What is Debt Financing? What are the common types of Debt Financing?

Start-ups in Hong Kong can use debt financing to raise funds for their companies. Debt financing means when a company borrows money to be paid back at a later date. This is a good way for young businesses who want to raise funds and also maintain control over their company in Hong Kong. Debt financing is usually adequate for SME that need a significant amount of capital quickly for business growth.

This Q&A aims to identify the most common types of debt financing in Hong Kong so you can pick the right ones for your business.

1. Loans from family and friends

Friends and family are usually the first source of financing for many young businesses. The upside of such loans is that they are usually interest-free and much easier to secure. However, companies must carefully assess the risk of borrowing from family and friends as this might pose an adverse effect on one’s personal relationships if things go south.

2. Loans

A start-up can obtain a loan from a bank or any qualified money lender. Lenders will often assess the corporate financial situation and lend money accordingly. There are a number of ways that a bank can go about lending money to businesses:

• Installment loans: This is the most common type of bank loan in Hong Kong. If a company takes out an installment loan from a bank, it will receive a lump-sum payment from the bank upfront. Then the company has to make regular payments (monthly or annually) to the bank until the loan has been fully repaid.

Term loans and small business loans are examples of instalment loans. Check out our guide on What do I need to know about Small Business Loans?

• Revolving loans: Instead of the bank giving you a lump sum right at the start, a revolving loan gives you access to a facility of credit that the company can draw down from. Unlike an installment loan, the amount repaid will become available for withdrawal again.

• Cash flow loans: A cash flow is a type of unsecured loan that is used for daily operations of a company. The loan is often used for inventory, rent, payroll, and is paid back with incoming cash flows of the company.

Instead of going through a comprehensive credit analysis of a business, a bank only makes an assessment of the ability to generate cash flow of the company when determining the terms of a cash flow loan.

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.

A Loan Agreement is needed when a company tries to raise funds by taking out a loan. A binding and legally enforceable written loan agreement operates as a contract between the borrower and the lender and will stipulate the followings:  

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.

3. Bonds

Another type of debt finance is bond/debenture issues.

A bond functions as a loan between an investor and the company. The company writes an unconditional promise to pay an amount of money to the investors at a predetermined future date under specific terms. A debenture is a bond which is generally unsecured to raise capital for specific projects and business expansion and is typically backed up only on the basis of the good name and credit history of the company.

An advertisement and invitation to subscribe for bonds issued by 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 authorized 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 company 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.

Here are some of the major documents needed for issuing bonds:

1. Term sheet: This should serve as a summary of the key terms of the agreement between the company and the investors.
2. Offering document: This is a disclosure document which provides investors with all material information about the company so they can make an informed decision.
3. Subscription agreement: This is an agreement between the company and the investors that lists out the main terms of the bonds (e.g. repayment terms, representation and warranties).
4. Deed of Covenant: This is used to give the bondholders rights of enforcement against the company if it fails to make repayment.  

Bond vs Loan

Please see the table below a comparison between a bond and a loan:

4. Convertible bonds

A Convertible Bond is short-term debt that converts into equity in conjunction with a future financing round. Convertible Bonds are bonds that can be converted into shares of the issuer at the discretion of the lenders. The lenders would receive equity in the company instead of principal plus interest like normal loans.

For more information, check out our Q&A on What is a Convertible Bond?

5. Corporate credit cards

Corporate credit cards are generally issued to representatives of companies (i.e. the employees) that authorizes them to charge business expenses. Corporate cards are issued generally to larger, established companies. Employees of the company are expected to strictly follow the company’s policy on how to use the credit cards.

There are a number of benefits of using a corporate credit card:

• A corporate credit card makes it easier for the company to manage expenses.

• Employees do not have to wait for reimbursements after making upfront payment for the company

• A company might earn different rewards by using the credit card such as miles or coupons.

Corporate credit cards are issued by banks therefore are subject to the Code of Banking Practice. A company should be advised to thoroughly read terms of business card agreement which should include the following:

• Whether or there is an over-the-limit facility
• Fees and charges
• Interest charged
• Right of set off over other accounts of the company

Please also be reminded that instead of the cardholder, the company is usually the one who will be wholly liable for the obligation of using a credit card.

6. Peer-to-Peer (P2P) lending

P2P lending allows corporations to obtain loans directly from the public individuals, with the aim to eliminate the financial institution as the middleman. P2P lending platforms connect borrowers directly to investors, and also set the interest rates and terms of the loan. Despite the lack of a clear regulatory framework and guidance, several P2P lending platforms have started operating in Hong Kong.

Depending on the manner in which the platform is operating, it might involve dealing in or advising on securities. In that case, a platform will need to obtain licenses and be subject to the restrictions on offers of investments under the SFO. A P2P lending platform, which is involved in money lending, could also be subject to the Money Lending Ordinance and might need a money lending license.

Requirement for money lending license

There are a number of conditions for applying for a money lending license in Hong Kong, including the following:

• The representatives of the money lending business (i.e. the directors and shareholders) must be “fit and proper” and have general knowledge, qualification and experience in money lending.
• The premise of the business should be suitable for money lending
• The grant of license is not in contrast to the public interest.

Key takeaways:

• There are several types of debt financing including but not limited to Loans from family and friends, Bank loans, Bonds, Debentures, Convertible bonds, Corporate credit cards and Peer-to-Peer (P2P) lending.

• Despite the similarities between a loan and a bond, there are a number of differences which set them apart from each other.
  
• Different methods of debt financing are subject to various regulations and require different legal documents which should be carefully drafted and observed by the parties involved.

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