Every business needs investments by the owner/manager in the early stages.  However, there is usually no guarantee that the investments made in a business at the early stages will be returned.  In fact, it is highly likely that once other lenders are engaged, they will want security in their investments, and will usually also want to make sure that the security they get ranks ahead of security given to others.  If you put money into the business without properly securing such investments, the debt owing to you by the corporation will rank with other general creditors at the end of the day and you risk getting nothing.  In order to increase your chances of getting some of your money back if the business does not work out, investments in your company should be made by way of loan rather than equity and such loans should be secured.

(a) Capitalization by Secured Debt

Operating businesses should be capitalized by the issuance of shares to the owner/manager for a nominal subscription price.  The financial capital required from time to time from the owner/manager can then be advanced as shareholder’s loans. Since the owner/manager’s investment by way of unsecured shareholder loans rank equally with the general creditors of the corporation, in the event the business fails the likelihood of the owner/manager recouping his/her unsecured investments is low.  Therefore, any shareholder loans advanced by the owner/manager should be secured by way of a general security agreement at the earliest possible time. 

The security interests should be perfected by registration in the Personal Property Security Registry upon the execution of the security agreement (and prior to any advance of funds).  As the security can be registered before any funds are advanced, the owner/manager should consider entering into a general security agreement with the operating business and registering security immediately after incorporation and organization of the corporation.   Recognizing that the outstanding balance of shareholder loan accounts changes frequently due to fluctuating capital requirements in the business and/or due to tax planning for tax purposes, the general security agreement should be carefully crafted to ensure that the investments being secured are defined as broadly as possible to avoid any inadvertent exclusion of any aspect of the shareholder’s loans from the security interest. 

(b) Capitalization of the Operating Company through a Holding Company

Where the owner/manager holds his/her interests in the operating company through a holding company, a general security agreement can be issued by the operating company to the holding company to secure all present and future advances made by the owner/manager through the holding company. 

Dividends can be declared by a subsidiary to its parent corporation free of income tax or tax on taxable dividends.  As such, the use of a holding company enables the owner/manager to securitize the retained earnings of the operating company.  On a regular basis, the operating company can distribute its retained earnings to the holding company by way of tax free dividends; those funds can then re-loaned back from the holding company to the operating company, secured by a general security agreement.  Effectively, the retained earnings of the operating company are converted into a secured loan ranking in priority to the general creditors (but inevitably subordinated to the company’s banker and other more senior lenders).

If there is more than one operating company, the holding company can essentially act as a banker providing secured loan advances to the different operating entities as required, and at all times in priority to the general creditors.

Capitalizing the operating company by way of loan, either from the owner/manger directly or through a holding company, gives the owner/manger the opportunity to secure his/her interests in such funds, thereby increasing the owner/manager’s chance of getting some or all of those funds back out of the company the business fails.

For further information, please contact Samantha Chapman by phone at (416) 368-0600 or by email at schapman@businesslawyers.com.

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