How does a Debenture work?

A debenture is a legal document that provides loan security to the lender. The document lays down the terms and conditions of a loan and provides clarity and protection to lenders if the borrowing company becomes insolvent.

Hence, attaching a floating charge to the debenture offers further benefits. It will enable the holder to rank above unsecured creditors when it comes to repayment.

Meanwhile, the floating charges will provide specific advantages for the board of directors, who receive a degree of protection when lending money from personal funds. It is common for directors of companies to invest money in their firm.

The loan terms in the debenture will give benefit to the firm from a flexible form of security if their company enters insolvency and is unable to bounce back to profitability.

Types of debenture charge

There are two types of debenture charge. Lenders will tend to seek one or both of the following.

Fixed Charge

A lender ensures it is the first creditor to recover outstanding credit if a borrower has a credit default. In essence, the cost will grant the lender the possession and ownership of a borrower’s asset if non-payment happens. A common form of fixed charge that can go against the property.

Other than covering the freehold or leasehold of a property, the fixed charge can also include building, trade fixtures, manufacturing plant and machinery, and motor vehicles. Furthermore, the borrower would not be able to sell the asset without the lender’s permission. The profit would go to the lender or purchasing a new asset. The lender will then place the new asset to a fixed charge.

Floating charge

A floating charge can be committed to all the company’s assets, or specific assets, such as stocks, raw materials, debtors, vehicles, fixtures and fittings, cash, and even intellectual property.

When the lender enforces the debenture in a credit default situation, the floating charge ‘crystallizes’ and effectively becomes a fixed charge. If this happens, the borrower will no longer

be able to negotiate with the assets in question, not unless the lender will open for a discussion.

The floating charge and how it works?

The floating charge is like a fixed charge. However, instead of using fixed assets, it uses a group of assets. The business can sell assets with a floating charge.

A fixed charge is mostly clocking the borrower from selling the assets without repaying the lender or following their agreement. While a floating charge is not held against specific assets, instead, help against over group of assets or the total assets of the company.

There are various assets where to consider a floating charge. The following assets may include:

  • Raw materials
  • Stock
  • Part-built products
  • Cash

Why “crystalizing” happen?

“Crystalizing happens to a floating charge by the time the business is going insolvent.

To illustrate, when the business at the start of the agreement is not yet experiencing insolvency, the floating charge is applied to groups of assets. However, if the company is in bad condition and liquidation happens, the floating charge will apply to specific assets. That is why it is called a crystalized.

The fluid nature of a floating charge has no restrictions on the use of these assets when the company is solvent. However, when the business enters insolvency, it is when the lender able to take action to recover their money.

The floating charge holders can appoint their own choice of the administrator. Alternatively, in some cases, an administrative receiver once the charge crystallizes. However, when a fixed charge and a floating charge are existing over the same asset, then the fixed charge takes priority in repayment.

Are Multiple Debentures possible?

The answer is yes, it is possible for a lender or lenders to have multiple debentures on the same creditor. These can be multiple fixed debentures against different specific assets, multiple floating debentures, or a mix of both. When the first lending firm places a debenture on the company, they would require consent if a second lender will add another debenture.

If a borrower has multiple lenders with debentures that will go against the latter’s assets, an agreement between lenders to set the priority of payments to receive, usually, lenders will come to sign a documented agreement and the borrower such as Deed of Priority.

Debenture as loan security – in conclusion

A debenture is a necessary evil of raising money to run the business. Some lenders will not lend money that is above a certain amount without a debenture. Therefore, regardless of how much you’re looking to borrow, you should be prepared to offer up your assets as security.

If you are not a risk-taker and putting your company’s assets on the line, an unsecured loan may be a better option.