the only security available to unsecured or, naked debentures.
c) Redeemable And Irredeemable Debentures:
This classification is made on the basis of terms of repayment.
Redeemable Debentures are for fixed period and they provide for payment of
the principal sum on specified date, or, on demand, or, notice. Irredeemable
Debentures are not issued for a fixed period. The issuing company does not fix
any date by which the principal would be paid back. The holders of such
debentures cannot demand payment from the company so long as it is a going
concern. Such debentures are perpetual in nature as they are payable after a long
time, or, on winding up of the company.
d) Convertible And Non- Convertible Debentures:
This classification is made on the convertibility of the debentures.
Convertible Debentures are those which are convertible into Equity Shares on
maturity as per the terms of issue. Convertible Debentures are those which are
convertible into equity shares on maturity as per the terms of issue. Convertible
debentures are now popular in our India and many companies issue convertible
debentures which are automatically converted into shares after a fixed period,
or, date (usually, after three years). The rate of exchange of debentures into
shares is also decided at the time of issue of debentures. Interest is paid on such
debentures till conversion. Such debentures are popular with the investing class.
Non- Convertible Debentures are not convertible into Equity Shares after some
period, or, on maturity. Prior approval of the shareholders is necessary for the
issue of convertible debentures. It also requires sanction of the central
government. The conversion of debentures into shares particularly of profitable
companies is always advantageous to debenture holders as well as to the
company.
Demerits of Debentures
a) Interest obligatory.
b) High liability.
c) Charged against assets.
d) Not meant for weak firms.
Merits of Debentures
a) Issuing is cheap.
b) No dilution of control.
c) Best for depression periods.

2.8 Convertible loan notes:

A convertible loan note (also known as a convertible note, or CLN) is a type of

short-term debt that is converted into equity shares at a later date. Making
an investment into a startup via a convertible loan note typically allows the
investor to receive a discounted share price based on the company's future
valuation.

IS IT DEBT OR EQUITY?

Investment into a company via a convertible loan note (CLN) is not for equity
initially. However, it is essentially a loan to the business that has the option or
requirement to convert to equity shares at a price that is yet to be determined.
The valuation is not usually defined when the investment is made. It is usually
also possible for the loan to be repaid in certain circumstances including any
coupons.

WHEN WILL I RECEIVE SHARES IN THE COMPANY?

Conversion into equity occurs on the next qualifying funding round or when a
certain date or duration is met. What is classed as a qualifying funding round
will be set out in the terms of the Convertible Loan Note.

AT WHAT PRICE WILL THE INVESTMENT CONVERT?

The price per share that will be allocated is not always a complete unknown.
There is sometimes/usually a maximum share price stipulated in the term sheet.
Shares may be issued at the lower of the max share price or a discount on the
next qualifying funding round.

WHAT IS THE COUPON?

The coupon is the amount of interest that accrues while the loan note is
unconverted. This is set out in the term sheet and may accrue daily, monthly or
annually. Occasionally, the terms are such that this interest can be paid out in
cash and others may offer the return of the principal also. Other times the
interest is added to the amount of investment paid on the outset and on
conversion the total will be converted into shares.

Please note, not all CLNs have a coupon attached and it is important to check
the term sheet in each case to see which the company is offering.

UNDER WHAT CIRCUMSTANCES IS THE INVESTMENT REPAID?

There is a longstop date by which the investment must be converted into shares.
If the company has not reached the funding target set out in the term sheet to
trigger conversion by the longstop date, the investment plus any interest is
usually repaid in full. There may also be other causes for default set out in the
term sheet or it may be chosen by the investor upon conversion.

WHAT IF I WANT MY INVESTMENT TO BE CONVERTED INTO

EQUITY BEFORE THEY HIT THEIR TARGET FOR A CONVERSION
EVENT?

In some cases, it is possible to notify the company at any point to convert the
investment into shares at the max price set out in the term sheet. This will be
highlighted in the term sheet.
WHAT IF THE COMPANY IS SOLD BEFORE A QUALIFYING FUNDING
ROUND AND MY INVESTMENT HAS NOT BEEN CONVERTED INTO
SHARES YET?

