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Helping Family Businesses
Prosper Across Generations®

Family Business Loan Programs

By Norbert Schwartz

Dividend or distribution policy is frequently an issue in family businesses. Because of the closely held nature of the family business, owners frequently lack liquidity and marketability for their stock. Often stock agreements and restrictions are put into effect to maintain ownership within the family. In addition to restricting ownership, such agreements often have restrictions on pledging the stock as collateral for loans from third parties. Pre-or post-nuptial agreements are also used to limit ownership to a family bloodline. While such restrictions protect the stock ownership for the family, they can cause liquidity and marketability problems for the shareholder.

Even with agreed-upon restrictions in place, shareholders often expect the investment to pay a financial return – perhaps a return approaching what would be expected from publicly traded securities. When the stock is viewed, even in part, as a financial investment as opposed to an heirloom or legacy, pressure for current distributions and some form of marketability increases.

Strategies

Primary strategies to address lack of liquidity and marketability include dividend policy and stock redemption agreements. Dividends offer shareholders a cash return on their investment, and redemption opportunities a way to sell restricted stock. Company sponsored shareholder loans are a less desirable strategy for providing liquidity for several reasons. While company loans allow the shareholder to obtain cash using unmarketable stock as collateral, many families see the disadvantages far outnumbering the advantages. Loan programs generally tend to:

  • be difficult to administer,
  • encourage a culture of entitlement to company capital,
  • promote inequality among owners,
  • invest capital outside the business, often for substantially lower returns,
  • force the company to support a business not within its field of expertise (i.e., lending money), ? place management in a difficult position with owner/borrowers,
  • open the door for company perks to shareholders,
  • provide a breeding ground for family conflict,
  • encourage the use of company stock to support living standards,
  • reduce the urgency for owners to complete estate and transfer plans, and
  • add to pressures for added distributions to accommodate loan payments.

In our experience, loan programs, when offered, are most often limited to offering home financing at levels within the normal standards of mortgage lending to the general public. In some cases, loans are also used to finance payment of estate and transfer taxes on stock. Loans should never jeopardize the financial health of the company, however.

If loan programs are offered, they should be limited as to purpose and amount. Scheduled repayment is usually required, and interest rates are generally below market but within IRS limitations. Loans should be administered by third parties such as banks, keeping management of the company out of the process. In some cases, companies provide guarantees to banks for loans to stockholders. Company stock is often pledged as collateral for the guarantees. If the borrower defaults, the bank can foreclose on the loan, or the shareholder can redeem his stock and pay the loan. Having a third party fund and administer the loan program keeps the loan transaction within market constraints, keeps management out of the loan approval and collection process, and limits the entitlement aspect of the program.

When loans are made using company capital, inherent inequities arise among shareholders. The borrower obtains a rate of interest generally subsidized by the company. Precious company capital is allocated away from the business. The company pays tax on the interest earned (a cost borne by the shareholders). As a result, loans tend to become selective perks for owners who borrow from the company at the expense of non-borrowing shareholders.

If direct loans are to be made by the company, shareholders should approve the capital allocation. The status of such loans should be reported to the shareholders regularly. Any action to collect or foreclose should be directed by shareholders, not management. A strict policy regarding collection and default should be followed (such as “ any loan or payment on a loan which is over 90 days delinquent shall automatically trigger redemption of stock pledged as collateral to pay the loan”).The objective is to take as much discretion out of the collection process as possible.

Special Concerns

What about “special considerations” such as the need for liquidity for estate tax purposes? The easy answer to this question is to ensure that all shareholders have adequate estate planning or liquidity protection, so as not to require special funding through the company. In the absence of such protection the shareholders must decide whether it is in the best interests of the company and all shareholders to support the need to settle tax liabilities, either by redemption or by loans. If loans are used, care should be taken to equalize the benefits to all shareholders, and to ensure the continued financial health of the company in accordance with its strategic initiatives. Shareholders should be cautioned that such exceptions to standard loan policies often lead to additional demands by other shareholders for similar treatment.

Redemptions offer a solution to the liquidity and marketability issues without bypassing market disciplines or penalizing other shareholders. Company capital, however, is still impacted. Redemption policies allow shareholders to sell shares back to the company at an agreed upon price, or pricing formula. The shareholder receiving the funds has to give up a portion of his ownership, just as in a public company. By using redemptions, the selling shareholder reduces his percentage of ownership, thus offering remaining shareholders the potential of increasing the value of their investments over time.

Conclusion

Whether the family business establishes a loan policy or not, the following steps should be taken to lay a proper foundation for providing added liquidity or marketability for family stock.

  • Establish a culture within ownership that avoids a “cookie jar” concept of family business entitlement.
  • Execute stockholder agreements and restrictions supporting the family ownership vision.
  • Establish dividend policy taking into account the needs of the company and comparable dividend returns on other financial investments.
  • Establish a redemption policy that is fair and equitable to all shareholders and does not jeopardize the financial health of the company.
  • Complete estate and transfer plans in all generations of stockholders.
  • If loan programs are deemed appropriate, establish firm policies and procedures for the loan progam and utilize a third party lender and administrator.

Whatever strategy is used to enhance liquidity and marketability of company stock, the financial health and needs of the business should prevail.

 


Common Practices with Family Loans

  • Generally, family businesses with which we’ve worked have approached family loan programs as follows: When ownership is limited and the owner is also actively running the business, some owner/managers will use the company as a source of personal cash. As ownership expands, this practice tends to cause conflict within the company and the family, even if the patriarch remains a majority shareholder.
  • Some (I would say most) prohibit loans, as they place the company in a difficult position and do not look good to others who see the balance sheet. They also get company into the loan business and tend to promote entitlement, with the company in the middle.
  • Some utilize loans from other family members (i.e. parents) to assure privacy and to reinforce the family role. ?Some set up a company guaranteed line of credit at a bank that will accept the closely held stock as collateral (collateral value is generally at about 50% of appraised value or book value).
  • Some establish policies to allow redemption of the stock by the company in order to provide liquidity and marketability to shareholders.
 

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