How do lenders treat loans the owner made to the company?

What a lender sees on the balance sheet

Owners put money into their companies in two ways: as equity, by buying shares or contributing capital, or as a loan, which the company owes back. Most owners choose the loan without thinking about it, because a loan's principal can be repaid on a schedule, while equity usually comes back only through distributions or a sale. Years later, that choice shows up in underwriting.

When an underwriter finds a shareholder loan, the first questions are practical. Is there a note, or only a ledger entry? What is the balance, and does it reconcile to the tax returns? Is interest charged, accrued or ignored? Has the company been paying it down, and from what? Who holds it: the owner, a spouse, a relative, another company the owner controls? Each answer moves the loan toward one of two readings.

Debt or equity: how it counts in the tests

Whether an owner loan helps or hurts depends on how the lender's covenants define their terms, and those definitions are negotiable. The common pattern, when the loan is properly subordinated:

• Senior leverage. Usually left out. Senior leverage counts debt that ranks with or ahead of the lender, and a subordinated owner loan does not.
• Total leverage. Depends on the definition of funded debt. Many lenders exclude fully subordinated owner loans that pay no cash interest; others include every interest-bearing obligation. Read this line before signing. Senior vs total leverage explains why the difference matters.
• Debt service coverage. If the loan cannot be repaid while the lender is owed, there is no payment to count. If the owner is allowed to take scheduled payments, those payments go into debt service like any other.
• Net worth. A tangible net worth covenant often adds subordinated debt back to equity, which can turn a thin or negative net worth into a passing one. This is where a well-documented owner loan does the most good.

The same balance can therefore make one company look stronger and another weaker. A business with modest equity and a large subordinated owner loan can present well; the same business paying that loan down each month presents as more leveraged, with less cash to cover the new lender.

An owner loan is worth most to a lender when it is written down, subordinated and not being repaid.

The subordination the lender will require

Nearly every lender will ask the owner to sign a subordination agreement as a condition of closing. It is a separate document from the loan agreement, and its terms are the same ones a seller note would get: the owner agrees not to be paid while the lender is owed, or to be paid only when conditions are met; not to take a lien ahead of the lender, and often not to take one at all; not to sue, accelerate or collect while the lender is owed; and to hand over to the lender anything received in breach, known as a turnover clause.

Where several people hold owner loans, each will be asked to sign. A relative who lent the company money years ago and has no other role in the business is often the hardest signature to get, and the one the lender will not close without. Identify every holder early. Seller note subordination terms covers the same clauses from the seller's side, and intercreditor agreements cover the version used between institutional lenders.

How much can be repaid, and when

Restrictions on repaying owner loans run from total to modest. Where a lender lands depends on how strong the credit is and how much the owner loan matters to it.

Owners hoping to use a new loan to take their money back out should know two rules. First, lenders size loans to cash flow, and proceeds used to repay an insider are proceeds not spent on the business, so most will resist. Second, on SBA loans, proceeds cannot fund a distribution to owners, or refinance debt that did, and an underwriter will look hard at any payment to an owner that resembles one. Shareholder loans in a refinancing covers what can realistically be taken out at closing.

Converting the loan to equity before a financing

Some owners solve the question by turning the loan into equity before they approach lenders. The balance sheet then shows more equity and less debt, the net worth test improves without any lender having to add anything back, and the underwriter has one less item to ask about.

The trade-off is permanence. A subordinated loan can eventually be repaid once the lender is repaid or allows it. Equity comes back only through distributions or a sale, on whatever terms the credit agreement permits. An owner who converts gives up that path in exchange for a cleaner file that a subordination agreement would often have achieved anyway. Ask the lender what it needs before converting: many are content with subordination.

Where the company has more than one owner, conversion has a second effect: it changes the cap table unless every owner converts in proportion. Shares issued for one owner's loan dilute the others. On an SBA loan that can matter directly, because every owner of 20% or more personally guarantees the loan. An owner who crosses 20% through a conversion becomes a guarantor; one who drops below it may stop being one. Model the ownership after conversion before the lender does.

The tax side of converting

The tax treatment of a conversion turns on the entity type, the owner's basis in the loan and how interest was handled, so this is a question for the company's tax advisor before anything is signed. The points that most often come up:

• Cancellation of debt. When a shareholder contributes a loan to the company's capital, the company is generally treated as having paid the debt with an amount equal to the shareholder's tax basis in it. Where that basis is lower than the balance, often because interest was accrued but never taxed to the owner, the difference can be income to the company.
• Accrued interest. Interest the company accrued and deducted but never paid, to an owner who never reported it, is the usual source of that gap. Clean it up with the advisor first.
• S corporations. An owner loan can give an S corporation shareholder debt basis that has been used to absorb losses. How a later conversion or repayment is taxed depends on that basis history.
• Uneven conversions. Where the shares issued do not match the value contributed, or owners convert unevenly, the difference can be treated as a gift or compensation between owners.
• Loans that are really equity. An owner loan with no note, no interest and no repayment schedule may already be treated as equity for tax purposes. Documenting it now does not rewrite its history.

Getting it into shape before you go to market

The fix is usually paperwork, and it is cheaper before a lender asks than after.

• Reconcile the balance to the general ledger and the tax returns, and explain any difference.
• Put the loan on a signed note with a rate, a maturity and a clear statement that it may be subordinated.
• List it on the business debt schedule with every other obligation, including who holds it.
• Decide with the tax advisor whether to keep it as a loan or convert it, and settle any accrued interest.
• Collect a signature commitment from every holder, especially relatives, before the lender's documents arrive.

Transparent reads the debt schedule and the balance sheet together, shows each owner loan in the lender package the way an underwriter will classify it, and runs the covenant tests both ways, as debt and as quasi-equity, so the owner can see which treatment to negotiate for. How we underwrite explains the approach, and how much debt a business can carry shows how the leverage and coverage math fits together.