3.3 Financing: Debt, Equity, Security and Distributions

Finance questions on SQE1 are not investment-banking questions. They ask whether a newly qualified solicitor can tell a client how to put money in, how to take value out, and what a lender actually receives when the client says "we'll give you security". From 1 September 2026, FLK1 finance includes debt and equity funding, expressly including redemption and buyback of shares, and it excludes other reductions of share capital and financial assistance under the Companies Act 2006. Listing, prospectus, and DTR rules are also out. Stay inside the Act's company-law machinery for unlisted companies.

Equity funding: allotting shares

Share capital is a bundle of rights: typically votes, dividends, and capital on a winding up. Ordinary shares take the residual. Preference shares usually take a fixed dividend in priority and may be cumulative, participating, or redeemable. Directors must not allot shares except as the Act permits (s.549). If a private company has only one class of shares, the directors may allot shares of that class unless the articles prohibit them from doing so (s.550). In any other case, including a public company or a private company with more than one class, allotment needs authority in the articles or an ordinary resolution under s.551, for a period of not more than five years (renewable).

Statutory pre-emption (s.561) requires a company, before allotting equity securities for cash, to offer them first to existing ordinary shareholders in proportion to their holdings. Private companies with one class of shares often disapply pre-emption in the articles or by special resolution (s.569). Ignoring pre-emption does not merely annoy a minority: it is a statutory wrong and a classic negligence claim against the solicitor who ran the completion agenda.

Shares must not be allotted at a discount to nominal value (s.580). They may be paid up in money or money's worth (s.582). Public companies face extra rules on non-cash consideration, including independent valuation in specified cases (s.593). Those valuation rules are company law. They are not a prospectus regime. An unlisted plc can still allot shares; you simply do not advise on FCA listing particulars in this topic.

Mini-scenario: the incoming investor

Northshore Ltd has 100 ordinary shares of £1, all issued and fully paid, held equally by A and B. C will subscribe £200,000 for 50 new ordinary shares. Check s.550/s.551 authority, s.561 pre-emption (A and B must be offered their proportion, or a valid disapplication must be in place), the subscription agreement, board minutes, a return of allotment, an updated PSC position if C will hold 25% or more, and share certificates. If the client instead wanted C to buy A’s existing shares, that is a share sale, not an allotment: money goes to A, not into the company. Do not confuse the two cashflows.

Redemption and buyback — in scope

A limited company may issue redeemable shares (s.684), but it may not issue redeemable shares at a time when it has no issued shares that are not redeemable (s.684(4)). A public company's articles must authorise redeemable shares (s.684(3)); a private company may issue them unless its articles prohibit. Terms of redemption must be set. Redeemable shares must be fully paid before they are redeemed. Financing of the redemption is from distributable profits or the proceeds of a fresh issue made for the purpose (s.687). A private company may also redeem (or purchase) out of capital if it follows Chapter 5 of Part 18: a permissible capital payment, a directors' statement of solvency with an auditor's report (s.714), a special resolution, and creditor publicity (ss.716–721). Directors who make the statement without reasonable grounds commit an offence and can be liable if the company is wound up within a year.

A limited company may purchase its own shares in accordance with Chapter 4 of Part 18 unless the articles exclude the power (s.690). For the unlisted companies in this topic, the purchase is almost always off-market (s.693(2)). The purchase contract must be authorised by special resolution before the company enters into it (s.694), and the selling shareholder's votes are not to be used on that resolution (s.695). Financing mirrors redemption: distributable profits, fresh-issue proceeds, or, for a private company, capital under Chapter 5. Shares purchased by a typical unlisted private company are cancelled. Holding purchased shares in treasury is a separate regime for companies whose shares are traded on specified markets, and it is not part of this unlisted FLK1 topic.

Mini-scenario: the departing 25% holder

D wants to leave Northshore Ltd and be paid for a 25% holding. Options include D selling to A and B (a secondary sale), or the company buying D's shares. A buyback needs distributable profits (or a valid out-of-capital procedure), off-market contract approval by special resolution without D voting, Companies House filings, and care that the remaining share capital is not an illegal structure (for example, leaving only redeemable shares in issue). This is inside the topic.

The FLK1 boundary: what you do not teach here

Other reductions of share capital are out. That means the general s.641 reduction — special resolution plus a private-company solvency statement, or court confirmation — used to cancel unpaid capital, write off losses, or return surplus capital other than through redemption or buyback. If a stem asks you to "reduce capital to create a reserve" or "cancel share capital with a solvency statement" and there is no redemption or purchase of shares, recognise the procedure and stop: it is outside this finance bullet.

Financial assistance pursuant to the Companies Act 2006 is also out (Part 18 Chapter 2, ss.677–683). In outline, a public company must not give financial assistance for the acquisition of its shares (or, in specified cases, shares in its holding company). Assistance can include gifts, loans, guarantees, and other help given for that purpose. Private-company "whitewash" was abolished by the 2006 Act; the live prohibition is aimed at public companies and certain groups. If a buyer of shares in a plc wants the target to pay the purchase price, guarantee the acquisition facility, or otherwise help fund the deal, flag that a separate assistance analysis exists — and do not run that analysis in this chapter. Redemption and buyback by the company of its own shares are a different statutory machinery; do not relabel them as assistance in order to smuggle the carved-out topic back in.