In the event of a sale of the company before a conversion event, usually the
company will issue a conversion notice and a redemption notice for investors to
decide which to opt for. Please note, each CLN will have different terms around
this and it is important to check the term sheet in each case.

IS THE CLN SECURED?

In some cases, the CLN is secured, however, most likely it will not be as it is
usually thought of not as a debt instrument but rather as prepayment for shares.

WHAT CLASS OF SHARES WILL MY INVESTMENT BE CONVERTED

INTO?

Each term sheet will be different. Occasionally, companies request for the share
class to be selected when making the initial investment. Other times, it is to be
selected on conversion

A convertible note is a form of short-term debt that converts into equity,

typically in conjunction with a future financing round; in effect, the investor
would be loaning money to a startup and instead of a return in the form of
principal plus interest, the investor would receive equity in the company.

The primary advantage of issuing convertible notes is that it does not force the
issuer and investors to determine the value of the company when there really
might not be much to base a valuation on – in some cases the company may just
be an idea. That valuation will usually be determined during the Series A
financing, when there are more data points off which to base a valuation.

Convertible Note Terms

When evaluating a convertible note, there are a few key parameters that must be
kept in mind:

Discount Rate
This represents the valuation discount you receive relative to investors in the
subsequent financing round, which compensates you for the additional risk you
bore by investing earlier.

Valuation Cap

The valuation cap is an additional reward for bearing risk earlier on. It
effectively caps the price at which your notes will convert into equity and – in a
way – provides convertible note holders with equity-like upside if the company
takes off out of the gate.

Interest rate

Since you are lending money to a company, convertible notes will more often
than not accrue interest as well. However, as opposed to being paid back in
cash, this interest accrues to the principal invested, increasing the number of
shares issued upon conversion.

Maturity date

This denotes the date on which the note is due, at which time the company
needs to repay it.

Convertible Note Examples

Let’s walk through a few examples of what this conversion into equity actually
looks like. We’ll start by singling out the two most important variables
associated with a convertible note – the valuation cap and discount rate – and
then will see how these two interact. For simplicity’s sake, we will ignore
accrued interest in our calculations.

1. In our first example, we’ll imagine that a company raised its seed round
by issuing a convertible note with a $4M valuation cap and no
discount before raising its Series A round at a $12M pre-money valuation
and a $10 price per share. In order to calculate the valuation cap adjusted
price per share for convertible note holders, you would divide the
valuation cap on the note by the pre-money valuation of the subsequent
round and apply that to the Series A price per share. In this example that
works out to $3.33 per Series A share for convertible note holders.
Dividing a hypothetical $10,000 investment by that $3.33 per share price
would grant the seed investor approximately 3,000 shares. Note that an
 investor investing that same $10,000 directly in the Series A round at $10
per share would only be issued 1,000 shares.

2. Now let’s suppose a company raised its seed round by issuing

a convertible note that had no valuation cap but did have a 20% discount
to the Series A round. In this exercise, the pre-money valuation at which
the Series A round was raised is not important, only the price per share.
Again, let’s assume that it is $10. Applying the 20% discount to that price
per share would yield a discounted price per share for the convertible note
holder of $8. If an investor were to have invested $10,000 in the
convertible note, they would therefore receive 1,250 Series A shares.
Again, note that that same $10,000 invested by a Series A investor would
only purchase 1,000 Series A shares.

More often than not though, convertible notes have both a valuation cap and
discount and will convert using whichever method gives the investor a lower
price per share:

1. Combining our previous examples, let’s say an issuer raises its seed
round by issuing a convertible note with a $4M valuation cap and a
20% discount. In our first scenario – where the company is raising at a
$12M pre-money valuation and a $10 price per share – the 20% discount
would convert seed investors at $8 per share. The valuation cap, however,
would result in a $3.33 per share price and would be the price at which a
note holder’s investment would convert into Series A shares.

