Apr 7, 2025
Corporate Financing: Equity, Debt, and Their Legal Significance
A company's financial structure is crucial for its operations and survival capability. The choice of financing sources and composition of capital affects both the company's freedom of action and creditors' security. This article provides an introduction to the various forms of financing for companies, with particular emphasis on the legal frameworks and consequences of different financing solutions.
The article will highlight the relationship between the company's liability form, capital requirements, and financing options, as well as the differences between limited liability companies and partnerships in this area.
Sources of Financing for Companies
A company can be financed through various sources, which can mainly be categorized as equity financing, debt financing, or hybrid forms between these. Which sources of financing are available and appropriate depends on the corporate form, the nature of the business, and the company's stage in its life cycle.
Equity Financing
Equity financing is the capital that the participants themselves inject into the company. For limited liability companies and public limited companies, this primarily constitutes stock contributions, while for partnerships, it is deposits that the participants may agree to provide to the company.
In limited liability companies and public limited companies, capital contributions are mandatory. The Companies Act has detailed regulation of the company's equity financing through contributions to the share capital. It is particularly important that the share capital is so-called "bound equity," which means that shareholders cannot freely dispose of it by returning it to themselves.
In contrast, there is no mandatory deposit requirement in partnerships, even though in practice, it is often necessary for the company's operations that the participants agree on capital contributions.
Access to the Capital Market
There are significant legal and practical differences between limited liability companies and public limited companies when it comes to the opportunities to obtain equity financing:
Limited Liability Companies cannot invite the public to subscribe for shares in connection with a capital increase (emission). Only existing shareholders or specific named persons may be invited to subscribe for new shares.
Public Limited Companies, on the other hand, can invite the public to subscribe for shares and list their shares on the stock exchange. This gives them access to a larger capital source through the "market."
These limitations for limited liability companies mean that they cannot conduct a public emission aimed at the public to then list the company – a combination that is common for public limited companies and provides them with both solid equity financing and liquidity in the shares.
Debt Financing
If the injected equity is not sufficient to finance the company's operations, it will be necessary to take out loans or credits – known as debt financing. This capital forms part of the company's external capital.
Unlike equity financing, which is a decision for the general meeting, taking out loans is typically a matter for the board and the chief executive. Debt financing is subject to general contractual law regulations, and the Companies Act has no detailed regulation of this form of financing.
Lenders, such as banks or other financial institutions, usually consider the size of the share capital when assessing whether to grant a loan to a limited liability company. Since the share capital cannot be freely returned to the shareholders, it provides the lender with some security that the capital will benefit the company's operations.
Hybrid Forms of Financing
Between pure equity financing and pure debt financing, there are various forms of financing that have characteristics of both categories:
Financial Instruments regulated in the Companies and Public Companies Act Chapter 11, such as convertible loans, loans with subscription rights to new shares, and subscription shares.
Subordinated Loan Capital, which are loans where the lender agrees to stand back for all the company's other creditors in case of bankruptcy or other dissolution of the company.
These hybrid forms may be appropriate in situations where the company needs more flexible financing solutions than traditional share capital or bank loans can offer.
Capital Structure and Risk Distribution
The Importance of Capital Structure
The company's capital structure – the distribution between equity and external capital – has implications beyond the purely financial. In larger companies, capital structure is deliberately used as a management tool.
Traditionally, it has been assumed that a high degree of equity financing in companies with dispersed ownership will reduce the shareholders' ability to control the management. A higher debt ratio, on the other hand, will give the management less freedom of action and increase the pressure on them to make good investments.
These strategic considerations are particularly relevant for larger companies, typically listed companies. In smaller limited liability companies, especially at the start of new ventures, practical limitations often determine the capital structure – it can be difficult to raise share capital, which forces a larger proportion of external capital, often combined with personal guarantees from the shareholders.
Company Form and Financing Opportunities
The practical reality is that liability form, capital requirements, and financing are closely connected, but the relationship is not always straightforward:
A bank may in some cases be more comfortable granting a loan to a partnership without equity, but with solid participants with personal responsibility, than to a limited liability company with a smaller share capital and without additional equity.
