In business finance, there are many ways for companies to raise capital and fund their options. One such method is shareholder loans. But what is a shareholder loan exactly, and how does it work? How do these loans differ from traditional bank loans in terms and conditions and risk? Let’s take a look at this often-forgotten method of corporate financing.
What is a shareholder loan?
A shareholder loan is a form of financing where a shareholder lends money to the company they own shares in. It is a debt obligation of the company to the investor, similar to a term loan from a bank or other external lender. Shareholder financing may be more flexible in interest and terms than bank loans and carried as short-term or long-term liabilities.
What is the purpose of a shareholder loan?
A shareholder loan provides short-term or long-term financial support for corporate operations. For example, a company may need money to expand its operations or invest in new projects. Instead of capital in the form of equity or approaching a bank or other external financing sources, the company can turn to its shareholders for financial support.
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What are the terms and conditions of a shareholders’ loan?
An investor, or investors, who are willing to lend money to the company can provide a loan under agreed-upon terms and conditions. The terms of a shareholder loan can vary depending on the agreement between the company and the shareholder.
Typically, the loan will have an interest rate, duration, and repayment schedule. The interest rate may be lower than what a bank would charge, making it an attractive option for both the company and the shareholder.
Shareholder financing is generally more flexible. Unlike traditional loans, which often have strict repayment terms, investor loans can be more lenient. The company and the shareholder, or shareholders, can negotiate the repayment terms and adjust them based on the company’s cash flow and financial situation.
Implications for shareholders
Shareholder loans come with risks. Unlike bank loans, shareholder loans are often made between parties who know each other well and have deep personal and professional connections. But there are also various technical implications that both parties must consider.
Risk and return
Shareholder lending carries risks and potential returns for the shareholder or shareholders providing the loan. By lending the company money, shareholders can contribute to its success and potentially earn interest on their loaned funds. Likewise, this shareholder financing may save the company money in bank interest charges, further valuing their company holdings.
However, if the company fails to perform and faces insolvency or bankruptcy, the shareholder risks losing their investments in terms of both equity and financing.
Tax considerations
Shareholder financing can have tax implications for the company and the lending party. Interest paid on the loan may be deductible for the company, reducing its taxable income. However, the lending shareholder may need to report the interest income on their personal income tax return and pay any taxes owed.
Before moving forward with an investor-backed loan, both parties must consult their respective legal counsel regarding their corporate tax or personal tax liability.
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Implications for the company
Companies must consider other implications when receiving a loan amount from a shareholder of a corporation who already knows the business.
Debt obligation
A shareholder loan creates a debt obligation for the company. The business must repay this obligation to the lending shareholder. Since accounts record the loan as a liability on the company’s balance sheet, it affects its financial position and creditworthiness.
Financial flexibility
Shareholder lending can provide the company with financial flexibility, especially when traditional financing options are limited or expensive. They can be a source of quick and accessible capital, allowing the company to meet its financial obligations or seize growth opportunities.
However, since a shareholder’s loan to the company uses personal funds, the loan should be structured properly to avoid any conflicts of interest or legal issues. The loan agreement should include all the necessary terms and conditions to protect the parties. It should also maintain a running shareholder loan balance to ensure a smooth and transparent transaction and repayment.
Is a shareholder loan a debt or equity?
A shareholder loan is a debt. Depending on the loan term, it will be recorded as a short-term or long-term liability. Investor loans were created so a company could borrow money from its investors. But the company repays the loan, often with interest. This transaction separates it from the investor’s equity holding in the company.
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Important notes
There are various types of shareholder loans. They may be used to expand human resources, increase operational capacity, or acquire other businesses. Ensure that the loan’s use is documented in the loan agreement.
Shareholders can also borrow money from a corporation. Though less common, an owner's cash withdrawal not recorded as a salary or dividend may be recorded to the shareholder’s loan account.
However, do not scare shareholders by being the owner who withdraws money after a shareholder loan is made. Do not scare investors by pressuring them to overstretch themselves by putting the loan on a personal credit card. While the shareholder will pay with personal funds, the loan should be an amount they are comfortable with and can afford.
Remember, a running shareholder loan account will help maintain a seamless and above-board transaction.
This video is a great review of shareholder loans, how to use them, and how tax issues with the CRA.
Conclusion
Shareholder loans are an excellent way to grow a business. Shareholder financing is typically more flexible and affordable than traditional bank or financial institution loans. However, the parties to the loan must understand the funding scope, terms and conditions, potential risks and rewards, and tax implications.
Businesses should take on any new debt carefully. This applies not only to shareholder-provided credit but also to credit cards and lines of credit, high-interest term loans, or invoice financing (also known as factoring).
Creditpicks has numerous articles regarding starting and building a business. We source information from the Government of Canada, leading online media and publications, and academia. Check back often for new updates or subscribe to our email list or browser alerts. You can also find low-interest personal loans through Spring Financial.
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