Debt Financing

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From the course by University of Illinois at Urbana-Champaign

Corporate & Commercial Law II: Business Forms, Financing & Governmental Regulation

12 ratings

University of Illinois at Urbana-Champaign

Corporate & Commercial Law II: Business Forms, Financing & Governmental Regulation

12 ratings

This course is the second course in a two-part series on corporate and commercial law. In this part, we focus on three main topics: business organizations, business financing, and governmental regulation. In the first module, we discuss the characteristics of a number of the most common forms of business entities, such as corporations and LLCs. Module two is devoted to debtor-creditor relationships, including bank financing, debt financing, secured transactions, and bankruptcy. We wrap up the course with two modules that focus on the most important aspects of governmental regulation, including the process by which administrative agencies make rules, and the regulation of anti-competitive behavior and securities transactions.

From the lesson

Module 2: Debtor-Creditor Relationships

In this module, we will learn about the laws that govern the relationship between a lender and a borrower. We will discuss the basics of bank financing and debt financing, with special attention paid to loans that are secured by collateral consisting of personal property. We wrap up the module with several lessons explaining the bankruptcy process, and how debtors and creditors navigate the three most common forms of bankruptcy.

Debt Financing4:18

Meet the Instructors

Professor Michael R Fricke
Teaching Assistant Professor
Department of Business Administration

In this lesson, we'll discuss debt financing,

which is a mechanism that allows businesses to sell

debt on an open market in order to finance their growth.

We already mentioned that there are multiple avenues

available to a business that's trying to raise money to expand.

The last couple of lessons,

we talked about getting a bank loan.

That's what most businesses do

especially when they're small and they need to raise some capital.

But as the business gets bigger especially,

more avenues become available for raising money.

On another module, we'll talk about issuing equity securities,

but one option available to companies that's a little bit above

the level of a traditional bank loan is what we call debt financing.

Now, a bank loan is a form of debt.

But when we say the word, debt financing,

we're really talking about selling debt securities which are traded on an open market,

which we usually call the bond market or something like that.

So, when we say debt securities,

you think of bonds,

we're really talking about the same things.

Instead of being a loan from

an individual bank like you go down to the local branch of your bank and get a loan,

a debt security or a bond is a loan from either an individual or institutional investors,

usually multiple investors who buy bonds issued by a company,

and it's a form of a loan but very different than a traditional bank loan.

So, a debt security is a form of security,

which we'll talk about in another module how securities work,

but debt securities carry with no ownership interest.

So, whereas an equity security like a stock or share of stock has ownership rights,

you can vote, all that kind of thing,

debt securities have no voting interest,

no ownership interest, whatsoever.

But what they do have is a guaranteed rate of return.

So, whereas if you have an equity security like a share of stock,

you don't have a guaranteed rate of return but you get some votes,

and you hope that you make some money.

Debt Securities, you get no votes but you,

at least have a guaranteed rate of returns.

It's just like any other loan,

there's an interest rate and periodic payments are made and

then the principal is repaid after a certain period of time.

There are different types of debt that we speak of when we talk about debt financing,

and these terms are a little bit flexible but for the most part,

when we talk about something called a debenture.

A debenture is an unsecured bond or an unsecured form of debt security,

meaning there is no collateral pledged by the corporation that the lenders can go,

the lenders being the investors,

can go and repossess in order to pay the principal if the borrower fails to do so.

On the flip side, there are secured bond.

Secured bonds unsurprisingly, are secured by some collateral,

it could be equipment, inventory, land, anything.

It's secured by some collateral so that if the company doesn't pay,

the lenders have some means of recouping the principal.

Getting a little more exotic.

Now convertible bonds are becoming much more popular especially

among people like venture capitalists and angel investors.

Why? Because when a company is small,

there's a lot of risk that it might not succeed,

and having a bond is good because there's a guaranteed rate of return. We like that.

But as it grows and especially when it goes public in an IPO,

having a bond has a much smaller upside than having common stock.

So, we want to convert that bond into

common stock when it goes public or is bought by someone else,

so that we can experience all the upside of the common stock.

So, convertible bonds are becoming very popular.

And then, there's this thing called a callable bond.

Most of the time, a bond has a maturity date,

and the company that issues the bond pays interest on regular intervals

until the maturity date at which time it

repays all of the principal amount of the bond or loan.

A callable bond allows repayment prior to the maturity date,

and these are used in some instances,

although they're not terribly common.

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