Lending money to your limited company, as a shareholder or director, can be a very sensible way of providing much needed cash in the business whilst avoiding tying up your personal resources in share capital.
However, it is worth carrying out some careful planning before making a loan to ensure that your contribution is recognised in the event that the company grows and/or is sold and also to properly consider any risks there might be to the loan being repaid.
- What is a shareholder/director loan and how do they work?
- What are the advantages lending money to your own limited company?
- What are the disadvantages of providing a shareholder/director loan?
- Risk to repayment if you and your fellow directors/shareholders disagree
- Risk to repayment if the company runs into financial difficulty or becomes insolvent
- You receive no additional upside in the event that your loan creates growth in the company that increases its value
- Shareholder/director loans can lack the focus and rigour of commercial loans
- What due diligence should you do before making a shareholder/director loan available?
- What are the benefits of the shareholder/director loan terms in writing?
- What would go into the shareholder/director loan documentation?
What is a shareholder/director loan and how do they work?
A shareholder or director loan is where you directly provide funding to your company from your own resources on the basis that this funding will be repaid to you by the company.
It is distinct from you taking share capital in your company in that your existing shareholding in the company does not increase by virtue of the loan itself and you therefore acquire no additional shareholder rights, rewards or risks.
The loan is accounted for on your company’s balance sheet and the only obligation on the company is to repay the loan to you with or without interest, as determined by you.
What are the advantages lending money to your own limited company?
There are several advantages to you lending money to your limited company:
Shareholder/director loans are quick and straightforward
It is quick and easy for you to provide a cash loan to your company.
Unlike investing in share capital or taking out a commercial loan, there are no mandatory forms to fill in and no particular process to complete. In fact, many times, there is no paperwork at all, not even a loan agreement. You just transfer the money into the company bank account and it appears on the company balance sheet.
Shareholder/director loans typically have no restrictions as to use
Unlike many commercial loans, typically there are no restrictions or stipulations as to how the company must use the loan funds.
As a shareholding director, it will be in your power, together with your fellow directors, to decide how you use the loan to further the best interests and business goals of the company.
Shareholder/director loans do not impact the shareholder structure
Unlike investing by taking additional share capital, when you lend money to your company, the shareholders and shareholdings do not change in any way.
Shareholder/director loans allow you to control repayment
Shareholder loans are often undocumented and in the majority of cases, repayable on your demand. This allows you, as the lender, to time repayment so that it suits both your company and yourself, subject to there being sufficient funds in the company for the repayment to take place.
This is in contrast to providing cash to your company by increasing your share capital, where it can be challenging to access the cash that you have invested, other than by sale or transfer of your shares or the company itself.
Interest can be charged on shareholder/director loans
You can charge interest on your loan. For your company the interest counts as a business expense and is deductible from profits.
However, interest is rarely charged on shareholder loans as it is taxed as income and therefore carries personal tax implications for you as the lender.
What are the disadvantages of providing a shareholder/director loan?
Risk to repayment if you and your fellow directors/shareholders disagree
Making a loan available to your company makes a lot of sense, when you and your fellow shareholding directors agree generally and particularly on the course of direction of the company, as in those circumstances, you can be confident of repayment.
However, and particularly if the loan is not by written agreement, there is a risk to you being repaid in the event that you and your fellow directors disagree.
The simple mitigation for this is to make sure the terms of your loan are in writing, and especially those terms specify when and how repayment will be made. This can be in a simple loan agreement between you and your company or in the shareholders agreement between you and your fellow shareholders.
Risk to repayment if the company runs into financial difficulty or becomes insolvent
In order to have your loan repaid, the company must make money and be able to pay its debts.
In the event that the company becomes insolvent and cannot pay its debts when they fall due then there is a risk that your loan is never repaid. There is a ranking of creditors in the event of the insolvency and liquidation of a company and loans to the company made by people with a connection to it rank at the bottom of the list of those creditors.
Equally, if your company is running into financial difficulty then any repayments made to you by the company can, in several circumstances, be clawed back by a liquidator in the event that your company becomes insolvent.
Having said that, investing by way of share capital does not provide any additional protection in the event of insolvency, as shareholders are the very last group to receive payment from any remaining assets of the company, if any.
If your loan is sizeable and intended to purchase certain assets for the company, then it is worth considering whether it is appropriate for you to take any security over those assets, which will improve your ranking and likelihood of getting paid, in the event of insolvency of the company. This all depends on the circumstances of your company, including whether you have any other commercial loans in place, as they may restrict how your company borrows.
It is a balance deciding how to fund your company, especially in the early stages, as commercial lenders will often require personal guarantees from shareholding directors, which can put your personal assets at risk in the event of your company becoming insolvent. A personal loan of an amount that you can afford to lose, if the worst comes to the worst, may seem attractive in comparison.
You receive no additional upside in the event that your loan creates growth in the company that increases its value
In the event that your loan is a key factor in the growth and success of your business and you eventually sell the company, then you might miss out on a sizeable return.
Typically, when a business is taken over, all debts are settled, including the repayment of any loans made by shareholding directors. Therefore, in this scenario, your loan would be repaid but as your shareholding remained the same, you would not receive any higher payout on your shares than any other shareholder because your shareholding did not increase as a condition of your loan.
If the amount of loan that you are providing is significant and there are other shareholding directors in the business who are not matching your loan, then you may want to provide that you receive some upside in the event of sale or receive additional shares in the company, in recognition of the additional support that you have provided. Alternatively, you could include in the loan agreement for the loan to turn into shares in specified circumstances, based on an agreed mechanism and valuation – simply saying that the loan is convertible without specifying the terms will not mean anything.
Shareholder/director loans can lack the focus and rigour of commercial loans
Applying for a business loan from a commercial lender often involves the preparation and production of detailed business plans and rationale.
Loans provided from shareholding directors are often not accompanied with the same rigour. There is a risk in this in that you make decisions that do not make best use of the cash that you are making available and therefore put the repayment of that cash in jeopardy.
What due diligence should you do before making a shareholder/director loan available?
There is limited technical due diligence required in order for you to make a loan to your company. The Articles of Association should be checked to confirm that loans from shareholders and/or directors are allowed.
Commercially, it is worth paying particular attention to your business plan in terms of where the loan will be applied and also when repayments are appropriate to suit both you and your company.
What are the benefits of the shareholder/director loan terms in writing?
The main benefit of documenting your loan is that it provides certainty in terms of when and how you will be repaid, assuming that the company has the funds to repay you.
This protects you in the event of any difference of opinion between you and your fellow shareholders and/or directors.
Equally, you may wish to recognise your additional contribution to the company by documenting that you will receive some form of additional upside in the event that the company grows and is sold, such as how the loan might convert to shares.
What would go into the shareholder/director loan documentation?
Loan documentation in these circumstances can be very simple.
It can take the form of a separate short loan agreement or can be inserted in general terms into the shareholders agreement if you are about to enter into a shareholders agreement.
The main provisions that will be covered are:
• the loan amount;
• when the loan will be repaid or a repayment schedule and the events that might trigger immediate repayment;
• whether any interest is due;
• what happens if you decide not to seek repayment when repayment falls due for whatever reason;
• any stipulations as to the use of the loan;
• the effect on the loan of any events such as sale of the company.
If you would like to explore any of the issues covered in this article please contact our corporate law team who are well placed to take this forward with you. Call us on 0800 689 1700 or fill out the short enquiry form below and one of our team will be in contact with you.