Capital Increase or Borrowing: How Should a Company Choose Its Financing Method?

Companies and investment institutions operating in Egypt face a critical decision when seeking to expand or overcome operational challenges: selecting the appropriate financing mechanism.

This raises a fundamental question: capital increase or borrowing, and how should a company choose its financing method? The choice between injecting new financing into the company’s equity through a capital increase and assuming liabilities and financial burdens arising from bank loans or credit facilities is not merely a financial decision. It is a complex legal and structural matter that determines the extent of control, the level of risk, and the company’s long-term tax and regulatory obligations.

Accordingly, this step requires a careful assessment of the company’s operational structure and legal framework, whether it is a local company or a foreign entity seeking to expand its business in the Egyptian market.

Legal and Regulatory Framework for Financing Methods in Egypt

Financing options in the Egyptian market are governed by a comprehensive legal framework intended to protect the rights of partners and shareholders and ensure the stability of economic entities.

1. Capital Increase (Equity Financing)

Investment and corporate laws in Egypt regulate the procedures and provisions governing capital increases, primarily the Joint Stock Companies, Partnerships Limited by Shares, Limited Liability Companies, and Single Member Companies Law No. 159 of 1981 and its Executive Regulations.

• General Assembly Resolutions: A capital increase requires a resolution of the extraordinary general assembly in joint stock companies, or an amendment to the articles of incorporation approved by the majority of partners in limited liability companies.
• Pre-emptive Rights: The law grants existing shareholders priority in subscribing for new shares to preserve their ownership percentages, unless the extraordinary general assembly resolves to suspend this right where necessary in the company’s interests.
• Regulatory Oversight: The General Authority for Investment and Free Zones (GAFI), and the Financial Regulatory Authority (FRA) in the case of listed companies or companies engaged in non-banking financial activities, oversee filing procedures, amendments to the commercial register, and the approval of general assembly resolutions.

2. Borrowing and Credit Facilities (Debt Financing)

Borrowing and banking facilities are governed by the Egyptian Civil Code No. 131 of 1948 and the Central Bank and Banking Sector Law No. 194 of 2020.

• Authorities and Powers: The company’s articles of incorporation must be reviewed to determine whether the board of directors or executive manager has the authority to borrow and mortgage the company’s assets, or whether the matter requires special authorization from the general assembly.
• Legal Security: Loans often require the provision of security in rem or personal guarantees, such as a commercial mortgage over the components of the business, a real estate mortgage, or a pledge over shares and bank accounts, in accordance with the Movable Collateral Regulation Law No. 115 of 2015.

Analytical Comparison: Capital Increase versus Borrowing

The answer to the question of capital increase or borrowing—and how a company should choose its financing method—depends on several legal and commercial dimensions that create a fundamental difference in the company’s legal position.

• Ownership and Control Structure: A capital increase (Equity) changes ownership percentages and may result in the admission of new partners or an adjustment to voting weights. Borrowing and facilities (Debt), however, do not affect the ownership structure or the voting rights of existing shareholders.
• Cash Flow Burdens: A capital increase does not impose fixed periodic repayment obligations, as profits are distributed when positive results are achieved. Borrowing, by contrast, imposes debt service obligations comprising the principal and interest under a strict repayment schedule, regardless of profitability.
• Legal and Default Risks: The risks of a capital increase are limited to a decline in share value, and shareholders may not seek the company’s declaration of bankruptcy on account of their contributions. Default on loans, however, may expose the company to enforcement against its assets and potentially to bankruptcy or liquidation.
• Procedures and Time Costs: A capital increase requires approvals from the competent investment authorities, amendments to the articles of association, and completion of valuation procedures. Borrowing requires credit negotiations, the drafting of mortgage and security agreements, and registration with the relevant authorities.
• Tax Treatment: Distributions are affected by income tax rules and taxes on dividend distributions. Loan interest, however, is treated as a tax-deductible expense subject to specific requirements under tax law.

Conditions and Practical Circumstances for Selection

When Is a Capital Increase the Most Appropriate Option?

1. Startups & Scale-ups: When their operations require substantial cash inflows for innovation and expansion without incurring immediate repayment obligations.
2. Companies with High Leverage: Adding new loans may present a risk that exceeds prudent financial limits and may lead to a deterioration in the company’s credit rating.
3. Long-Term Development Projects: Projects that do not generate rapid cash flows sufficient to cover immediate debt service obligations.

When Is Borrowing the Better Financing Option?

1. The Need for Short- or Medium-Term Operational Financing: To finance working capital or purchase specific equipment capable of generating rapid returns.
2. The Existing Partners’ Desire to Retain Full Control: And avoid admitting new parties that would participate in the company’s decision-making and management.
3. Low Interest Rates and the Availability of Favorable Credit Facilities: When the cost of borrowing is lower than the anticipated return on investment.

Legal Risks and Commercial and Operational Implications

Every financing step is associated with a range of risks that may directly affect the company’s continuity. Their nature varies according to the instrument selected.

Capital Increase Risks

• Dilution: A reduction in the ownership interests of the original shareholders and a decline in their ability to block or influence decisions within general assemblies.
• Valuation Disputes: Disagreements over the fair value of the incoming investor’s interest, which may delay the transaction or give rise to litigation.
• Restrictions Arising from Shareholders’ Agreements: Potential conflicts with pre-emption provisions or rights established under (Tag-Along / Drag-Along) clauses.

