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“Never a lender nor borrower be…”

Shakespeare’s famous quote is good advice, but it’s hard to put into practice.

Many clients know all about the benefits and perils of borrowing money, but it’s likely they’re less prepared to be lenders.

Read: What to do when a business owner goes personally bankrupt

As their advisor, be prepared to help your clients understand what their rights and responsibilities are. For example, your client is considering lending $50,000 to a small business. What are your client’s options?

Let’s start with a pre-lending checklist – what should your client do to protect themselves before they lend a business (or a person) money:

  • Know who you are lending the money too. This may seem obvious, but particularly when your client is lending to a small business, she needs to know if she is lending to the owner(s) of the business or the business directly. To lend to the business directly it needs to be incorporated. If it is incorporated it is a good idea to have the owner(s) guarantee the corporate debt.
  • Know what the money is to be used for. The borrower should have a clear plan for the money. If it is to finance equipment, then perhaps your client should be registering a lien or charge on the equipment. If the loan is for working capital, your client needs to consider how risky this type of loan can be. Your client should never lend money she can’t afford to lose, regardless of how safe she thinks the loan may be.
  • Know how the money will be repaid. Believe it or not, this piece is often missing. If your client doesn’t have a repayment plan, then she should treat the loan as a “gift.” At least then if it’s repaid she’ll be pleasantly surprised.

Read: Ontario changed its bankruptcy laws, and it may affect your client’s home

The next concept for your client to understand is related to risk and rates of return (in this case, the interest charges. As with a bond, the higher the risk that a loan will not be repaid, the higher the interest rate that should be charged.

To reduce risk, your client should consider adding security features to the loan. Security may take the form of personal guarantees as mentioned in point one, or collateral as mentioned in point two. The advantage of a guarantor is the lender has more than one party that they can try and collect repayment from. The advantage of collateral is your client might have a physical asset that can be seized and sold to recover the debt. Of course the guarantee and collateral need to have value in order to reduce your client’s risk.

Read: Protect clients from abusive debt settlement practices

So, what if the business your client lent $50,000 to goes bankrupt?

If the borrower files for bankruptcy and the debt is guaranteed, or is secured by collateral, your client has rights above those of an ordinary unsecured creditor. In the case of a guaranteed debt, your client may pursue the guarantor for repayment. In the case of a debt secured by collateral, your client has a right to the collateral. Further, if the borrower continues to make payments on the debt then your client may not be affected by the bankruptcy at all.

Let’s suppose for a moment that when your client lent the now-bankrupt business the money, she didn’t ask for any guarantees or security. Unfortunately, your client would rank as an ordinary unsecured creditor along with all of bankrupt’s other creditors. In a bankruptcy, the secured creditors get to exercise their rights to the various assets of the business: equipment, receivables, inventory, or cash, based on their specific security arrangements. The unsecured creditors get to divide any funds that remain after the secured creditors have exercised all of their rights on a pro rata basis. In most cases, there is very little (frankly, nothing) left for the unsecured creditors.

The best advice you may give a client that approaches you about lending money is to only do so if they are in the business of lending money. Banks and other financial institutions have systems and procedures in place to properly assess the creditworthiness of a business or person. If a business cannot borrow from a commercial lender that is a red flag that the loan is high risk.

Ted Michalos, B.A., CPA, is a Licensed Insolvency Trustee and co-founder of Hoyes, Michalos & Associates Inc. in Ontario, Canada.
Originally published on Advisor.ca
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