Protecting Your Investments
This is a series of columns that appear in Okanagan Business Magazine.
“You indicated in an earlier article that a shareholder in a company could protect their investment if the business went sideways, how can this be done?”
The protection of a shareholder’s investment in a company can be accomplished with some pre-arranged business planning.
When a shareholder originally invests money in a company which is traded on a stock exchange, the dollars that are paid for the shares represent the shareholder’s investment in the company. If the company fails, this amount will be lost.
In a company which is not publicly traded, the investment made by a shareholder is usually structured to consist of both a payment for shares and a loan to the company. The amount paid per share is minimal and the investment made for working capital is done by way of a loan to the company. This makes an investor in a company both a shareholder and a creditor, and it allows the principal of the loan to be withdrawn by the creditor without any income tax consequences. If the business fails, the shareholder still loses the minimal amount they have paid for their shares, but they do not necessarily have to jeopardize the amount that they have loaned the company.
When the loan is initially made, most shareholders simply advance money to their company and they remain as an unsecured creditor to their own company. If the company fails, and the assets are not sufficient to pay all of the company’s liabilities, then the assets that remain will be shared between the unsecured creditors on a pro rata basis after satisfying secured claims. This means that the shareholder will not receive any loan repayment in priority to the other unsecured creditors of the company, and may have to settle for less than the full amount of the loan they have made.
It is possible for a shareholder to make themselves a secured creditor so that they receive repayment of their loan in priority to all the unsecured creditors. To do this a shareholder treats their own company as if they are lending money to a stranger, and no different than the company’s bank would treat the company. The courts in British Columbia have held that it is appropriate for shareholders to secure their shareholders’ loans to their companies to create a payment priority over the unsecured creditors of the company. However, there are some steps to take and some things to be aware of to ensure that the intended secured position is obtained.
To effectively secure a shareholder’s loan, it is important to establish the mechanics of the lending arrangement at the earliest possible moment. Ideally the mechanism should be established before the loans are originally made, but they may still be effectively put in place afterwards, as long as the business has not begun to decline. If the mechanism is established at the time of decline, the priority over unsecured creditors will not likely stand up to a court challenge. The laws regarding the payment of creditors state that a debtor may not prefer one unsecured creditor over another, and if the assets are not enough to pay all the bills, then the unsecured creditors share the assets on a pro rata basis. If a shareholder waits to secure their loans until the business is in decline, then they risk having the mechanism set aside by a court and being considered as an unsecured creditor.
The first component of the mechanism is to make a loan agreement between the shareholder and the company which establishes all of the ground rules between the shareholder and the company. That agreement will dictate the full terms and conditions of the loan, including: the interest rate charged on the loan; the repayment terms; the possibility of future advances to the company; and, the security that is given to secure the investment. The agreement is preferably set up in advance of monies being paid and is the type of document that a bank would create if they were the lender.
The second component of the mechanism is the creation of the security that the company grants in its assets to secure repayment of the money. Assets fall into two categories, real estate and personal property. Where the company has real estate, a mortgage is registered against the land to secure the shareholder’s loan. Where the company owns other assets, a general security agreement is signed which grants the shareholder security under the Personal Property Security Act, in all of the company’s assets other than land. These security arrangements allow the shareholder to invoke the remedies contained in them when their loan is in jeopardy or the company has defaulted on the payment terms. The assets that are secured for payment of the loan are then available to repay the shareholder’s loan, after payment of any other secured claims that might be registered in priority to the shareholder’s security.
Usually a company obtains a certain amount of conventional financing from a bank and that bank will require its security to have priority over the shareholder’s security. This is accomplished by the bank and the shareholder signing a priority agreement acknowledging the priority of the bank’s security. The priority agreement is easy to create and the company’s bank should recognize the creation of the shareholder’s security as a prudent step in a well executed business plan.
Using a properly established loan mechanism allows a shareholder to ensure that they get their money back, immediately after the company’s lender. There should be no reason for a shareholder who loans money to their own company to share the assets of the company with other unsecured creditors, if they take these simple steps in advance.
It should be noted that the impact of the law on any given situation depends upon each individual’s circumstances and the opinions contained in this article should not be relied on for assessing anyone’s legal position. Advice should be obtained directly from our business law lawyers regarding your particular situation.