Owner Financing – Debt, Equity, or What?

By David Tayman

From paying business expenses out of personal funds, to credit card advances, to cutting a check from a personal account to cover payroll in advance of a progress payment, business owners, particularly owner-operators, often serve as the financing source of first recourse when there is a cash flow deficit.  All other things being equal, an owner’s advancement of funds to his or her business from time to time is not a problem.  If everything works out, these transactions typically resolve themselves in the ordinary course of the business’ life.  If something goes wrong, however, these transactions may be subject to scrutiny by co-owners, lenders, creditors, or other parties-in-interest.  If this happens whether the owner contribution will be treated as debt or equity is much more situationally-dependent than the owner may realize when making the advance.

Because this issue is most likely to arise when the business that received the advanced funds is troubled, and because debt generally takes priority over equity in the divvying up of the spoils of a business gone bad, the party challenging the characterization of an advance is much more likely to seek to characterize what the owner considers to be debt as equity, rather than the other way around.  In most traditional businesses, there is usually no advantage to be gained by seeking to characterize equity as debt.

When push comes to shove and the matter is made the subject of litigation, courts are not required to simply accept the label of “debt” or “equity” placed upon a particular transaction.  A court will inquire into the actual nature of a transaction rather than accept the original parties’ characterization.  The primary factor considered when evaluating whether funds advanced by a shareholder are the result of an equity contribution or a loan is whether the transaction bears the earmarks of an arm’s length negotiation.  The more the supposed debt transaction reflects the characteristics of an arm’s length negotiation, the more likely such transaction will be treated as debt.

In making this determination, courts consider a variety of factors, including: (1) the names given to the certificates or documents evidencing the indebtedness; (2) the presence or absence of a fixed maturity date; (3) the source of payments; (4) the right to enforce payment of principal and interest; (5) participation in management flowing as a result of the funds advanced as part of the original transaction; (6) the status of the contribution in relation to regular (i.e., third-party) corporate creditors; (7) the intent of the parties; (8) ‘thin’ or inadequate capitalization; (9) identity of interest between creditor and stockholder; (10) source of interest payments; (11) the ability of the corporation to obtain loans from outside lending institutions; (12) the extent to which the advance was used to acquire capital assets; and (13) the failure of the debtor to repay on the due date or to seek postponement.

A critical group of these factors concern the formality of the alleged loan agreement.  The more specific and complete the parties are in identifying and codifying the terms of the alleged loan, the more like debt the transaction appears, and the more likely a court will be to agree to characterize the advance as a loan.  On the other hand, if the terms of such an agreement are vague and non-specific, the alleged loan may be interpreted to be more like a shareholder contributing equity to sustain his investment.

Another important group of factors concern the financial situation of the business at the time the owner made the purported loan.  If investing in the company appears to have been particularly risky (e.g., it was thinly capitalized), or the source of repayment of the “loan” was not made clear when the funds were advanced, then the transaction may be more readily characterized as an equity contribution.  The final group of factors is the relationship between the business’ equity owners, their respective interests in the business, and the identity of the parties’ participating in the making of the loan.  Where control of the business appears to be dependent upon the making of the loan, the loan is more likely to be characterized by the court as equity.

Uncharacterized fund advances happen all the time.  All too often, business owners fail to properly structure these transactions to withstand adverse scrutiny after the fact.  Business owners would be well-advised to take the long-term view and structure these transactions with an eye to the factors identified in this article.  Doing so may short circuit disputes before they have a chance to grow to the point where they cost the company and parties-in-interest unnecessary attorneys’ fees or even threaten the company’s health or well-being.