When you’re searching for a way to finance your business, most owners will explore all possible avenues.
Government loans, traditional bank loans, crowdfunding and venture capital are just a few of the ways that come to mind.
One option a minority of owners might consider is accepting an informal loan from shareholders, other directors and sometimes even friends or relatives.
However, these arrangements are not without consequence or risk.
What risks do informal loans carry?
When loans to finance your company are made without a formal agreement, key details, including repayment schedules, interest rates, conditions of the loan and what happens if the business cannot repay the money, are left unconfirmed.
With these details missing or unclear, it opens the door wide open to disputes and uncertainty as to whether the business can continue to operate
If nothing has been recorded in writing, discussions can quickly descend into conflicting recollections about what was or was not agreed.
That sort of “he said, she said” dispute is difficult to resolve and can strain both business and personal relationships, particularly where the lender is a friend, family member or fellow director.
If you do not have a structured repayment plan, it can also become harder to manage cash flow effectively, which can negatively impact the business’s overall financial health, which could have severe detrimental consequences for a business.
In some cases, the person lending the money may assume that their financial support gives them a say in how the business is run.
Expectations around influence, voting rights or involvement in decision-making are not always discussed openly at the outset.
That is another reason to proceed with care. If control has not been clearly addressed from the start, it can lead to tension later, particularly if the lender believes their investment entitles them to make or challenge key decisions.
How to prevent these risks
To prevent the risks associated with informal loans, here are some tips:
- Arrange for a formal, comprehensive loan agreement to be entered into that records exactly what has been agreed between the parties and is signed by all parties.
The loan agreement should amongst other terms, include provisions in relation to the following
- How much is being lent, the term of the loan, whether interest applies, when repayments are due and how they will be made.
- What the loan can be used for.
- What the borrower can and cannot do in relation to any security assets.
- What constitutes default, whether the loan becomes repayable on demand and when any security can be enforced.
- Whether the lender has any rights to influence management decisions or whether the arrangement is purely financial.
You should consult with a legal professional to draft an agreement that addresses all potential issues, providing clarity and security for both parties involved before making any final decisions.
Contact our experts for legal advice for your business.