Debt funding

Debt includes an overdraft, a term loan, a revolving facility, intra-group loans, director loans, and debentures or loan notes. Interest is a contractual cost; unlike dividends, it is not a Part 23 distribution. Debt does not dilute votes, but it must be repaid, often on covenant breach or an event of default. Advise on capacity and authority (board minutes, any article restriction, and, for substantial transactions with directors, the CA 2006 conflict and long-term service-contract rules taught with governance), on whether a guarantee is being taken from a parent or from individuals, and on security. Partnerships and LLPs also borrow: the 1890 Act firm borrows through partners with authority; the LLP borrows as a corporate person.

Types of security

Security gives a creditor a right against an asset, not merely a personal promise.

A typical bank debenture over a trading company mixes a fixed charge over land, plant, goodwill, and a blocked account with a floating charge over stock and other undertaking. Re Spectrum Plus Ltd is the functioning-knowledge warning: if the company may use book-debt proceeds as its own cash, the charge is floating even if the deed says "fixed". Crystallisation converts a floating charge into a fixed charge, commonly on winding up, administration, cessation of business, or a specified notice or event in the deed.

Company charges must be registered at Companies House under s.859A within 21 days beginning with the day after creation. Miss the window and the charge is void against a liquidator, administrator, and creditors. The debt remains; the priority is gone. Land charges still need Land Registry (or specialist asset) registration as well. Partnerships have no equivalent s.859A register; security over partners' land still needs the land register, and taking security from individuals raises consumer-security and independent-advice issues that a solicitor must spot.

Retention of title (a Romalpa clause) is quasi-security: the seller keeps title until paid. It can fail if goods are incorporated or resold, and it is not a registered charge if it is a true retention of title. Do not treat it as a substitute for a debenture.

Distribution of profits and gains

Part 23 CA 2006 polices distributions. A distribution is every description of distribution of a company's assets to members, with specified exceptions such as an issue of bonus shares, a reduction of capital, a redemption or purchase of own shares, and a winding-up distribution (s.829). A company may make a distribution only out of profits available for the purpose (s.830): accumulated realised profits less accumulated realised losses, so far as not previously utilised or written off. A public company must also satisfy s.831: net assets must not fall below called-up share capital plus undistributable reserves. The figures come from relevant accounts (s.836) — usually the last annual accounts, or interim or initial accounts that meet the statutory requirements. Management-account optimism is not enough.

An unlawful distribution can be clawed back from a member who knew or had reasonable grounds to believe it was unlawful (s.847). Transferring an asset to a shareholder at an undervalue can be a disguised distribution and must still satisfy Part 23. Directors who authorise an unlawful dividend also risk breach of duty.

Partnerships and LLPs do not apply Part 23. Partners share profits as the agreement (or s.24) provides and may make drawings. Over-drawings become a debt to the firm. LLP members likewise follow the LLP agreement. Advise the client on the vehicle before you use the word "dividend".

Mini-scenario: the illegal dividend

The board wants a £50,000 dividend because "cash in the bank is £80,000". The last annual accounts show accumulated realised losses and no distributable profits. Interim accounts have not been prepared to s.836 standard. The correct advice is no distribution. Cash is not the test. If the shareholders have already been paid, s.847 repayment and director-duty analysis follow.

Financial records, information and accounting requirements

Section 386 requires adequate accounting records: daily entries of receipts and payments, a record of assets and liabilities, and, where the business deals in goods, statements of stock. Private companies must generally keep records for three years, public companies for six (s.388). Directors must prepare individual accounts (s.394) and, if the company is a parent, group accounts unless an exemption applies (s.399). Accounts must give a true and fair view. Copies are sent to members (s.423) and filed (s.441).

Size classifications (micro, small, medium, large) drive reduced disclosure and, for many small private companies, audit exemption. A public company is ineligible for the small-companies regime. Exact numerical thresholds are set by regulations and have been increased in recent years; on the exam, know that the regime exists, that eligibility depends on turnover, balance-sheet total, and employees, and that ineligibility (including being a public company) blocks the exemptions. Designated members of an LLP perform analogous filing functions for LLP accounts.

Registers of members and PSCs are part of the information a creditor, investor, or outgoing member will inspect. A solicitor who advises on a facility or a buyback without asking for the last filed accounts, the management accounts, and the articles is guessing.

Mini-scenario: debt versus equity at the first board meeting

A start-up Ltd needs £100,000. A bank offers a loan plus a floating charge over book debts, with directors' personal guarantees. An angel offers to subscribe for 20% of the enlarged share capital. Advise: guarantees put personal homes in view despite Salomon; a floating charge will not give the bank the same control as a true fixed charge if receipts remain freely usable; equity does not have to be repaid but dilutes and engages pre-emption and PSC rules; a later buyback of the angel is possible only if the Act's buyback rules can be met. Do not reach for a s.641 reduction or a plc-style assistance structure to "clean up" the cap table — those routes are outside this topic.