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Wary of The Bake Sale? The Best Ways to Raise Capital in 2020

Jul 2020

The slowing global economy and uncertain market conditions arising from the COVID pandemic have put a strain on many businesses and the need for access to funds is as great as ever. The obvious response for many is to undertake a capital raising. However, this is not always as easy as it sounds, especially for smaller or mid-size entities (SMEs), which can struggle to get their piece of the pie.

This article sets out some key methods you can use to raise funds, without having to put your apron on. Some important considerations with respect to each method are also outlined, with the focus being on legal considerations for unlisted SMEs, rather than financial or accounting considerations.

Debt Financing

In addition to traditional bank borrowing, businesses may wish to approach private investors, private credit funds, or institutional investors to raise funds. To assist with reducing the interest expense burden, businesses can look at issuing share options, alongside debt, or consider payment in-kind (PIK) arrangements, where interest is paid via assets rather than cash.

Aside from exploring new sources of debt, businesses can also seek to obtain trade finance, drawn on existing undrawn facilities or negotiate with existing lenders to extend or increase credit.

When seeking debt capital, businesses should consider the following:

  • Do the terms and conditions of existing lending arrangements impose additional requirements or prevent your businesses from taking on further debt? For example:
    - Is permission from existing lenders required?
    - Will your business still be in compliance with representations, warranties, and undertakings in existing debt agreements?
  • Will taking on new debt cause your business to breach financial covenants imposed by existing borrowing agreements?
  • How will the debt impact your business’s solvency, especially in relation to director duties (notably the duty against trading while insolvent)?
  • If security is required:
    - Is your businesses in a position to provide the required security?
    - How will this impact existing security obligations? For example, granting another security interest over assets that are already secured may breach pre-existing security arrangements.
    - What are the consequences in an event of default when a security interest is exercised?
  • How will the debt impact on your credit rating, and future ability to access funds through loan agreements?
  • What are the potential tax implications or benefits in contrast with other forms of funding (noting that interest charges are usually tax deductible)?

It is important to note that there are some differences between debt and equity capital raising (see below for more information). Typically, shareholder approval is not required for a company to enter into debt arrangements (unlike with raising new equity). However, unlike equity, the obligation to pay a rate of return (interest) on capital is not contingent on whether the business makes a profit. That means the obligations of borrowing are in some ways more onerous as they are largely inflexible in response to changes in profitability.

Equity Financing

Alternatively, companies can raise equity by selling shares at a determined price. Notable recent examples include Qantas, who over the course of the next three years will roll out their COVID recovery plan with assistance from the substantial capital it will raise via a share issue.

Unlike debt funding, equity financing has no fixed rate or return (such as interest). Instead, there is an expectation from funders (shareholders) to generate profits and pay dividends or an expectation that the company will increase in value over time. A strong advantage of a share issue is that the principal funding amount (share capital) does not have to be repaid directly to investors (unlike a loan principal).

Despite those perks, share issues are not without shortcomings, including that:

  • by issuing more shares to new investors, existing shareholdings can become diluted;
  • share issues can trigger change of control provisions in various commercial contracts (including loan agreements). In some instances, a change of control may result in default or give the counterparty a right to terminate the contract;
  • share issues can give rise to governance implications (especially for SMEs) if a new shareholder’s investment is subject to acquiring a seat on the company’s board; and
  • some Shareholder Agreements restrict share issues (partially to avoid dilution or change in control) and may guarantee some pre-emptive rights for existing shareholders, before new shares are issued to new investors.

Convertible Notes

Another common mode of capital raising is the use of convertible notes. Convertible notes are a form of short-term debt that later convert into equity. It is a ‘hybrid’ form of capital raising as it contains features of both debt and equity funding instruments. Convertible notes involve an investor providing a ‘loan’ (the ‘Face Value’) with the investor (the ‘noteholder’) paying interest, but instead of receiving the Face Value, the noteholder receives shares, typically either when a specified event occurs (e.g when a substantial new investor is secured, or upon an Initial Public Offering being made) or at a specified ‘maturity’ date.

Yet as a hybrid, many of the concerns mentioned above for both debt and equity financing apply to convertible notes: including change of control and dilution of shareholding implications, and debt liability and credit rating concerns from debt financing. In addition to considering these disadvantages, it is important to think about whether a company’s Shareholders’ Agreement facilitates or permits shares to be issued to a note holder upon conversion without stepping through typical share issue constraints (such as pre-emptive rights for existing shareholders).

Convertible notes are popular with early stage businesses because the value of the company (for the purposes of equity funding) can be determined later when the note converts to shares. Often, this allows convertible notes to be quick and easy to execute and can easily be issued in multiple rounds of fundraising. Consequently, this type of capital raising is popular among small start-ups and similar ventures, such as Melbourne-based fintech platform Nimo Industries, which recently announced its intention to issue convertible notes.

Preference shares

Preference shares are another type of hybrid instrument. The advantages for investors are that:

  • if the company becomes insolvent, holders of preferred shares get paid out before other shareholders; and
  • preference shares usually have a guaranteed rate of return (in the form of dividends), providing certainty on the investment.

Redeemable preference shares and convertible preference shares are both common variations of preference shares.
Redeemable preference shares specify a date at which the shares can be redeemed for cash, whether at the shareholder’s option, the company’s option, at a particular ‘ maturity’ date, or when a specified event occurs.

Convertible preference shares are preference shares that convert to ordinary shares, again, at the shareholder’s option, the company’s option, at a particular ‘maturity’ date, or when a specified event occurs. Convertible preference shares may also allow the holder to redeem the shares for cash.

When issuing preference shares of any kind, the rights attaching to the preference shares must be approved by a special resolution of shareholders or as set out in the company constitution. This essentially means that ordinary shareholders must agree to the rights attaching to the preferences shares. Advantageously, preference shares do not grant voting rights to the holder, meaning ordinary shareholders are not diluted and control of the company can be better maintained.

Unfortunately, as a hybrid, many of the concerns mentioned for both debt and equity raising are relevant.

What suits you?

Ultimately, the type of capital raising best suited to your needs is highly unique to your business, its current financial standing, and the reasons for raising the capital. Notable considerations include the amount of capital required, how quickly it is required, and the impact to existing shareholders. Tax and accounting considerations will also be relevant. Further, businesses should seek advice if the funds are sourced from overseas based investors to determine whether Foreign Investor Review Board (FIRB) approvals are necessary.

Some companies, like Virgin Australia, have used a mixed approach, issuing convertible notes and issuing shares. That mixed approach only emphasises the importance of considering how forms of capital raising interact with each other, or with existing arrangements whether this be borrowing agreements, other commercial contracts or a Shareholders’ Agreement. Regardless of your decision, it is vital to consider the advantages and disadvantages of each approach as they relate to your business and the purpose for which the funds are being raised.

Contact the team at Hazelbrook Legal to discuss the most suitable fund raising options for your business.

Material in this article is available for information purposes only and is a high level summary of the subject matter. It is not, and is not intended to be, legal advice. Hazelbrook does not guarantee the accuracy of the information provided. You should first obtain professional legal advice prior to taking any action on the basis of any information contained in this article. This article is copyright. For permission to reproduce this article please email Hazelbrook Legal:

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