Starting a new business, or expanding an existing one usually requires significant funds. Securing a bank loan to enable cash flow is one option, however in our experience the banks are so risk averse that their requirements for real estate security to cover their exposure can make this option unpalatable.
Consequently business owners often fund start-ups using their personal financial resources. We often see examples of individuals who have advanced funds to a family company. Whilst these “at call” loans are common and acceptable practice, care and expertise is required to ensure that the appropriate protections are in place for the lender.
To illustrate the importance of adequate formality and structure of such shareholder loans, consider the following catastrophic example:
John and James want to establish a new company, and they require $1.0m to acquire goodwill, buy stock and provide working capital. John and James combined have the required $1.0m as cash reserves, and they are advised to invest through a $2 shelf company, with the balance of $999,998 advanced to the new company as a shareholder loan. They are soon swamped with the daily business of running the enterprise and trying to make it profitable, and they choose not to spend money on anything that doesn’t make their company a quick return. Their accounts show they have loaned $999,998 as an “at call loan”. The loan is never formalised nor secured. The company has one major creditor – an overseas manufacturer who has retention of title over the assets advanced and a director’s guarantee should there be any funding shortfall. All goes well until 2 years later when the company hits a major trading hurdle from events which were totally unforeseen – the collapse in the $A by 40%. Concerned about the company’s position, their major supplier moves quickly and appoints a liquidator. John and James and their inadequately documented $999,998 loan is now at the end of a long queue of unsecured creditors. Their financial destiny is now in the hands of the liquidator appointed by their major supplier.
This situation is easily avoidable with sound advice and attention to detail:
1. Structure the Debt and Equity Appropriately: Had the company been structured with the correct balance of debt and equity, for example, $400,000 in share capital and $600,000 as a shareholder loan, they could have avoided director guarantees as the company would have had reasonable paid-up capital.
2. Formalise Loans: Shareholders should pay attention to detail and properly minute loan advances. A formal loan agreement with commercial terms should be established, secured by a floating charge over the assets of the company, registered on the PPSR (Personal Property Securities Register) and stamped by the Office of State Revenue.
Had this been in place when the company encountered financial difficulty, John and James would have been the first ranking secured creditor of the company, and as such would have had control in determining their company’s destiny, rather than the liquidators appointed by their supplier.
Attention to detail, appropriate structuring of debt and equity, spending the money on professional advice, then protecting your interest with a PPSR registration and a charge over your company’s assets can mean the difference in saving or losing a significant part of your capital in a corporate collapse. We have witnessed too many examples where individuals have sought advice too late – in the excitement of starting a new venture, they didn’t take the time to consider the consequences of it not succeeding.
For more advice on this or other business matters, please give us a call on (02) 9908 9888.