Borrowing Risks

• Financial Covenants Breach Risks: The company may be unable to comply with the financial ratios stipulated in facility agreements, thereby entitling the bank to declare the entire debt immediately due and payable.
• Enforcement against Security and Assets: Lenders may initiate compulsory enforcement against the company’s tangible and intangible assets registered in the commercial register or the movable collateral registry.
• Personal Liability of Managers: These risks arise when managers sign security cheques or personal guarantees without observing the requirements of proper legal authorization.

Special Considerations for International Clients and Foreign Investment

For foreign investors and multinational companies operating or investing in Egypt, financing planning becomes even more important in view of several specific factors.

1. Central Bank Rules and the Repatriation of Profits and Capital: It is necessary to ensure that capital is deposited through official banking channels and that “foreign funding certificates” are issued to facilitate the future repatriation of profits or liquidation proceeds abroad.
2. Implicit Deficit and Disguised Financing Rules (Thin Capitalization Rules): Egyptian tax law imposes limits on the debt-to-equity ratio, generally 1:4, and interest on loans exceeding this ratio is not deductible from the taxable base. This requires careful legal treatment of loans provided by parent companies to their subsidiaries.
3. Foreign Exchange Fluctuations (FX Risk): Foreign currency-denominated loans must be assessed against revenues generated in local currency, with hedging and risk provisions included in the relevant agreements.

Common Mistakes in Selecting and Implementing Financing Methods

• Exceeding Authority and Disregarding the Articles of Incorporation: Entering into loan agreements or resolving to increase the capital without obtaining the required authorizations from the competent authority, whether the board of directors or the general assembly.
• Failure to Register Security in the Movable Collateral Registry: This may invalidate or subordinate the lender’s priority in relation to other creditors.
• Relying on Standard-Form Loan Agreements or Subscription Agreements: Without including clear dispute resolution mechanisms, investor exit terms, or debt restructuring provisions for times of crisis.
• Mixing Personal and Corporate Financing: Partners may provide personal guarantees for the entity’s loans without clearly defining the limits of such liability.

Practical Best Practices

1. Conducting Comprehensive Due Diligence: From both financial and legal perspectives, before signing any investment agreements or credit facilities.
2. Preparing a Clear Delegation of Authority Matrix: By reviewing internal resolutions to ensure that the decision-maker acts under a valid power of attorney or authorization in accordance with the law and the articles of association.
3. Structuring Hybrid Financing (Mezzanine / Convertible Debt): By using instruments such as convertible bonds, which combine the advantages of debt with the protection of equity rights.

When Is the Involvement of a Specialized Lawyer or Local Counsel in Egypt Required?

Regulatory and financial complexities require companies to engage legal counsel at specific stages, particularly when structuring financing or arranging its security.

• When structuring or negotiating major financing agreements with banks and international financial institutions.
• When drafting or amending shareholders’ agreements (SHA) and articles of association to accommodate the admission of new investors.
• When preparing, implementing, and filing capital increase procedures with the General Authority for Investment and Free Zones (GAFI).
• When assessing the validity of mortgages and registrations in the movable collateral registry and ensuring compliance with tax rules and the regulations of the Central Bank of Egypt.

How Can Specialized Legal Support Help?

The legal team at El Rouby Law Firm provides comprehensive and tailored support to companies and investment institutions throughout the process of selecting and implementing financing mechanisms through:

• Regulatory Compliance: Completing all procedures before the General Authority for Investment and Free Zones (GAFI), the Financial Regulatory Authority (FRA), and the Commercial Registry.
• Risk Management and Transaction Structuring: Providing strategic advice on capital increase or borrowing and how a company should choose its financing method, in a manner that achieves its expansion objectives and reduces the risk of legal liability.
• Drafting and Reviewing Agreements: Preparing syndicated loan agreements, mortgage and security agreements, share subscription agreements, and shareholders’ agreements to a high professional standard.
• Dispute Prevention and Negotiation: Representing companies in negotiations with financial institutions or new investors to ensure a balanced allocation of obligations between the parties.
• Representation before Egyptian Authorities and Dispute Resolution: Providing Local Counsel services and legal representation before the economic courts and arbitral tribunals in the event of any financing dispute.

Conclusion

Selecting the appropriate financing method is not merely an accounting step; it is a fundamental determinant of the commercial entity’s future and legal soundness.

Accordingly, a careful analysis of the implications of a capital increase or borrowing ensures the company’s balanced growth while protecting the rights of shareholders and creditors alike.

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Frequently Asked Questions

What Is the Fundamental Difference Between a Capital Increase and Bank Borrowing?

A capital increase involves introducing financing in exchange for ownership interests in the company, without an obligation to repay the principal amount. Borrowing, however, involves obtaining external financing that the company must repay with interest according to a specified schedule, without relinquishing ownership in the company.

Does Borrowing Require the Approval of the Company’s General Assembly in Egypt?

This depends on the company’s articles of association. If they grant the board of directors or the manager unrestricted borrowing authority, general assembly approval is not required. If they impose restrictions or specified amounts are exceeded, a resolution of the general assembly is required.

What Is the Permitted Tax Ratio for Deducting Loan Interest in Egypt?

The Egyptian Income Tax Law provides that interest on loans exceeding a debt-to-equity ratio of 4:1 is not deductible, and any excess is not recognized as a tax-deductible expense.

May Existing Shareholders Object to a Capital Increase Intended to Admit a Foreign Investor?

The law grants existing shareholders pre-emptive subscription rights. These rights may only be suspended by a resolution of the extraordinary general assembly based on serious grounds set out in a report approved by the statutory auditor.

What Are the Legal Risks of Providing Company Assets as Security for a Loan?

The primary risk lies in the lender’s right to enforce against these assets and sell them at public auction in the event of default on installment payments, which may result in the suspension of the company’s operations.