We know that to carry on business activity; we require money. We usually know this money as “capital”. When a company needs a sizable amount of money, it issues shares to the public. The money that is raised by the issuing shares is known as “the share capital of the company”.
If a company borrows money as debentures, we do not count it as part of the share capital of that enterprise. Debentures are a debt instrument. Lets understand the difference between shares and debentures.
Shares have only nominal value. In the following section, we have defined shares very lucidly.
Meaning and definition of Shares
Section 2(84) of the Companies Act, 2013 states that “A share is a share in the share capital of a company and includes stock.” Share is an instrument of investment. We define them as the smallest unit of a fixed amount of a company’s capital.
Shares represent a right to take part in the gains (profits) made by the issuing company. It also holds claims in the assets of the company with liquidation. Companies sold shares in the stock market to raise funds. A person who purchases a share of a company gets a portion of ownership of that company.
A share is a kind of movable property that is a ‘good’. In India, ‘goods’ include stocks and shares. Though shares are a kind of movable property, we can transfer them only according to the articles of that particular company.
Companies Act, 2013 clearly states that a company can issue only two types of shares. Two types of shares are:
- Equity Shares: equity shareholders of a company cannot claim a fixed rate/amount of dividend. However, they possess voting rights on all matters affecting the company. Equity shares of a company are not redeemable.
We can also characterize equity shares as those shares that do not preference shares.
- Preference Share: we identify preference shares with a fixed rate/amount of dividend. A company pays a dividend to the preference shareholders in preference to the equity shareholders.
Preference shareholders have a limited/restricted voting right. An equity shareholder of a company can vote on all matters. The rules mandatorily assure preferential shareholders of a preferential dividend.
What is a Debenture?
Let us understand what is debenture and what are different debentures?
Meaning and definition of Debentures
We can also define debentures as a kind of bond issued by a company bearing a fixed rate of interest. Debentures are usually secured/charged against the asset of the issuing company.
If a company wants to extend and develop its business activities or to fund its projects and doesn’t want to increase its share capital, it borrows money from the market (public). Here, a company issues debentures and we consider it as the most common form of raising loans from the public.
Now let us consider the official definition of debentures as given by the government itself.
Section 2(30) of the Companies Act, 2013, has defined a debenture in the following way:
“Debenture includes debenture stock, bonds or any other instrument of a company evidencing a debt, whether making up a charge on the assets of the company or not.”
Features of Debenture
Some of the important characteristic features of a debenture are as follows:
1. Every debenture has a fixed or specific date of redemption. The repayment of the principal and the interest as mentioned in the debenture are fixed.
2. Debentures create a charge on the undertakings of the concerned company, which issues the debenture.
Usually, debentures have a ‘pari passu’ clause added in the terms and conditions. In case, if a company cannot repay the whole desired amount or obligation, the debenture holders will get their returns proportionally.
Types of Debentures
We classify shares, as well as debentures, in various ways. Usually, debentures are classified into 6 different types. These may be of the following types:
- Bearer Debentures: They are a kind of negotiable instrument that is usually transferable by delivery. Bearer debentures are payable to the bearer. A company usually uses attached coupons to pay the interest on bearer debentures. Names of bearer debentures do not appear in the company registers.
- Registered Debentures: Registered debentures are paid to those individuals whose names are registered in the company’s debenture-holder register.
- Perpetual or Irredeemable Debentures: The Companies Act, 2013 does not mention irredeemable debentures, these cannot be issued anymore. Previously, Section 120 of the Companies Act, 1956, contained provisions for irredeemable debentures. As the name suggests, perpetual or irredeemable debentures are not paid back. Now companies cannot issue fresh irredeemable debentures.
- Redeemable Debentures: A company issues redeemable debentures for a fixed or specific period. A company may have its properties/assets released from the mortgage (and/or charge) if it pays back the debenture-holder after the expiry of that specific period. Companies Act 2013, specifies that only redeemable debentures can be issued.
- Secured and Naked Debentures: It is a known fact that debentures are more secure than shares of a company. The debentures of a company are usually secured by a charge on the company’s assets. The mortgage may also be used. However, if the debentures are not secured by a charge on the company’s assets, they are known as Unsecured or Naked debentures.
- Convertible Debentures: Convertible debentures of a company can be converted into equity or preference shares at predefined rates of exchange, after a specific period. If a convertible debenture is converted into a share, it cannot be reconverted to the company’s shares.
Shares and Debentures are two different things. The major points of difference between shares and debentures may be counted as follows:
- A shareholder in a company is a member of the company. A debenture-holder is not a member of the company.
- When we earn interest through debentures, we consider it as a form of a business expense. Hence, we allow it as a deduction from the profit of the company. Dividend on shares can not be allowed as a deduction because we regard it as the appropriation of profit.
- A shareholder earns profit only when the company earns the same. They are paid dividends only out of the company’s profits. All debenture holders of a company are entitled to an interest rate that is fixed.
- Share-holders have to deal with higher risk whereas debenture holders have fixed returns. Debentures are one of the most secured instruments of investment.
- It is possible to convert debentures into shares but shares of a company cannot ever be converted into debentures of that company.
- In the case of winding up, debenture holders are paid preferentially over shareholders. Shareholders are usually paid when all the outstanding debt and dues are paid by the company.
- Shares depend on the market performance of the company. They are not secured. Debentures do possess risk but their repayment is assured.
- Shares of a company usually provide high returns. Debentures provide medium to low returns on investment.
It depends upon the risk appetite of the prospective investor. Both shares and debentures are ways to raise the funds by a company. However, the difference lies in the preferential treatment in payments. Debentures are better for low-risk investors and equity shares are a better investment instrument for high-risk takers.
Share vs Debenture is a matter of choice. Both shares and debentures have their merits and demerits. An investor can choose to invest in either of the two as per his financial requirements and goals. Or, you may add both to your investment portfolio. But we should base all of our decisions on investment on sound financial advice and insights.
Frequently Asked Questions
How do we classify debentures?
We classify debentures into 6 different types. These are Bearer Debentures, Registered Debentures, Perpetual or Irredeemable Debentures, Redeemable Debentures, Secured and Naked Debentures, and Convertible Debentures.
The difference lies in voting rights and preferential treatment of repayment. Equity shares provide ownership in the company with voting rights. Debentures have a fixed rate of repayment.
Shares are of two types: equity shares and preferential shares. Equity shares may come with voting rights or with differential rights.