You And The Law: Protecting Your Shareholder Loan

New businesses are often set up as companies to limit the liability of the shareholders (i.e., the owners). Typically, you as a shareholder invest some cash – a small amount goes toward paying for your shares and the rest is money put in to your new company to finance its start-up expenses. how do you protect t

If the business goes bust, you lose the minimal amount you paid for your shares. But he rest of your investment so you don’t forfeit that too?

If you simply provide money to the company without doing anything else, it may be considered a capital or equity contribution (made for the purpose of sharing in the company’s profits) rather than a shareholder loan, depending on the circumstances. For example, if payments to the company are made in proportion to the shareholders’ ownership interest, they might be considered equity contributions rather than debt. So if three shareholders loan $10,000 to the company, and the shareholder with 10% of the shares lends $1,000, the 20% shareholder lends $2,000 and the 70% shareholder lends $7,000, their investments might not be characterized as shareholder loans.

The difference is important. If the company goes bankrupt and your advance of money is a capital or equity contribution, you may get nothing. This is because all creditors and lenders get paid first. 

Getting the company to sign a promissory note would help to show that your investment is a loan.

But as an unsecured creditor, you would still only rank equally with other unsecured lenders and creditors at best. If the company’s assets aren’t enough to pay all its debts and liabilities, the law is such that the remaining assets would first go toward paying the secured creditors. Then the unsecured creditors would be paid on a pro rata basis (your company couldn’t pay off your loan first before repaying other unsecured loans). So if you loaned $5,000 and another unsecured lender loaned $10,000, and the company only has $1,500 in assets left, you’d receive $500 and the other lender would get $1,000. 

However, you can help protect your loan by making yourself a secured creditor. As a secured creditor, you would rank ahead of the unsecured creditors and receive repayment of your loan before they would be entitled to anything.

How do you do this? The company would grant you a security interest in its assets. If the company owns real estate such as land or a commercial building, then a mortgage could be registered against that property to secure your loan. Where the company owns other assets like machinery, factory equipment or office furnishings, then a general or other security agreement could be put in place, giving you security under the Personal Property Security Act in those assets. Having a mortgage or security interest would give you the right to sell the secured asset to help repay your loan.

If the company also borrows money from a bank at the same time or later, the bank will probably insist that its security be given priority over your shareholder’s security. So you might end up having to sign a priority agreement with the bank acknowledging the priority of the bank’s security. But your lawyer can structure your company loan to help ensure that you have the best chance of getting your money back in the event of future problems.

 

This column has been written with the assistance of ANDREW LAU. The column provides information only and must not be relied on for legal advice. Please contact ANDREW LAU at (604) 681-3833 for legal advice concerning your particular case. 

 

Lawyer Janice Mucalov, author of this article, writes about legal affairs for several publications. “You and the Law” is a registered trade-mark. © by Janice Mucalov.

 

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