What Is a Shareholder Loan Agreement?
A shareholder loan agreement is just that, a contract between a company and a current shareholder of that company to lend money to that company for a specified purpose. The shareholder may want to loan the money to the company for any number of reasons including that the company is out of cash and can’t pay expenses or immediate creditors, they need cash to buy an asset and the bank won’t finance it or the company has unrestricted cash but the shareholder prefer that the company issues more equity instead of buying the asset.
Some common approaches to structuring a shareholder loan agreement include: 1) a loan at a fixed rate of interest; 2) a loan at a variable rate of interest; 3) a loan where the interest is only payable until the debt is paid; 4) a loan where the debt is paid over time and interest is also paid over time; 5) a loan where interest is only payable at maturity and over time at a prescribed rate.
The interest payable under a shareholder loan agreement is generally interest at a fixed rate calculated on the face value of the shareholder loan. The number of payments of principal and/or interest, the amount paid in each payment, the timing of each of the payments and how the payments are made are all set out in the shareholder loan agreement.
A shareholder loan agreement can be short-term (less than one year) or long-term (greater than one year) or be for a term that the parties decide . For example, if you know exactly what the shareholder loan is going to be used for, a shareholder loan agreement may be entered into for the term that the funds will be needed. If it is a long-term facility with ongoing advances and repayments, a credit facility agreement may be entered into. Both documents would include the same provisions and just differ in scope in this scenario.
From time to time, there may be circumstances when the company and a shareholder do not enter into a shareholder loan agreement and instead rely on a share purchase agreement to fund the acquisition of shares. In these circumstances, the subject shareholder does not borrow the funds from the company and instead receives an advance on the purchase price of their shares. If the consideration is less than the market value of the shares or the value attributed in the share purchase agreement, the shareholder may receive a shareholder loan instead of shares.
A shareholder loan agreement differs from other types of loans (for example, a bank loan) because generally it is unsecured and not guaranteed by a third-party. The lender also has control over the timing and amount of any repayments without being subject to additional contractual restrictions such as negative covenants or financial reporting requirements.
A shareholder loan agreement differs from a director’s loan agreement in that it is between the company and a director who is also a shareholder.
Key Elements of a Shareholder Loan Agreement
A shareholder loan agreement is a lender’s best friend. A well-drafted agreement can set out in some detail the parties’ intentions, specify the terms of the underlying loan and make certain future events more predictable – and, therefore, less risky. One of the most significant terms in any shareholder loan agreement is the principal amount, which is simply the total amount that needs to be repaid by the borrower. Like any loan, a lender wants to make sure that the full amount of the loan will be paid back in a timely manner, preferably with interest. In a shareholder agreement, it is often easy to determine the amount being lent, as it is usually a sum of money that the corporation has provided to the borrows over time, such as a loan by the corporation to the borrower. But joint determinations can be made about other amounts that will be lent. For example, a parent shareholder followed by a brother and sister shareholder could undertake to lend a total of $40 million to the corporation. The parent could lend $20 million, with the $10 million each from the brother and sister being in the form of loans from them. The parties can then potentially agree as to the terms and dates by which the funds are lent by each shareholder. Another key component of a shareholder loan agreement is the interest rate which will be charged on the amount of the loan, including all accrued but unpaid interest. Both the shareholder and the corporation may benefit from this component, as an interest-bearing loan can potentially be better from a tax perspective and a non-interest bearing loan could be the subject of scrutiny by the CRA. There are many ways in which interest can be charged. Interest on a loan might increase or decrease over time, and may or may not be tax-deductible. However, what is most important is that the parties are clear, consistent and accurate in their determination and use of any interest rate. Not only can an inconsistent interest rate result in significant miscommunications and disputes, but it may ultimately result in penalties or extra taxes being assessed by the CRA. Another key component of a shareholder loan agreement is a repayment clause. Under this clause, the parties must determine how the loan will be paid back, when it will be paid back, and whether the company may demand repayment within a certain period of time. Whether a shareholder loan is secured can make a difference here. For instance, a secured loan agreement often gives the secured party the right to demand payment in full if the borrower defaults under the agreement or takes on additional debts. Without collateral securing the loan, if the corporation falls to pay off the loan, the shareholder may be forced to write off the loss, or potentially pursue shareholder remedies against the corporation. A final key component of a shareholder loan agreement is a default clause. This clause clarifies when a default has occurred, and what remedies are available to the other party in the event of a default. A loan will typically be considered in default if the borrower has not made payments in accordance with the agreed-upon schedule. An interest-baring loan may include additional types of defaults, such as if the borrower does not pay interest when due or even where the amount of interest paid is less than the amount owed (where the liability is calculated in accordance with the loan agreement). A well-prepared shareholder loan agreement provides clarity to both the shareholder and the corporation and can save substantial headaches, time and money for both parties.
