EQUITY LOANS. AN ATTRACTIVE FINANCIAL HYBRID FOR START-UPS
When it comes to finding alternatives to fund entrepreneurial projects, tax advisors are often asked which are the instruments at the investors’ disposal. An attractive alternative are equity loans.
Equity loans are a particular kind of loan in terms of its features as well as their legal and tax treatment. They are loans by virtue of which the lender grants a certain amount of capital to the borrower, at interest, but with certain particularities that distinguish them from what would be an ordinary loan:
- They are a liability for the borrower and are treated as external funding from an accounting standpoint.
- They accrue, imperatively, a variable interest, which means that interest is based on factors that are inevitably variable such as: net profit, gross income, the company’s equity, etc. In addition, the parties may also agree upon a fixed interest.
- As they remain an accounting and tax liability for the borrower, the amounts paid by way of interests are fully deductible.
- They are not object to early payment. In fact, it is prohibited by law. Also, the parties may also agree on further penalties in such event. This is in order to protect the company’s ordinary creditors’ interests.
- For the purpose of the corporate legislation they are considered as equity of the borrower.
- They rank last in the hierarchy of claims and are subordinated to the ordinary creditors of the borrower.
They are a very versatile and flexible instrument for both parties when it comes to joining forces when it comes to launching and developing an entrepreneurial venture.
On one hand, it’s attractive for the lender as it allows him to take part in the project, participating economically (and relatively risk-free) in its growth without having to get actively involved in the borrower’s corporate structure; the downfall is that they rank last in the list of claims.
On the other hand, this instrument allows the borrower to obtain quality external financing without the need to allow the investor in its capital and decision-making. Also, the accrued interests are fully deductible in the borrower’s tax returns.
Finally, and this is where the real advantage of this instrument resides, the equity loan is considered as an item of the company’s equity (regardless of its strictly accounting treatment) in the mercantile legislation, having its consequences in the fields of mandatory company liquidation, transformation from a Corporation to a Limited Liability Company, among others.