2. In our second scenario, the company is raising its subsequent round at

only a $4.5M pre-money valuation and the same $10 per share price. The
20% discount would again result in an $8 per share price for note holders.
Because dividing the $4M valuation cap by the $4.5M pre-money
valuation and applying that to the $10 share price results in a higher $8.89
per share price for seed round investors, in this case it would be
the discount that drives the conversion.

2.9 Warrants:

In finance, a warrant is a security that entitles the holder to buy the underlying
stock of the issuing company at a fixed price called exercise price until the
expiration date. Warrants and options are similar in that the two contractual
financial instruments allow the holder special rights to buy securities.
 Warrants are a contract that gives the right, but not the duty, to buy or sell a
security—most usually, equity—before expiry at a certain amount. The price at
which the underlying security may be bought or sold is called the exercise price
or the strike price.

What are warrants examples?

Taxes on Stock Warrants

For example, say you exercise warrants with a strike price of $20 per share
to buy 100 shares of XYZ and you originally paid $400 for the warrants. Your
total investment is thus $2,400. If the market price on the day of exercise is $40,
the shares are worth $4,000 and the difference is $1,600

Why do companies issue warrants?

Companies typically issue warrants to raise capital and encourage investors
to buy stock in their firms. They receive funds when they sell the warrants and
again when stocks are purchased using the warrant.

Are warrants debt or equity?

Warrants are a derivative that give the right, but not the obligation, to buy or
sell a security—most commonly an equity—at a certain price before expiration.

Advantages of investing in warrants

 High returns in Long-term.
 Low-cost alternative to standard options.
 Improved capital management.
 Also Read: Top 15 Cryptocurrencies to Invest other than Bitcoin (2020)
 Substantial risk.
 Opportunity cost.
 Infrequent Utilization.
 Recommended: 10 Best Long Term Investment Options in India.

What is Warrant Redemption?

Warrants to purchase Common Stock that were issued under the Warrant
Agreement in a private placement simultaneously with the IPO and that are still
held by the initial holders thereof or their permitted transferees are not subject
to this redemption.

Stock Warrants vs. Stock Options: An Overview

A stock warrant gives the holder the right to purchase a company's stock at a
specific price and at a specific date. A stock warrant is issued directly by the
company concerned; when an investor exercises a stock warrant, the shares that
fulfill the obligation are not received from another investor but directly from
the company.

An equity stock option, on the other hand, is a contract between two people that
gives the holder the right, but not the obligation, to buy or sell a stock at a
specific price, prior to a specific date, referred to as the contract expiration
date.

KEY TAKEAWAYS

 A stock warrant represents the right to purchase a company's stock at a

specific price and at a specific date.
 A stock warrant represents future capital for a company.
 A stock warrant is issued directly by a company to an investor.
 Stock options are purchased when it is believed the price of a stock will
go up or down.
 Stock options are typically traded between investors.

Stock Options
Options are purchased by investors when they expect the price of a stock to go
up or down (depending on the option type). For example, if a stock currently
trades at $40 and an investor believes the price will rise to $50 next month, he
or she could purchase a $40 call option today, which would give them the right
to purchase the stock at that price prior to contract expiration. Then, the
investor could turn around and sell it for $50, making a profit of $10, less the
cost of the option, referred to as the "premium."

Stock Warrants
When an investor exercises a warrant, they purchase stock, and the proceeds
are a source of capital for the company. A warrant certificate is issued to the
investor when they exercise a warrant. The certificate includes the terms of the
warrant, such as the expiry date and the final day it can be exercised.
However, the warrant does not represent immediate ownership of the stocks,
only the right to purchase the company shares at a particular price in the future.
Warrants are not extensively used in the United States, but they are more
common in China.

There are two types of warrants: a call warrant and a put warrant. A call
warrant is the right to buy shares at a certain price in the future, and a put
warrant is the right to sell back shares at a specific price in the future.

Key Differences
A stock warrant differs from an option in two key ways: a company issues its
own warrants, and the company issues new shares for the transaction.
Additionally, a company may issue a stock warrant if they want to raise
additional capital from a stock offering. If a company sells shares at $100 but a
warrant is just $10, more investors will exercise the right of a warrant. These
warrants are a source of future capital.

