One of the significant and often over-looked challenges for entrepreneurs and private business owners is to separately consider their various stakeholdings and to legitimize each of their roles as if they were being provided by a third party.
It is not unusual for business owners to simultaneously fill the roll of: common shareholder (majority or minority), preferred shareholder, officer, director, employee and/or lender. Each role has its own fair market rewards, risks and legal protections. But, with the day to day pressures of running a business, this is often ignored. As an employee, owners are paid last; as a director, they are not compensated at all; as a lender, they are undocumented and not paid back on time or with interest. These are all common examples of owners not treating themselves as they would be forced to treat others.
One of the most significant and missed opportunities is with respect to shareholder loans. What is the difference between a bank loan and a shareholder loan? Very little, apart from the bank taking the time to document the loan and take security. Shareholders can and should do this as well.
We are constantly advising owners to treat their shareholder loans as real loans. There must be documentation, terms, and security.
The security is the key. With security, you are the bank, subject to charges registered prior to yours, of course. With security you have rights as a lender that potentially place you above unsecured creditors, other shareholders, and various other claims against the company. With security, and a well drafted security document, you have the right to appoint a receiver if the company stumbles and, importantly, to affect a restructuring from a position of strength.
We recently advised a company that had two equal shareholders. One shareholder did the work and was paid fair value. The other shareholder provided the money – way more than they should have. The money was loaned to the company, was properly documented and was secured. All parties agreed to the loan.
As often happens, there was a falling out between the shareholders and the company stumbled. Who won the battle? The secured shareholder of course. They exercised their rights and now own the entire business without any participation by the other partner. Hopefully they can succeed where the other failed.
One of the objections we always hear when it comes to owners securing their shareholder loans is that, in the future, the company intends to attract other investors and they will want to see the owner’s investment as equity. While this may be true, it is no reason to avoid documenting the loan now and registering security. In the future, you can always discuss with new investors a subordination, postponement or conversion to an unsecured loan or equity.
Shareholder loans are loans:
1. Prepare and execute a Loan Agreement and requisite corporate resolutions;
2. Prepare and execute all Amendments to the Loan Agreement;
3. Prepare a Security Agreement;
4. Register the Security;
5. Create a paper trail for the advances (for example, if part of the loan is unpaid wages or expenses, pay yourself and the taxes, and then immediately put the available money back into the company); and,
6. Talk to your lawyer, one experienced in debt and security agreements.
This last point is important. Security isn’t effective if not properly documented and registered.
Posted by Scott Sinclair, Range Advisors
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