It is quite common for a business owner to provide a personal loan to their business to fund working capital demands, capital purchases and expansion plans. This may be because you have some spare cash, you have exhausted your business funding lines, or just because it seems an easier option than dealing with the paperwork and high interest rates demanded by third-party lenders.
Before you put more of your personal wealth on the line to help your business, consider adopting these strategies to ease potential future pain.
Protecting your personal wealth
As a starting point, we always recommend that business owners keep their personal wealth separate and distinct from their risky business activities. For this reason, many owners operate their business through a company and hold personal assets in a trust or in the name of a spouse not involved in the business.
It may seem obvious, but people often overlook a critical first question – would you lend to this business if you didn’t also own it? Put another way:
- Is your business objectively viable is your business?
- Will your business be using the funds to create more wealth, or plug a hole?
- Will you ever see this money again – and will it come with a healthy return?
When people put more money into their business, particularly when it is struggling, they are often making an investment in their ego. It can be hard to admit defeat, but it is always better to call time-out when you have personal resources outside of your business with which to fight another day.
If you decide to lend your business money, you need a strategy to ensure that you will be repaid if something does go wrong in your business. You do this by acting like a bank!
Document your loan
When you access personal wealth to loan money to your business, you need to accurately document what is going on. When we say document, we don’t just mean a short ‘minute’ prepared 18 months after the event. A minute is not an agreement and will not be legally binding on your business (or anyone else). When we document loans, we do so by means of a ‘Deed’. This provides the strongest and most enforceable legal obligation.
There are several reasons for properly documenting your loan, including:
- Documentation means that you have a legal right to be repaid, and receive interest (if applicable);
- The Tax Office will understand what you have done. If you later repay the loan, you must be able to convince the Tax Office that you are only getting your non-assessable capital back; and
- If you have business partners, you need to record who has contributed what, and on what terms. You must have the legal right to repayment of your capital before distributions of profit to other owners.
Most importantly, without an enforceable loan agreement, if your business becomes insolvent, at best you will line up with all the other unsecured creditors to get your money back. At worst, your contribution may be seen as an injection of capital, that sits behind both secured and unsecured creditors in priority.
We therefore recommend you document the loan in the form of a commercial loan agreement that includes a comprehensive security clause. This agreement must clearly identify your financial assistance as a loan and give you security over your business’ assets.
Take comprehensive security
As a term of your loan, you should require your business to grant you a comprehensive security interest over all the business’ assets.
This is usually achieved through the combination of:
- An explicit clause in the loan agreement granting security (and agreeing to grant security in the form of a General Security Agreement) over all the present and future, fixed and circulating assets of your business (an ‘ALLPAAP’ security interest); and
- Entering into a separate General Security Agreement (GSA) containing compressive provisions that grant, acknowledge, and regulate the security interests that have been given to you to support the repayment of your loan.
To be effective, the security interests that support your loan must be registered on the Personal Property Securities Register (PPSR). The registration needs to take place within a short period of the loan being made to maintain your priority for payment ahead of other creditors. Please note, a loan, not supported by a properly perfected security interest on the PPSR, is not worth much.
The PPSR governs ‘security interests’ in ‘personal property’. Most types of property other than land are considered personal property for the purpose of the PPSR. This includes not only tangible property, such as goods, equipment, and cash, but also intangible assets like intellectual property, contracts, and shares and other financial instruments.
‘Security interests’ come in many forms, including interests that arise under hire arrangements, equipment financing, deferred payment terms, vendor financing arrangements and, for our purposes, loans.
Unsecured loans and the statute of limitations
Even with a properly prepared loan agreement, there is a risk that over time it becomes ineffective. Under each State and Territory’s Statute of Limitations, an unsecured loan agreement ‘expires’ if no repayments are made or none are demanded. In all but the Northern Territory where the statute of limitations is 3 years, the limitation period for unsecured loans is 6 years. Keep your company loan agreement ‘fresh’ by either, making some repayment or demand, or entering a simple deed of recognition of the loan.
Do you need to charge interest?
The question many business owners ask is if it is necessary to charge interest on a loan made to a related entity.
There is no legal requirement to charge interest, but not charging interest can have adverse impacts. For example:
- If you have borrowed the funds (for example, against your home) to make the loan to your business, you will only be entitled to claim a deduction for the interest on your home loan if you charge at least the same amount to your business.
- If the loan agreement says that you must charge interest, and you do not charge interest, then this will undermine the enforceability of the loan if you need to demand repayment in the event of the insolvency of your business. This is because the liquidator will claim that the loan is a ‘sham’ and you never intended to enforce your rights under the loan agreement, as evidenced by the fact that you have not required the interest to be paid as specified in the agreement.
In short, you do not need to require interest payments, but if you specify interest needs to be paid in the document, then you need to ensure that you follow the terms of the document.
Think about what your business will be doing with your money
To protect your personal wealth, consider how best to apply the money you put into your business. There are some clever strategies that can improve you overall position:
Repay Loans: Many directors take remuneration as ‘drawings’ instead of being paid wages as an employee. This may save on employee on-costs, but it creates a loan owned by you (the owner) on the business Balance Sheet. If the business becomes insolvent, a liquidator will demand repayment from you for this loan balance. Therefore, if you have a loan balance, any money that you lend the company might best be used to reduce the amount you owe the company.
Use the money to pay employee entitlements: Under section 560 of the Corporations Act, if a person has advanced funds to a company for the express purpose of making payments in relation to employee entitlements (in particular, to wages, superannuation contributions, leave and termination of employment entitlements) then the lender will get a priority ranking if the company subsequently goes into liquidation. Accordingly, when relevant, you should specify that this is the purpose for which you are making the loan.
Take over secured interests: Instead of lending the money to your business, you might use your personal funds to ‘take over’ the loan of a third party lenders who already hold PPSR registered security, for example a bank. Provided you ensure that the PPSR security is not released, you will take over the bank’s security position.
Think ahead
If done properly, lending money to your business can increase your control over your business and improve your overall position. However, many people fail to understand or implement the correct options.