Stock options are listed on exchanges. When stock options are exchanged, the
company itself does not make any money from those transactions. Stock
warrants can last for up to 15 years, whereas stock options typically exist for a
month to two to three years.

Therefore, for long-term investments, stock warrants may be a better

investment than stock options because of their longer terms. However, stock
options may be a better short-term investment

2.10 Term loans:

A term loan is a monetary loan that is repaid in regular payments over a set
period of time. Term loans usually last between one and ten years, but may last
as long as 30 years in some cases. A term loan usually involves an
unfixed interest rate that will add additional balance to be repaid.
Term loans can be given on an individual basis, but are often used
for small business loans. The ability to repay over a long period of time is
attractive for new or expanding enterprises, as the assumption is that they will
increase their profit over time. Term loans are a good way of quickly
increasing capital in order to raise a business’ supply capabilities or range. For
instance, some new companies may use a term loan to buy company vehicles or
rent more space for their operations.
 What is term loan example?
Car loans, home loans and certain personal loans are examples of long-term
loans. Long term loans can be availed to meet any business need like buying of
machinery or any personal need like owning a house.

Long Term Loans

A form of loan that is paid off over an extended period of time greater
than 3 years is termed as a long-term loan. This time period can be anywhere
between 3-30 years. Car loans, home loans and certain personal loans are
examples of long-term loans. Long term loans can be availed to meet any
business need like buying of machinery or any personal need like owning a
house.

Long-term loans are the most popular form of credit in the financial industry.
With the advent of technology and easy banking, home loans and auto loans
have become a prevalent form of loan. These loans generally offer a hefty loan
amount and are thus spread over a considerable period of repayment tenure.
Features of long-term loans can vary considerably depending upon the cause for
which these loans are being taken. Long-term loans almost always offer pre-
payment option to customers so that people who want to pay-off their loan
earlier than the stipulated timeframe do not have to pay continuously for long
tenures.
Long-term loans are sanctioned based on the regular income of an applicant and
generally require a continuous source of income as well as collateral to be
submitted with the lending bank.
Features of long-term loan
Features of long-term loans are generally similar across loan products however,
they differ based on the category of loan. Hence, home loans differ slightly in
features with respect to vehicle loans.

