Company financing is one of the major concerns for operating any business. Debt financing and Equity Financing have been the two types of financing options that are most commonly sought after by companies in Hong Kong and around the world.
Equity Financing
Equity financing means someone is putting money into the business in return for ownership in the company. Apart from the ownership rights, equity investors also get parts of the future profit of the business.
How?
An advertisement and invitation to acquire shares of a company to the public are prohibited unless:
- It complies with the prospectus requirements under the Companies (Winding Up and Miscellaneous Provisions) Ordinance; and
- It has been authorised by the Securities and Futures Commission of Hong Kong (SFC) under the Securities and Futures Ordinance (SFO).
Instead of an offer to the public, a small and medium enterprise can raise funds by way of Private Placement which is subject to less regulations than an offer to the public. A Private Placement means an offer which:
- made to no more than 50 persons
- the total consideration does not exceed HK$5,000,000
- the minimum principal amount to be subscribed for is not less than HK$500,000
A Private Placement must contain an appropriate warning in the form stipulated by the Company Ordinance. Besides, there should be no advertisement and press release regarding the offer and each offer document should be individually addressed to specific offeree and state clearly that it is not an offer to the public.
Advantages
- No obligation to pay dividends on equity
- Experienced investors can provide the company with valuable insights
- No negative repercussions even if the company loses all the investor’s money
- Reducing reliance on debt and improving financial health of the business
Disadvantages
- Giving up a portion of ownership and control of the company
- Attracting investors can be harder than getting a loan since equity investors risk more
Debt Financing
Debt financing means when a company borrows money and promises to repay the principal plus interest at a later date. Bank loan is the most common form of debt financing in Hong Kong.
How?
In Hong Kong, a loan can be given by an authorized money lender or a bank. A company if wishes to borrow money must enter into a Loan Agreement with the lender. A Loan Agreement operates as a contract between the borrower and the lender and will stipulate:
- Whether this is a secured or unsecured loan
- Principal amount
- Interest rate
- Any conditions to be fulfilled before the loan becomes available to the company
- Dates for repayment
- Obligation of borrowers and lenders
- Governing law of the contract
For more information, check out our Commercial Loan Agreement template, please be reminded that in case of a secured loan, additional security documents are required.
Borrowing money from a financial institution which is not a bank is governed by the Money Lending Ordinance, whereas a bank loan is governed by the Code of Banking Practice. Both regulations set out how money lenders should conduct their business.
Advantages
- No dilution of ownership of the company
- Future profits will not be shared with lenders
- Debt obligation (mainly interest payment and repayment of principal) are more predictable
- Interest is tax deductible as expenses
- There are flexible alternatives for collateral and repayment options
- The company can build up credit score by making instalment payments over time.
Disadvantages
- Debt must be repaid even when the business goes under
- Some debt instruments restrict business from pursuing further or alternative financing options
- Higher debt-equity ratios increase the financial risk of the company
- Owners’ personal guarantee and securities for the debt are usually required by the bank
Comparison between Equity and Debt financing
| Debt Financing | Equity Financing | |
| Meaning | Borrowing money directly | Obtaining funds through the sale of shares. |
| Ownership in the business | No giving up of ownership rights | Giving up of ownership rights |
| Nature of the financing | Recorded as “Liability” | Recorded as “Asset of the company” |
| Duration | Comparatively short | Long |
| Status of the financier | Lender | Owner (i.e. shareholder) |
| Risk | Low-risk | High-risk |
| Different types of financing | Term Loan, debentures, bonds, etc. | Shares and stocks |
| Investment payoff | Interest and principal amount | Dividends |
| Nature of return | Fixed and regular interest | Variable, irregular dividends |
| Security | Security usually is required | No security is required |
Key takeaways:
- Debt finance means borrowing of debts, whereas equity finance is about raising funds by selling ownership in the company.
- A SME is recommended to raise funds by private placement or entering into a loan agreement with an authorized money lender or a bank. Parties should be reminded to observe the relevant governing rules.
- Debt and equity financing have their own strengths and weaknesses.
- Debt and equity financing differ in a number of aspects including ownership in the business, nature of the financing, duration, status of the financier, risk, different types of financing, investment payoff, nature of return and security.
Bibliography:
- Money Lending Ordinance
https://www.elegislation.gov.hk/hk/cap163
- Code of Banking Practice
https://www.hkma.gov.hk/media/eng/doc/code_eng.pdf
- Securities and Futures Ordinance (SFO)
https://www.elegislation.gov.hk/hk/cap571
- Companies (Winding Up and Miscellaneous Provisions) Ordinance