Legal and Operational Considerations
Shareholder loan agreements, while essential for the effective functioning of corporations, must also comply with various federal and provincial laws that govern corporate financing and lending. The Canada Business Corporations Act, for instance, imposes requirements and restrictions relating to loans that a corporation makes to its shareholders.
Some jurisdictions require annual reporting of disinterested shareholder approval for certain types of corporate loans to its shareholders and certain related parties and persons. These rules are part of the disclosure-based regime applicable to larger entities in Canada. We recognize that not all firms have a firm understanding of their obligations under securities legislation, which is why we are here to help ensure compliance and reduce risk from the liabilities associated with a breach. Even in absence of any express requirement for shareholder approval, a lender would be wise to obtain it, as compensation of directors, officers and other insiders can be challenged by dissatisfied shareholders.
In certain jurisdictions, such as Ontario, corporations with debt owing to non-arm’s length persons or entities (including shareholders) must have the debt approved by shareholders if the corporation becomes subject to the Companies’ Creditors Arrangement Act or the Bankruptcy and Insolvency Act (Canada). Failure to comply with this provision will result in an automatic subordination of the debt to the claims of unsecured creditors and can expose a corporation to the reputational damage that accompanies a bankruptcy filing and can even lead to potential liability for directors and officers. Shareholders should be aware of the limited exceptions available to them in avoiding the operation of this provision.
On the contrary, for arm’s length shareholders in a corporation undergoing a court-supervised restructuring or bankruptcy, debts made to shareholders are not affected by this type of provision.
How to Create a Sample Shareholder Loan Agreement
When drafting a sample shareholder loan agreement, it is important to keep in mind the specifics of the situation. This includes the amount of the loan, the interest rate, the term of the loan, and the repayment schedule. Additionally, it is essential to include clauses that protect both parties’ interests, and to use clear and concise language throughout.
Some specific clauses to include in a loan agreement are:
• A clause outlining the purpose of the loan
• A clause specifying the interest rate and repayment schedule
• A clause allowing for prepayment without penalty
• A clause detailing the consequences of default , such as acceleration of the loan or foreclosure on collateral
• A clause specifying the governing law and jurisdiction for any disputes
• A clause that allows for amendments to the agreement only in writing and signed by both parties
• A clause that includes any additional terms specific to the agreement, such as a non-compete clause or a confidentiality agreement
It is important to ensure that both parties fully understand the terms of the agreement, and to encourage questions if anything is unclear. Clear language is essential to avoid any potential misunderstandings or legal disputes down the line.
Once the agreement has been drafted, both parties should have a chance to review it with their respective attorneys before signing to ensure that their interests are fully protected.
Mistakes to Avoid
As much as I have indicated that every shareholder loan agreement needs to be specific to a shareholder and a corporation, there are some common mistakes that I see over and over. Let’s explore the most common mistakes to avoid:
Not using the correct agreement – there are different kinds of shareholder loan agreements and it is important to know which one to use. The shareholder loan agreements that I prepare are for current shareholders. If the loan agreement is prepared for a new shareholder, there may be some additional provisions required to work them into the corporation.
Not paying interest – shareholders will often forget to pay interest on time, or at all, because of the nature of their relationship with the corporation. Remember, the Canada Revenue Agency will want to be paid interest on an unpaid shareholder loan and if the shareholder does not pay interest, the shareholder will actually have to report the interest as income even though no interest may have been paid.
