By Oyetola Muyiwa Atoyebi, SAN.

Insolvency refers to a situation in which a company’s or an individual’s financial liabilities exceed assets, to the point where Creditors cannot be paid. In simple terms, Insolvency is a financial situation in which a business is unable to pay its debts. A Firm or Corporation cannot function without funding. When it comes to raising capital for commercial purposes, companies essentially have two options: Equity financing and Debt financing. Despite their differences, most businesses use a combination of debt and equity funding.

INTRODUCTION:

Capital is necessary for the operation of a business or corporation. Companies primarily have two types of financing options for raising funds for commercial needs: Equity financing and Debt financing. Though each has its peculiarity, most businesses utilize a combination of debt and equity financing.

Insolvency denotes the inability to fulfil financial obligations. Such a state can be presumed to be reached due to the failure of a company to maximise its financial options for its betterment.

This article aims to analyse the relationship between Debt and Equity financing to understand its workings, and which best prevents a company from becoming insolvent.

INSOLVENCY IN A COMPANY

The term Insolvency connotes a circumstance in a company, or it relates to an individual when financial liabilities supersede assets such that Creditors cannot be settled.

Insolvency is the failure of a company to fulfil its financial obligations[1]. Section 572(a)(b)(c) of the Companies and Allied Matters Act, 2020[2] and Section 408(d) of Bankruptcy and Insolvency (Repeal and Re-enactment) Act, 2016, describes Insolvency as the failure of firms to recompense financial obligations particularly the creditors by an assignment which the firm owes a sum above N2oo,000.00.

By the clear provisions of Section 572 (a) of the Companies and Allied Matter Act[3], the creditor must give notification of its claims to the firm at its head office demanding the sum which is outstanding for three (3) weeks and after the expiration of such period, where the firm or company fails to or declines to disburse the unpaid amount to the approval of the creditor or lender[4], such a company is deemed to be insolvent. The clear wordings of Section 572 (a) are replicated for a better understanding;

“A company is deemed to be unable to pay its debts if— (a) a creditor, by assignment or otherwise, to whom the company is indebted in a sum exceeding N200,000, then due, has served on the company by leaving it at its registered office or head office, a demand under his hand requiring the company to pay the sum due, and the company has for three weeks thereafter neglected to pay the sum or to secure or compound for it to the reasonable satisfaction of the creditor”

There are essentially two techniques for determining Insolvency: Equity-based insolvency and Balance-sheet-based insolvency. In the equity sense, insolvency refers to a debtor’s inability to pay his debts when they fall due in the normal course of business. According to the balance-sheet approach, insolvency occurs when the debtor’s entire liabilities exceed his total assets.[5]

Insolvency is not the same as bankruptcy. Bankruptcy is a legal status of an insolvent person or an organization, as well as an individual who cannot pay up the debts they owe to Creditors[6]. Insolvency may be distinguished from bankruptcy to the extent that in Nigeria, a person unable to pay his debts cannot declare himself bankrupt except by the Court, after considering a petition brought before it for that purpose. It is only the Court that has the power to declare an individual bankrupt[7].

Also, in some jurisdictions, the term Bankruptcy is reserved for individuals with the inability to pay debts owed to creditors while insolvency is used for companies unable to pay debts owed.

We shall now consider the financing options; debt and equity available to a company.

DEBT FINANCING

Getting a loan or a mortgage is the most popular type of debt financing. Debt finance is the process of lending money with the intention of repaying it with interest. The primary benefit of debt financing is that creditors do not own the company; instead, they are just entitled to the loan and the agreed interest rate. In the long run, this allows for a higher profit margin without having to sell the majority of the company to creditors.

Debt financing also enables a company to forecast expenses because loan payments do not fluctuate[8]. This option of financing prevents and protects the control and ownership of a business to numerous shareholders especially when it is a small business. This is because once the loan is repaid, the relationship with and obligation owed to the financier is severed.

Advantages of Debt Financing

The company retains ownership and control over business operations.
The company is only liable to the creditors to the extent of debt owed.
Debts are known expenses that can be easily forecasted by a company.
In most jurisdictions, tax deductions are possible with debt financing.
Disadvantages of Debt Financing

The loan must be repaid even at difficult times when it is due.
It may be more expensive because of the higher interest rate on a loan.
In times of recession and economic depletion, it’s harder for small businesses to partake in debt finance with little credit worthiness.
Financiers may place restrictions on the use of loans.
EQUITY FINANCING

“Equity” is another word for ownership in a company[9]. Equity financing is a financial option that involves selling a portion of a company’s equity in return for capital[10]. A company’s equity includes shares, stocks and any stake in the ownership of such company.

A major peculiarity with this option of finance is that there is no requirement for repayment of debts to the investors as in the case of debt financing. The investors however have percentages and ownership rights in the business or company. This option relieves a company of numerous financial burdens as well as provides more capital to fund the growing business.

Advantages of Equity Financing

Equity financing involves lesser risk because there is no obligation to repay loans.
Equity financing is more likely to increase the cash flow of a company. In a company that has credit problems, equity financing is recommended.
Investors in equity financing do not expect immediate returns on their investment and as such, it gives room for long term planning.
Disadvantages of Equity Financing

Profits of the company are to be shared among the investors.
Equity financing may also lead to delay in decision making, as all investors may be consulted before any major action is taken in the company.
The only way to remove investors is to buy them out, but that will likely be more expensive than the money they originally gave you.
INSOLVENCY: THE SUITABLE FINANCING OPTION; DEBT OR EQUITY.