In partnerships without equity (deposits), the operations must be financed by external financing. Creditors will then assess both the company's earning potential and the participants' personal finances, as the participants are personally, directly, and unlimitedly liable.
In limited liability companies, it is very common for banks to require personal guarantees from the shareholders when lending to companies with low equity or high risk, which in practice undermines the shareholders' limited liability.
Equity and Debt: Legal Definitions and Significance
Equity
Although there is no legal definition of the term equity in the company legislation, both the Companies Act/Public Companies Act and the Accounting Act are based on a generally recognized view:
Equity = Assets - Liabilities
Equity is thus an expression of the value of the company's assets minus the company's liabilities. Since equity is equal to the accounting net wealth, it may, as a result of the company's operations, be lower than the share capital, and it may even be negative.
Division of Equity
The Accounting Act divides equity into two main categories:
Contributed Equity: Capital injected by the owners at incorporation or later (through capital increase)
Earned Equity: Capital earned as a result of the company's operations
This distinction primarily has accounting significance by making it easier to read the financial statements, but it does not have direct legal significance in the company legislation.
Equity as a Legal Fact
In the Companies Act and the Public Companies Act, equity is significant as a legal fact, affecting the company's freedom of action in several contexts:
Distributions from the Company: Equity forms the basis for distributions to shareholders in the form of dividends. Only the so-called "free equity" (equity that exceeds bound equity) can be distributed.
Management and Operation of the Company: The Companies Act/Public Companies Act § 3-4 requires that the company's equity and liquidity must at all times be sound based on the risk and scope of the company's business.
Duty to Act in Case of Low Equity: If equity does not meet the soundness requirement, the board is obliged to "immediately address the matter" and propose measures, possibly dissolving the company if the situation cannot be remedied.
In assessing whether the equity is sound, it is the actual equity that matters, not necessarily the book equity. This is particularly relevant in cases where the company's assets have appreciated in value since acquisition, which may mean that the actual equity exceeds the book equity.
Debt
The debt expresses the company's liabilities, regardless of how they have arisen. This includes loans or credit from banks, financial institutions, the participants themselves, or others. In accounting terms, debt represents the obligations the company has towards external parties.
The Company's Balance Sheet
In the annual financial statements, assets on one side and equity and liabilities on the other side are drawn up separately:
Assets (assets side): Property belonging to the company
Equity and Liabilities (liabilities side): The company's financing, both equity financing and debt financing
The sum of the value of assets on one side and the value of equity and liabilities on the other must always be equal in accounting terms, hence the word "balance."
The Distinction Between Bound and Free Equity
A fundamental principle in company law is the distinction between bound and free equity, which runs as a red thread through the rules of the Companies Act and the Public Companies Act concerning capital use.
Bound Equity
Bound equity consists of:
Share Capital
Funds for unrealized gains and funds for valuation differences
Shareholders are barred from freely disposing of the bound equity. This is a central element in creditor protection in company law.
Free Equity
Free equity is the part of the equity that exceeds the bound equity. This can be disposed of by the shareholders under certain conditions.
The Companies Act and the Public Companies Act set out a number of rules that require certain dispositions to only be made if the company has free equity, including:
Dividend distribution
Group contributions
Gifts from the company
Credit (loans) to shareholders
Acquisition of and pledge in own shares
Capital reduction
Differences Between Limited Liability Companies and Partnerships
For partnerships, there are no corresponding rules on bound capital. There is neither a deposit requirement nor an obligation to bind capital in the company. Participants can freely dispose of the company's equity, but in return, they are personally liable for the company's obligations.
Conclusion
The financing of companies is a complex area where legal, economic, and strategic considerations come into play. The choice of financing sources and the composition of capital impacts the company's flexibility, shareholders' control, creditors' security, and the company's growth opportunities.
The legal frameworks for financing vary significantly between limited liability companies and partnerships. While limited liability companies are subject to extensive regulations on capital contributions, capital binding, and restrictions on capital use, partnerships have greater flexibility but unlimited liability for the participants.
When choosing financing solutions, the company's management and owners must therefore consider both the legal frameworks and the practical consequences of various capital structures. This is especially important for limited liability companies, where capital use is subject to significant restrictions through the distinction between bound and free equity.
