Lending to Yourself

"Good news, Harry! We've reviewed your company's application to the Bank for the $100,000 operating loan and we've agreed to advance the funds today. The terms of the loan are as follows: there will be no security, no interest charged and the loan will be repayable when you have the extra cash to pay us. We hope you will agree to accept the loan under these terms".

Stop laughing!! Did you just say that no bank would be crazy enough to make a loan under these terms? And what was that about the bank having to protect its depositors' money when lending? And what was that about earning interest on depositors' funds?

Seriously, a Banker who made that loan would be guilty of the most extreme career-limiting move possible. A Bank that intended to stay in business would almost never make that loan without security over the business assets - accounts receivable, inventory, equipment, furniture, and anything else of value.

Now let's take a look at your company's balance sheet. If your company owes money to you, its shareholder, is that loan unsecured, interest-free and open for repayment only when convenient? Why are you not entitled to the same protection that your banker would require from the company before lending it one dollar? In fact, not only are you entitled to the same protection, you should demand it! Perhaps your company has already borrowed from a Bank and has pledged all its assets as security for that loan. Remember that, in the event a financial crisis forced the liquidation of those assets to repay the Bank as secured creditor, any surplus funds remaining after full repayment to the Bank would be available for sharing by all unsecured creditors. If your shareholder's loan were properly secured and registered, you would be next in line to receive the surplus funds. Remember also that the bank's position may change dramatically from the date you advanced your loan until the time when assets are being liquidated. There may even be no money owing to the bank when the liquidation takes place, in which case your loan would enjoy a first position over the proceeds.

There are a number of ways to secure your shareholder's loan. The most common is to obtain a general security agreement. This is a document given by the company, pledging basically all the assets of the company as security for repayment of your loan. The general security agreement must be properly registered. In Ontario, for example, it would be registered under the Personal Property Securities Act. You should have it completed by your lawyer at the time of advancing funds, because even the slightest error could negate the registration. This type of security is usually provided to support a documented loan agreement which would reflect the conditions under which the loan is being advanced, the rate of interest being charged, the terms of repayment, and the conditions under which you, as the secured lender, have the right to seize and dispose of the collateral in order to repay the loan. In the normal course of business, this documentation will have no immediate bearing on the company's operations. However, circumstances change. An unanticipated lawsuit could render the company insolvent. A dramatic reversal of fortune in the marketplace, or some other catastrophe, could suddenly change your focus to one of preserving your own personal position ahead of the company and its unsecured creditors.

Your company's obligations to its unsecured creditors are as real as its obligations to its bank and to yourself. There is nothing improper or immoral in establishing your priority position in this manner. The very fact that you are operating a "limited liability corporation" serves notice to your creditors that they are unsecured if the business fails. They always have the right to search under the Personal Property Securities Act and determine who is registered ahead of them. They also have the right to demand security from the company before they sell to it on an unsecured basis. That is always a matter of negotiation. Creditors can obtain, for example, either a Purchase Money Security Interest in the specific goods being sold to you, or a General Security Agreement over all company assets.

When Trustees in Bankruptcy distribute liquidation proceeds to unsecured creditors, loans from shareholders are often included in the category of unsecured debts. As a result, it is common for shareholders to realize only a small pro -rata portion, if anything at all, out of the available funds. However, in situations where the loans have been properly advanced and appropriate security has been pledged and registered, shareholders receive their money ahead of the unsecured creditors. And, in these instances, a shareholder loan is often frilly repaid.

An additional benefit of properly securing shareholder loans arises when the company is facing financial pressures. Having a shareholder's secured loan in place will sometimes allow certain reorganization options to be implemented, which would not be possible without the secured loan being there. The point is that, for a minimal cost, no matter how healthy the business is at the time of the loan, shareholders should always secure their loans to their corporations. Shareholders never invest money in their businesses with the expectation that the business will fail. Yet things change and some businesses do not survive. An investment in your business deserves the same care that you would apply to any other investment, and at least the same protection that a bank would require when lending to your business.

Contributed to businessmatch-maker.com by Frank Kisluk.