UK Start Up Equity - Share Capital or Loan

[Mulholr]

Hi All,

First post here from a newbie so please treat me gently

I'm just starting up (UK - Ltd Company) as a freelance Insurance Consultant. I'm putting £15,000 into the business to lauch

Because it's an FCA regulated industry, were I to put the capital in as a loan to the business, it would have to be a subordinated loan with an original maturity of at least 2 years or if there's no fixed term, it has to be subject to at least 2 years notice of repayment (which I have no issues with). The business would also have to enter into a subordinated loan agreement with specific wording to satisfy the FCA's requirements.

My questions are 2-fold: Is there any benefit / value to putting a proportion of the capital into the business as share capital? Currently the business has a nominal £100 of ordinary share capital (I am the sole director)?

Secondly, if the capital is treated as a subordinated loan, I'd effectively be signing the agreement as the Lender and also signing the agreement on behalf of the business as the Borrower - can anyone foresee any issues with this?

Thanks in anticipation.

Ray

 

[Samir]

I'm not sure about the UK, but when a company pays a loan in the US, the interest is expensible to the company. Of course, it counts as income on your side so it can be a wash. But this can reduce the net income of the company if that's what you want.

 

[Counterofbeans]

I'm also not sure about the UK, but if a company has no equity & only has a loan that is financing the operations, under US GAAP, that is, by definition, a variable interest entity (VIE) & that has a complex set of rules to consider

 

[Samir]

I'm also not sure about the UK, but if a company has no equity & only has a loan that is financing the operations, under US GAAP, that is, by definition, a variable interest entity (VIE) & that has a complex set of rules to consider

Thank you for mentioning that. I'm sure there were some other drawbacks to zero equity, but wasn't fully aware of them.

 

[ICAEW]

The only things I can think of are as follows:

1) Issues with the gearing of the company and further borrowing--With no equity invested, the gearing would be close 100%, by default. Furthermore, if you were to make a loss during the first year, it would create a negative balance on the retained earnings/losses (equity erosion). This, if you were to get audited, would result in a EOM (Emphasis of Matter paragraph which states that there's significant doubt over company's continued existence due to the company making an X amount of loss in the current year, and the erosion of equity) in the audit report as well. Banks usually ask for the audited accounts before advancing any loans. However, since you're also the sole shareholder, you could provide a support letter stating that you're willing to settle all the debts of the business as and when they fall due.

2) Performance management and classification of liabilities--You will not be able to calculate meaningful financial performance measures such as Return on Capital Employed (ROCE) or Return on Investment (ROI) without making some adjustments prior to the calculation. Furthermore, non-derivative financial liabilities need to be measured at amortised cost in accordance with IAS 39/IFRS 9. As the loan would bear interest, this will also need to be recognised in the income statement.

All in all, it depends on how strong you want your company's position to appear in the financial statements. With the amount invested as share capital, you will not be able to claim any interest on the loan. However, it will keep things pretty straightforward.

Hope this helps.

Best regards,

Kian

 

[Counterofbeans]

Thank you for mentioning that. I'm sure there were some other drawbacks to zero equity, but wasn't fully aware of them.

In this example, if there truly were no equity stakeholders (that seems like a very unusual situation, but...), I'd say there's a 99.9% chance that the loan-holder would consolidate the VIE when preparing their financials. The only way he wouldn't would be if there was some bizarre contract or something that gave control of the entity to someone else, but I'd have to see all the facts.

VIE rules, for the most part, are actually fairly easy if you simply understand Enron and what Andy Fastow was doing. I like to describe it as, "the tail wagging the dog."

Whoever the tail is consolidates.

The documentary, "The Smartest Guys in the Room" was pretty fascinating to me.

Oh, and I'd kick Andy's ass if I ever got the chance.