Preference shares: if you want the money back, do not lend it

Hook

We have covered two things you cannot do: you cannot lend money to a director, and you cannot casually lend money to another company that merely has the same boss. So the boss asks a very reasonable question: "I just want to put money into the company and take it back later when business is good — is that not allowed either?" It is. And there is a tool in the Companies Act designed for exactly that. Most SMEs have simply never used it.

Why lending is where the trouble starts

First, be clear about why lending to the company is not ideal. The boss puts money into the company and it is recorded as a director's current account, on the credit side. The company owes you. That in itself is perfectly lawful. But it has three side effects. First, it is a liability. And because you can ask for it back at any time, it usually has to be classified as a current liability. Your gearing looks worse for no good reason. Second, banks and buyers frown when they see it. "The boss can pull that money out whenever he likes" is, in their eyes, a sign of instability. Third, charging interest and not charging interest are both awkward. Charge it, and you pay tax on the interest; do not charge it, and you have to explain why. The same money, in a different legal coat, and all three problems disappear.

Section 72 of the Companies Act: preference shares

That coat is the preference share. Section 72 of the Companies Act 2016: "Subject to the constitution, a company having a share capital may issue preference shares." Note the first phrase — subject to the constitution. That is the first fatal point. Without authority in the constitution, you cannot issue. And many companies have had no constitution at all since the new Companies Act. So the first thing to do is not to call an accountant, it is to dig out the constitution and read it. The provision goes on: with authority in the constitution, a company may issue redeemable preference shares — shares the company can buy back later. That is exactly what the boss wants: when the money goes in it is share capital, not a liability; and when it comes back out, it is redeemed on the terms written into the constitution. When you can take it back is something you design yourself, not "withdrawable at any time".

Three sources for a redemption, and one gate

To redeem, the provision has rules. First, those shares must be fully paid up. Not fully paid, not redeemable. Second, the money for the redemption may come from only three places: one, profits; two, a fresh issue of shares; three, the company's capital. The first two are relatively simple. If you redeem out of profits, the provision requires an equal sum to be transferred into the company's share capital account — meaning those profits can no longer be paid out as a dividend; they have taken the place of what left. The third — redeeming out of capital — has a gate. All the directors must make a solvency statement, and the company must lodge a copy of that statement with the Registrar. All of them, not a majority. And one more line: the Registrar must be notified within fourteen days of the redemption. Incidentally, the provision also says something that puts a lot of people at ease: redeeming preference shares is not a reduction of the company's share capital.

Where a lot of people come unstuck: equity or liability?

Now the most valuable part of this episode. You assume that once you have issued preference shares the company's equity is thicker and the gearing looks better. Not necessarily. Because the accounting standards do not look at the name, they look at the terms. If the terms say the shares must be redeemed, or that the holder may require the company to redeem them, then in the accounts they are a liability, not equity. And the "dividend" you pay becomes interest expense in the profit and loss account. If the terms say redemption is at the company's own option, and the dividends are discretionary, only then are they equity. Where is the difference? In who holds that option. The option sits with the holder, and it is debt. The option sits with the company, and it is equity. So a carelessly drafted set of preference share terms will let you think you have raised capital, and then — your gearing has gone up rather than down, and the bank's loan covenants are triggered anyway. How the terms are written matters more than whether you issue at all.

Back to group consolidation

Last, back to the group accounts we have discussed before. Loans between companies, preference shares between companies — what happens to them in the consolidated accounts? If the other party is a subsidiary, everything is eliminated. The money you lent it and the money it owes you cancel each other out in the consolidation and disappear. If the other party is an associated company, nothing is eliminated. That receivable stays on the face of your balance sheet, in plain sight, where everyone can see it. So from the group's point of view, one sentence matters: money moved between subsidiaries changes nothing at all on the consolidated accounts. All that changes is the legal risk, and the tax. But move money to an associated company and that receivable stays on the face of the statements — everyone can see it, and everyone will ask one question: is it collectable? That is another reason why the shareholding line has to be drawn so clearly.

To close

So, one line: money you want back should go in as shares, not as a loan. To use shares, you have three things to do first: read the constitution, write the terms, and work out whether it is really equity or a liability. None of the three is difficult. What is difficult is that nobody ever reminds you to do them. Want to see whether preference shares suit your situation, and how the terms should be drafted? Grab a coffee first and talk about your business. For the accounting, come to LTT. I am LTT, helping SME bosses get their accounts straight. Follow us, and see you next time.