The South African corporate finance landscape provides financiers with various options when it comes to securing their loans, and financiers are often faced with difficult decisions regarding which vehicle or structure is best suited to provide finance facilities to borrowers.

Debentures and preference shares are some of the many options available to financiers for purposes of securing their loans. This article explores some of the benefits and risks posed to financiers associated with debentures and preference shares as vehicles through which to provide financing.

Debentures versus preference shares:

The term ‘debenture’ is not defined in terms of the Companies Act No. 71 of 2008 (“Companies Act”) and a debenture can take on various forms. In terms of South African common law, a debenture can be defined as a document issued by a company acknowledging that it is indebted to the debenture holder in the amount stated therein. Debentures may have characteristics similar to shares in the event of the company issuing a debenture in the form of a debt instrument as contemplated in section 43 of the Companies Act. In terms of section 43 of the Companies Act, unless the memorandum of incorporation of the company provides otherwise, the debenture holder may have voting rights pertaining to the affairs of the company, may appoint directors of the company and may have the option to convert the debenture to shares within the company.

The term ‘preference share’ is also not defined in terms of the Companies Act. In terms of South African common law, a preference share can be defined as a share which provides the shareholder with preferential rights in respect of dividends declared by the board of the company, accompanied by limited voting rights – save in the event of breach by the company of the preference share terms, whereafter the financier is typically afforded more extensive voting rights.

Debentures may be more appealing for financiers than preference shares as debenture holders usually have a fixed date on which they are entitled to repayment of capital in terms of the agreement in place between the parties, whereas preference shareholders have no specified date of repayment of capital and are only entitled to payment of dividends upon the company making a profit (or having sufficient assets for a distribution) and the directors have unconditionally declared a dividend to be paid or distribution be made. Debenture holders will rank above preference shareholders in receiving payments upon liquidation of the company.

On the other hand, preference share terms are flexible and financiers can agree with the company to modify these terms so that the option of preference shares suit the requirements of financiers (any rights conferred upon preference shares will however be dependent on the memorandum of incorporation of the company).To provide an example, preference shares can be participating, meaning that the preference shareholders are entitled to share in the profits of the company similar to ordinary shareholders, in addition to the fixed preferential dividends that they are entitled to. Additionally, preference shares may provide a tax benefit to financiers, meaning that in specific circumstances, the dividends paid by the company to the financier may be exempt from both income and dividend tax.

Concluding remarks:

Debentures and preferences shares provide benefits and risks unique to their respective intrinsic natures to financiers. Both instruments can however be modified to suit the unique needs of the financier concerned. The determination as to whether a debenture or preference share is the best suited vehicle through which financiers can provide finance to a company will depend on the specific needs of the financier concerned.

VDMA’s team of experts are available to assist you and your business with any legal requirements pertaining to your corporate financing needs, including advice regarding debentures and preference shares, as well as the drafting of the associated agreements, memorandum of incorporation and/or debenture or preference share terms.

Published 30 June 2022