The three most common methods of financing a company are:
sale of shares of the company;
loans from shareholders; and
borrowing from non-shareholder sources.
Many companies in a start-up phase are capitalized by methods (1) and (2) above. There are advantages and disadvantages to each of the three methods, which are discussed below.
The first shareholders of a company often provide the initial financing to a company through a combination of share subscriptions and shareholders’ loans. In fact, it is quite common (particularly when shareholders are not subscribing for preferred shares having a fixed redemption or retraction price) for most of the shareholders’ initial cash contributions to be by way of loans, with the shareholders only paying a nominal subscription price (e.g. $0.01 per share) for their shares. Under the British Columbia Business Corporations Act (the “Act”), a share of a company is not considered to be issued until consideration is provided to the company for the issue of the share by one or more of (i) past services performed for the company, (ii) property and (iii) money, so some money must be paid for shares before they can be considered issued.
A shareholder who lends money to a company can more easily recover its investment than a shareholder who finances a company by purchasing shares. The investment in the company is easily recouped by repayment of the loan. Repayment of an investment in the form of shares is much more complicated as it involves the company’s redemption or purchase of the shares, the payment of dividends, or a reduction of the company’s capital.
Another advantage of financing by way of loan occurs when a company becomes insolvent. A shareholder who has lent money to the company ranks at least equally with all other unsecured creditors, instead of behind them as would be the case of a shareholder who had financed the company by purchasing shares.
A shareholder who lends money to a company may take security for the loan from the company, thereby entitling the shareholder to rank ahead of unsecured creditors and other shareholders. If a third party subsequently lends money or extends credit to the company, however, the lender will likely require subordination of the shareholder’s security to that of the lender and may also require that the shareholder execute a postponement and assignment of claim, postponing its right to be repaid on account of the shareholder’s loan to the lender’s right to repayment from the company. Section 40(1) of the British Columbia Personal Property Security Act permits secured parties to enter into subordination arrangements and provides that those arrangements may not only be effective between the parties to the subordination agreement but also may be enforced by a third party, if the third party is a person or one of the class of persons for whose benefit the subordination was intended. The ability of a person who is not a party to the subordination agreement to enforce the agreement goes beyond common law since, at common law, a person who is not a party to a contract cannot take the benefit of it.
One method whereby an investment in shares can be returned to a shareholder is to have the company purchase or redeem those shares, which is permitted if the company’s articles permit such purchase or redemption. The company must be solvent, however, for this to be an option. Also, this approach may have detrimental tax consequences if the purchase or redemption price exceeds the capital cost of the shares for tax purposes. To the extent that the purchase or redemption price paid by the company for the shares exceeds the capital cost of the shares, the shareholder is deemed to have received a taxable dividend.
A second method of returning a shareholder’s investment is by payment of dividends on the shares, but, as with the purchase or redemption of shares, the company must be solvent for this to be an option.
A third method is to effect a capital reduction under s. 74 of the Act. If a capital reduction is effected by court order, the time and legal costs in effecting the reduction could be significant compared to a simple repayment of a shareholder’s loan.
In conclusion, it is generally advisable to arrange for the initial financing of a company by way of shareholders’ loans as opposed to other methods such as the sale of shares. As for the matter of additional financing, this is typically dealt with in any shareholders’ agreement entered into by the company and its shareholders. It is common for a shareholders’ agreement to provide that the additional funds required by the company will be obtained to the greatest extent possible by borrowing from a chartered bank or other lending institution. It is relatively easy to get the approval of the shareholders on this provision. The more contentious provisions, however, deal with necessary financing that is not available from such outside sources or, if available, available only at exorbitant interest rates.
This is a topic for another day.