Owner Managers are often required to advance personal funds to their business when available capital, including bank financing, retained earnings and shareholders’ equity, is not sufficient to meet working capital demands. The advances can be in various forms including direct transfers, reduced pay, or charging business expenses to a personal credit card, and are often done urgently and as a practical matter – the business needs cash.
It is typical for Owner Managers to simultaneously fill many roles in a corporation, all with unique rights and obligations. Examples include: Common Shareholder (majority or minority), Preferred Shareholder, Officer, Director, Employee and, when shareholder advances are made, Lender.
But, with the day to day pressures of running a business, the different rights and obligations of each role are often ignored. As an Employee, the Owner Manager is paid last; as a Director, the Owner Manager is not compensated at all; as a Lender, the loans are not documented, not secured and repayments are not scheduled.
What is the difference in substance between a bank loan and a shareholder loan? Very little, apart from the bank taking the time to document the loan and its security. We always advise Shareholders to treat their corporate advances as real loans, which means they should be documented with scheduled repayment terms, reasonable interest and, when possible, security over the assets of the company.
Consider a company we once advised that had two equal shareholders. One shareholder did the work and was paid fair value for employment. The other shareholder provided the money, which, the partners had agreed, was loaned to the company with a credit facility and general security agreement prepared by corporate counsel.
As often happens, the company stumbled and there was a bitter falling out between the shareholders. Who won the battle? The shareholder with the secured loan because, when it comes to matters of restructuring and insolvency, secured debt trumps unsecured debt, which, in turn, trumps shareholders. The shareholder with the secured loan demanded on the loan, acted on the security and took over the entire business, effectively ousting the partner and third party unsecured debt (suppliers).
Owner Managers sometimes object to treating shareholder loans as loans because they intend to attract other investors, or a bank, and they fear that investor will want to see the owner’s investment recorded as equity. While this may be true, it is no reason to avoid properly documenting the loan now. In the future, one can always negotiate with the new investor and agree to a subordination, postponement or conversion to an unsecured loan or equity.
Shareholder loans are loans and should be respected as such:
- Execute a Loan Agreement and requisite corporate resolutions;
- Execute all Amendments to the Loan Agreement;
- Execute a Security Agreement;
- Register the Security;
- Maintain a paper trail of all advances; and, most importantly,
- Seek help from your lawyer because the legal treatment of shareholder loans, even when properly documented, will vary from jurisdiction to jurisdiction.