 Higher loan amounts

Long-term loans generally come with higher loan amounts. Hence, home
loans, auto loans etc. offer hefty loan amounts as compared to short-term
loans like personal loans. Since, these loans are mostly secured via collateral
submission hence banks are not apprehensive in lending heavy loan amounts
to long-term loan applicants.
 Lower rate of interest
Since the time period of loan repayment is higher for long-term loans, banks
and other lending entities levy lower rate of interest on these loans. Hence car
loans and home loans come at lower rates than personal finance.
 Collateral Submission
Since the loan amount involved in long-term loans is way higher than other
types of loans, collaterals are almost always required to be submitted to the
bank. This helps banks in recovering lost cash in case a borrower defaults to
repay the loan.
 Repayment in installments
Repayment of long-term loans generally happens in equated installments
spread over a substantial period of time. These monthly installments are
generally made up of two components, principal and interest.
 Tax Benefits on long-term loans
Tax benefits are applicable on long-term loan repayment. However, this
depends upon the type of loan. For example, an auto loan is a luxury loan and
hence it does not offer any tax rebate whereas home loan is a loan for the
basic need of housing and as such offers tax exemption on the repayment of
loan. These tax benefits are subject to laws under the Income Tax Act.
Examples of long-term loans
Long-term loans are loans whose repayment is spread over a long period of
time. This definition applies to several types of loans. Long-term loans is just a
broad category of loans and is a wide umbrella which has numerous sub-
categories of loans under it. Listed below are some of the most prominent
examples of long-term loans.
 Education Loans
Education loans or student loans are generally granted for a long period of
time especially for courses like engineering and medical. These loans offer a
longer repayment tenure to applicants. These loans are taken for a period of
more than 3 years and this can go up to a period of 30 years. Education loans
can be taken by applicants who wish to go for higher studies in India as well
as abroad. The loan amount limit and the rate of interest might differ
according to the lending entity as well as according to the course for which
loan is being sought.
 Home loans
Home loans are one of the most suitable examples of long-term loans. The
tenure for home loans goes much beyond 3 years and the loan amount is
considerable. Collaterals require to be submitted to the bank and a guarantor
also is required to sign the loan application. These loans offer pre-closure
 option to customers and depending upon the lending bank, this option may be
charged or not charged. Home loans also give buyers the option of choosing
between fixed and floating rate of interest.
 Car Loans
Car loans have slowly become the most necessary loan instrument in recent
times. Since the time banks eased the process of obtaining credit for purchase
of vehicles, taking car or auto loans have been on the rise. Cars are
considered as luxurious items and as such rates offered on these loans are
higher than those for home loans. However, stiff competition among lending
entities have forced banks to lower the rate of interest for car loans. A typical
car loan may have a long-term payment tenure of up to 7 years. Pre-payment
of loan is available for car loans and is subject to a pre-closure fee in case of
certain banks. On the other hand, some banks do not levy any penalty fee on
pre-payment of car loan amount.
 Personal Loans
Personal loans that offer a repayment tenure of more than 3 years come under
the category of long-term loans. However, even when these loans are longer
in tenure, the rate of interest offered is not low because personal loans are
mostly unsecured loans and as such borrower does not need to submit any
collateral as security. Banks do not have any collateral to fall back on in case
a borrower defaults to pay back his/her personal loan.
 Small Business Loans
Long-term loans can be availed by both individual customers as well as
companies. For expansion of business or buying of heavy machinery,
business houses may also require credit in the form of loans. These loans are
known as small business loans. These loans can have a tenure greater than 3
years and can have loan repayment installments that last for a substantial
number of years. All major public and private sector banks offer small
business loans as part of their loan portfolio.
 Long-term payday loans
Long-term payday loans are small loan amounts that are offered for a long
repayment tenure. These loans require similar eligibility criteria and
documents that are needed for other types of long-term loan. These loans are
best suited for urgent financial needs of customers who wish to pay in small
installments over a substantial repayment period.
Eligibility Criteria for long-term loans
Long term loans offer huge loan amounts and as such have stringent eligibility
guidelines. However, these criteria differ with different lending banks. Listed
below are some of the most common criteria that apply to almost all long-term
loans.
 Applicant should be aged between 18-35 years of age
 Applicant should be earning a regular income
 Applicants should be a resident of India
 A guarantor is required to sign the loan application
Documents required for long-term loans
Certain documents needs to be submitted to the lending bank for approval of
any long term loan. The list of these documents differs according to the lending
bank. Most banks require a copy of the following listed papers.
 Proof of permanent address
 Proof of identity, passport, voter ID, driving license etc.
 Income proof of co-applicant/guarantor
 Optional guarantor form, duly filled
 Bank account statements if required by the bank
 Salary slips of the applicant

2.11 Asset-backed finance (securitization):

What Is Asset-Based Finance? Asset-based finance is a specialized method of

providing companies with working capital and term loans that use accounts
receivable, inventory, machinery, equipment, or real estate as collateral. It is
essentially any loan to a company that is secured by one of the company's
assets.

What Is Asset-Based Finance?

Asset-based finance is a specialized method of providing companies
with working capital and term loans that use accounts receivable, inventory,
machinery, equipment, or real estate as collateral. It is essentially any loan to a
company that is secured by one of the company's assets.

Asset-based funding is often used to pay for expenses when there are
temporary gaps in a company's cash flows or the usual time lag in the cash
collection cycle between buying raw materials until receiving cash for goods or
services from customers, but it can also be used for startup company financing,
refinancing existing loans, financing growth, mergers and acquisitions, and for
management buy-outs (MBOs) and buy-ins (MBIs).

