Don’t expose yourself… Be a clever lender to your company.

This article by Robbie Gimblett originally appeared in the August 2005 issue of NZ Business.

Do banks and financial institutions lend funds to private companies without security or some type of priority regarding payment? Absolutely not! Why then do so many private business owners do exactly that in relation to their businesses?

Most private business owners have a debt due as a shareholder of the business. These loans often arise when the business is first established and increase as the company grows through its life cycle.

With the many benefits of owning shares in private companies through family trusts, we are also seeing larger debts accumulating to the trustees of family trusts as the legal owners, due to dividends being declared but not fully paid.

It is not unusual for private companies to have working capital tied up in debtors, stock and other assets, resulting in dividends being credited to shareholder advance accounts as opposed to being fully paid in cash.

It is commercially prudent for shareholders to fund a company through advance accounts rather than it all being through shareholder capital. Reasons include:

advance accounts can have priority in relation to repayment;
it is a lot simpler to extract funds by repaying loans than it is to return shareholder capital.

Banks and financial institutions require repayment protection in the form of a mortgage or a registered security interest over all the assets of a company or particular assets in order to protect advances.

These forms of security are not complicated or expensive to establish but give protection of the disposal of assets, and priority for repayment of advances to shareholders in the event the company fails and goes into receivership or liquidation. Such protection should be put in place by professional advisers to ensure security interests are perfected in accordance with the requirements of the Personal Property Securities Act 1999, a piece of legislation that is often not well known by owner operators of SME’s.

Repayment priority is unlikely to be ahead of the bank, but will rank ahead of other parties such as unsecured creditors and the IRD in relation to certain taxes.

I will never forget an assignment we were involved with several years ago where a couple spent their lifetime developing a textile business which failed through external economic and industry issues (not poor management). As times got tough and the company needed further funding their house was sold and the funds advanced to the company. Thank goodness their advisor at the time secured the advances through a second debenture ranking behind the prime bank funder.

When the business failed they received a reasonable amount of funds from the liquidator, allowing them to buy a small home and get on with life. Certainly a much better scenario than being totally cleaned out!

It is also worth noting that trustees have fiduciary obligations to the beneficiaries of the trust. Hence it amazes me that I still see a large number of quite significant advances from family trusts (including professional advisors as independent trustees) to private businesses where there is no security in place.

These trustees are exposing themselves as it could be argued such advances are reckless and not in the beneficial interest of all beneficiaries where there is no security and terms often include no interest or charges being incurred.

Many shareholders of private companies are complacent in relation to their lending and security arrangements. This exposes them to unnecessary financial risk and trustees particularly need to better understand their fiduciary responsibilities.