Not preparing the agreement in the first place – Obviously, without the agreement, there are no terms to the loan, so all repayments may be applied against interest. Repayments may always be disputed by the Canada Revenue Agency. Interest can be deducted by the corporation if there is an agreement in place evidencing the rate of interest and terms of repayment.
The amount of the loan should be reduced by any unsecured amounts owed by the corporation – shareholders will often forget that the amount of their loan to the corporation needs to be reduced by any unsecured amounts owed by the corporation to the shareholder. There aren’t often any unsecured amounts, and the unsecured amounts need to be at least $1.00 more than the loan amount, but it is very important that the shareholder understands that the loan amount needs to be reduced by the value of any unsecured amounts owed to the shareholder.
Giving unsecured loans or unsecured amounts to a shareholder – if the corporation wants to provide a shareholder with money for any reason, the money should be provided as a loan with interest and a repayment schedule. If money is advanced to a shareholder and there is no documentation evidencing the transaction as a loan, the Canada Revenue Agency will regard that money as a deemed dividend subject to tax in the hands of the shareholder. The only exception to the deemed dividend is for debts which are secured by non-arm’s length property where security is provided before the loan is advanced.
Using a promissory note instead of a shareholder loan agreement – a very (annoyingly) common mistake that I see is corporations using a promissory note instead of a shareholder loan agreement to evidence a loan to a shareholder. Promissory notes are short and are often prepared very quickly. They do not usually take into account any nuances unique to a particular shareholder such as unpaid vacation wages or unpaid bonus entitlements and instead uses the full value of the shareholder loan. A shareholder may actually owe over and above the value of the loan based on unpaid wages or unpaid bonus. Shareholder loan agreements will have full recitals evidencing the debt owed by the corporation to the shareholder, including details of any unpaid wages or unpaid bonus and terms for repayment.
Shareholder Loan Agreement FAQ
Frequently Asked Questions About Shareholder Loan Agreements
What happens if the shareholder who made a loan leaves the company?
Without an agreement in place between the company and the departing shareholder, the company must continue to return the loan to the shareholder according to the terms of the loan.
However, if you have a shareholder buy-sell agreement in place between the company and the departing shareholder, then, if you followed the process in your buy-sell agreement, the loan becomes part of the shares held by the departing shareholder, which means upon the purchase of the departing shareholder’s shares, the loan will be purchased from the departing shareholder.
It is important to have a buy-sell agreement in place at the time a salary shareholder of a private corporation makes a loan to his/her company.
What if the shareholder who made a loan dies?
Unless the shareholder has a designated beneficiary under his or her plans (which unfortunately is not sufficient to cover the shareholder’s debt/capital account at his/her death) there is no will that can establish the terms of a loan repayment/forgiveness unless the deceased shareholder has a will and the terms of the will deal with the loans/credit or capital account at death.
By having a buy-sell agreement with a surviving family member or his or her estate, the loan would be paid by the deceased shareholder’s estate as part of the purchase of the shares as outlined above .
Can a loan be forgiven through estate planning?
The Golden Rules of Estate Planning provides that common law generally does not prevent a person (other than a company) from forgiving a loan which was made a short time before death and which proves to be a transfer of property to the borrower.
However, if a company is the lender and the company maintains economic means to enforce the loan, then a forgiveness of the loan would probably be considered to be a gift, unless the forgiveness was clearly in accordance with a shareholder agreement, loan agreement or otherwise, then the party forgiving the loan should be done in the context of an estate freeze and documented to evidence same. This is especially important if the forgiven loan was used to purchase the shares in the company.
What about shareholder loans to other shareholders?
If a shareholder who is not a member of a family cred its account with a third party for an equipment purchase, then the deal can be treated as an account receivable if properly documented.
Issues to consider:
Do not indicate that the loan is a shareholder loan. One way to ensure that the loan is not considered a shareholder loan is to lend the funds from an inter vivos trust established for the benefit of all of the family members, including the shareholders.
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