Asset-based finance may also be called asset-based lending or commercial

finance.
KEY TAKEAWAYS

 Asset-based financing is a way for companies to use property, inventory,

or accounts receivable as collateral to obtain a loan.
 Asset-based finance is a field solely used by businesses, not by
individuals seeking personal loans.
 These types of loans may be more flexible than traditional commercial
loans; however, the downside of this type of arrangement includes high
financing costs.
 Other names for the asset-based finance industry are commercial finance
and asset-based lending.
 Asset-based loan financing may be used by companies that need short-
term working capital to keep day-to-day operations, like payroll, for
example, up and running.
Understanding Asset-Based Finance
An example of asset-based finance would be purchase order financing; this
may be attractive to a company that has stretched its credit
limits with vendors and has reached its lending capacity at the bank. The
inability to finance raw materials to fill all orders would leave a company
operating under capacity and could put the company at risk for closure.

Under a purchase order financing arrangement, the asset-based lender finances

the purchase of the raw material from the company's supplier. The lender
typically pays the supplier directly. After the orders are filled, the company
would invoice its customer for the balance due. The accounts receivable set up
at this time would typically be paid directly from the customer to the asset-
based lender.

After the lender receives payment, he then deducts the financing cost and fees
and remits the balance to the company. The disadvantage of this type of
financing, however, is the interest typically charged, which can be as high as
prime plus 10%. However, these loans do have lower interest rates than
unsecured loans because of the loan's collateral that allows the lender to recoup
any losses if the borrower defaults.

Asset-Based Lending
Asset-based loans are agreements that secure the loan via collateral, like
equipment or property owned by the borrower. Asset-based lending may be
a line of credit or a cash-funded loan, but either way, the loan money is secured
by some sort of collateral from the borrower's business or properties, such as
inventory or accounts receivable.
The most frequent users of asset-based borrowing are small and mid-sized
companies that are stable and that have physical assets of value. However,
larger corporations do use asset-based loans from time to time, usually to cover
short-term cash needs.

Asset-based finance lenders tend to favor liquid collateral that can be easily
turned into cash if a default on the loan occurs. Physical assets, like machinery,
property, or even inventory, may be less desirable for lenders. When it comes
to providing an asset-based loan, lenders prefer companies with not only strong
assets but also well-balanced accounts.

Securitization is the procedure where an issuer designs a marketable

financial instrument by merging or pooling various financial assets into one
group. ... In theory, any financial asset can be securitized—that is, turned into a
tradeable, fungible item of monetary value. In essence, this is what all securities
are.

Securitization is the financial practice of pooling various types of contractual

debt such as residential mortgages, commercial mortgages, auto loans or credit
card debt obligations (or other non-debt assets which generate receivables) and
selling their related cash flows to third party investors as securities, which may
be described as bonds, pass-through securities, or collateralized debt
obligations (CDOs). Investors are repaid from the principal and interest cash
flows collected from the underlying debt and redistributed through the capital
structure of the new financing. Securities backed by mortgage receivables are
called mortgage-backed securities (MBS), while those backed by other types of
receivables are asset-backed securities (ABS).
The granularity of pools of securitized assets can mitigate the credit risk of
individual borrowers. Unlike general corporate debt, the credit quality of
securitized debt is non-stationary due to changes in volatility that are time- and
structure-dependent. If the transaction is properly structured and the pool
performs as expected, the credit risk of all tranches of structured debt improves;
if improperly structured, the affected tranches may experience dramatic credit
deterioration and loss
Securitization has evolved from its beginnings in the late 18th century to an
estimated outstanding of $10.24 trillion in the United States and $2.25 trillion in
Europe as of the 2nd quarter of 2008. In 2007, ABS issuance amounted to
$3.455 trillion in the US and $652 billion in Europe.WBS (Whole Business
Securitization) arrangements first appeared in the United Kingdom in the 1990s,
and became common in various Commonwealth legal systems where senior
creditors of an insolvent business effectively gain the right to control the
company.

2.12 Leasing:

A lease is a contract under which one party, the lessor (owner of the
asset), gives another party (the lessee) the exclusive right to use the asset,
usually for a specified time in return for the payment of rent.

Leasing is the process by which a firm can obtain the use of certain fixed
assets for which it must make a series of contractual, periodic, tax-deductible
payments. A lease is a contract that enables a lessee to secure the use of the
tangible property for a specified period by making payments to the owner.