Before a company reaches the point of insolvency, they can effectively engage in debt restructuring using any of the financing options. Debt restructuring enables a company to renegotiate its debts in order to restore liquidity. It is usually a better alternative to bankruptcy[11].

A company’s financial structure can be optimized by combining various funding alternatives. In order to keep a company afloat while it is on the verge of insolvency, a combination of funding options will be determined by the company’s current financial situation. A corporation may benefit from debt financing but investors’ returns on investment must also be considered. Continuously taking on debt may not always be the wisest solution. Debts require payback and increased interest rates, which raises the chance of payment default and reduces earnings, investor returns on investment and cash flow. Securing equity funding, on the other hand, might be a simpler procedure than obtaining debt financing, but the company must have appealing financial prospects.

According to the Modigliani-Miller theory used in financial and economic studies to analyse the value of different companies; Companies that use debt financing are more valuable than those that finance themselves purely with equity. That is because there are tax advantages to using debt to manage their operations. These companies are able to deduct the interest on their debt, lower their tax liability, and make themselves more profitable than those that rely solely on equity[12].

Deciding which financing option works best for a company is limited to certain factors. This may include the company’s credit worthiness, the number of investors, profitability, business goals, risk tolerance, need for control and the company’s ownership structure. Debt financing may be cheaper because of its tax benefits but the risk worthiness of it is more prevalent than that obtainable in equity financing.

Debt financing tends to be riskier than equity financing because of the pressure from lenders and financiers when the company is less profitable. Many businesses in the startup stage will pursue equity financing, while those already established, and those who have no problem with debt and possess a strong credit score, might pursue traditional debt financing types like small business loans[13].

It is our humble opinion that either of the financing options, debt or equity should not be used exclusively. When a balance is made between debt financing and equity financing, the capital structure of a company is easily optimized.

CONCLUSION

Not all financing options available to a company are ideal. The lack of understanding of the suitable financing options for a company makes such a company prone to insolvency.

Companies’ capital structure varies and several factors are also considered before the best financing option for a company can be ascertained. Debt and equity financing are the basic forms for a company to acquire its necessary funding, and the ability to decide the best form of financing enable businesses to achieve capital optimization.

AUTHOR: Oyetola Muyiwa Atoyebi, SAN.

Mr. Oyetola Muyiwa Atoyebi, SAN is the Managing Partner of O. M. Atoyebi, S.A.N & Partners (OMAPLEX Law Firm) where he also doubles as the Team Lead of the Firm’s Emerging Areas of Law Practice.

Mr. Atoyebi has expertise in and a vast knowledge of Corporate and Commercial Law and this has seen him advise and represent his vast clientele in a myriad of high level transactions. He holds the honour of being the youngest lawyer in Nigeria’s history to be conferred with the rank of a Senior Advocate of Nigeria.

He can be reached at atoyebi@omaplex.com.ng

COUNTRIBUTOR: Joannah Emmauel.

Joannah is a member of the Corporate and Commercial Law Group at OMAPLEX Law Firm. She also holds commendable legal expertise in helping businesses and startups raise capital.

She can be reached at joannah.emmanuel@omaplex.com.ng

[1] Rashid Shamim, ‘Bankruptcy Laws: A comparative study of India and USA.’ [2019] 10 (2) Int. J. Management;247 –

252.

[2] The Companies and Allied Matters Act Cap C20, 2020, Laws of the Federation of Nigeria.

[3] Ibid, n. 2

[4] Adebola, B.A, ‘Corporate Rescue and the Nigerian Insolvency System’, [2012] (Unpublished PhD Thesis Submitted to the University College, London for the Degree of Doctor of Philosophy), 15.

[5] Britannica, The Editors of Encyclopaedia. “insolvency”. Encyclopedia Britannica, [25 Aug. 2019]. Available at< https://www.britannica.com/topic/insolvency> Accessed on April 13, 2022.

[6] Leonard C. Opar and Livinus I. Okere and Chinwendu O. Opara, ‘The Legal Regime of Bankruptcy and Winding up Proceedings as a Tool for Debt Recovery in Nigeria: An Appraisal’. [2014] 10 (5) Canadian Social Science 2014, pp. 61-69.

[7] Op cit, n. 5

[8] Maverick, J.B ‘Equity Financing V. Debt Financing: What’s the Difference’. [2022] Investopedia. Available at Accessed on April 18, 2022.

[9] Adam Hayes, ‘Financing’ [2022] Investopedia. Availabe at < https://www.investopedia.com/terms/f/financing.asp > Accessed on April 20, 2022.

[10] ibid, n. 9

[11] Corporate Finance Institute, ‘Insolvency’ [2022] CFI website, Available at Accessed on April 14, 2022.

[12] Op cit; n. 8

[13] Daniel Odupe, ‘Lessons: Issues and Practical Consideration in Equity Financing in Nigeria’ [2020]. Available at Accessed on April 20, 2022.