Debt financing can be a great capital-raising vehicle for growing companies. It can stave off valuation issues and prevent the need for early dilution. However, startups often have difficulty securing debt as lenders are wary of extending credit to companies without lengthy credit histories. Furthermore, some loan agreements offered to startups can include terms that threaten the financial future of a company or its principals.
When seeking debt financing, two considerations startups should watch for (and sometimes walk away from) are:
a) personal guarantees
b) broad security interests
Lenders often seek personal guarantees from early-stage companies because they lack sufficient credit history and assets to be considered creditworthy. These kinds of assurances can put individual guarantors (often the company founders) at significant risk as they can become personally responsible for the debts of the company.
Sometimes individuals attempt to “credit-proof” themselves or reduce the consequences of personal bankruptcy by protecting assets from potential seizure by creditors. That can be a risky and challenging strategy. On occasion, courts have even rolled back actions that guarantors have taken to credit-proof their assets (e.g. by voiding a contract).
For example, in Bank of Montreal v Javed (2016 ONCA 49), the Ontario Court of Appeal considered a Bank of Montreal small business loan made to a donut shop in 2011. The loan was provided based on personal guarantees, which the court enforced. One of the guarantors had not had an active role in the business for several years when the company finally defaulted. Moreover, the court found that the guarantor’s attempt to transfer their interest in their matrimonial home to their spouse was a fraudulent conveyance. Despite attempts to provide a reason for the transfer that was unrelated to the knowledge of the corporation’s financial problems, the court undid the transfer.
Attempting to shield assets after providing a personal guarantee is a risk that borrowers should be aware of, especially with respect to personal assets that could potentially be seized.
Secured Loans & Broad Security Interests
In addition to personal guarantees, lenders may also seek security for the loan. A loan may be secured against specific assets, such as inventory, or against all of the company’s property. Such security can mean that, in the case of an unresolved default, a lender can eventually enforce its rights by seizing and selling those assets, sometimes at a loss, in order to be made whole.
A secured loan will often have a lower rate of interest than an unsecured loan since it is backed by some asset(s). However, it is crucial for borrowers to consider which asset(s) to choose as loan collateral, as secured lenders will have priority rights over other lenders to that business asset(s). For example, providing a secured interest against a company’s accrued refundable SR&ED tax credits may be a better option than providing a secured interest against a company’s inventory. If the latter is seized, it could immediately affect the company’s ability to generate income.
While such a devastating result may seem unfair, unfortunately, such outcomes are often upheld. Absent misrepresentations and fraud, courts can have little sympathy for a party making a bad bargain. As the Ontario Court of Appeal said in the case of Titus v. William F. Cooke Enterprises Inc. (2007 ONCA 573), “[a] transaction may, in the eyes of one party, turn out to be foolhardy, burdensome, undesirable or improvident…” and yet remain enforceable.
Access Debt Financing Confidently
Prior to taking on any form of debt financing, companies and individuals should make sure they are able to meet their obligations and understand the potential liability if they fail to do so. In an ideal world, your business should only seek loans secured against assets that, if seized and sold, do not pose an existential threat to the company. This is where tax credit financing can play a vital role.
In general, loans secured against refundable tax credits are given when the lender is confident that the estimated refund is accurate. With a proper accounting of qualified expenditure, both the lender and debtor can be confident that the tax credit refund used to secure against the loan will be disbursed by the CRA, which in turn pays back all principal and fees to the lender. This allows the debtor to benefit from the lower cost of a secured loan without having to secure against an asset crucial to operations, such as inventory.
If your company has questions about different types of debt financing and how they can affect your business, get in touch with legal experts on the Slingshot team at Gilbert’s LLP.
Partner, Gilbert’s LLP
IPC Student, Gilbert’s LLP