Capitalising your business – Loan or shares?

Capitalising your business is a start-up or business continuation move that can have long-term effects on your company’s success. Funding start-up expenses, inventory and operations is a challenge for many business owners. However, numerous options are available to entrepreneurs who are willing to consider both conventional and non-traditional ways to capitalise their businesses. (Mayhew, 2016).

We are often asked whether it is better to inject capital into a business as a loan or as additional shares. I have noticed that this question comes up often when foreign shareholders are involved, as it seems the norm overseas is to capitalise via share capital and not on loan account. In South Africa the opposite seems to be true – and many companies choose to capitalise via shareholders’ loans, as opposed to share capital.

The decision should be based on the specific circumstances surrounding the use of capital and the business involved. There are however a few general points that are worth considering.

The benefit of raising a loan is that it is easier to repay in the future, should the company be in a positive cash flow (subject to the Solvency and Liquidity test requirements of the Companies Act). Whereas, a share buy-back (following capitalisation via share capital) requires a more onerous administrative process. It also allows certain shareholders to fund the business disproportionately to their shareholding, and be repaid prior to any shareholder capital repayment. Interest can be raised on the loan, which cannot be done for share capital. The tax deductibility of the loan will depend on what the cash was utilised for. There are also capital structuring opportunities, such as loans that are convertible to shares based upon certain events, and this may compensate the investor for the additional risk taken.

A problem often arises however when the company is Technically Insolvent as a result of raising a loan instead of share capital. This can be overcome by a Subordination Agreement that allows the loan to be subordinated in favour of creditors, until such time as the assets exceed the liabilities. This subordination can rectify the technical insolvency.

However there is a sometimes a problem with loan accounts that are never repaid, in that companies find themselves in a position where the loans have grown over the years to a large amount, which most probably will not be repaid. They may be growing further due to rate of exchange differences and interest charges being levied. We find this situation in older companies and there is a need to “clean up” the balance sheet and resolve the technical solvency issue permanently. It is then often recommended to capitalise the existing loan to share capital. The amount is fixed going into the future, and technical solvency resolved.

Should you require any advice on capitalising your business, please contact us.

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)