One of the strategic decisions that every business owner needs to consider is how to structure the ownership of their business. For most this will be a decision as to whether they should operate as a sole-trader or whether they should incorporate a company.
In the 2020 calendar year 58,621 new companies were incorporated. Perhaps one of these was yours?
The primary benefit to be obtained from operating as a company is the ability to obtain limited liability. This means that your personal financial risk is limited to the share capital of the company. This principle is most clearly demonstrated in the operation of listed companies on the share market. For instance, if I chose to buy shares in Chorus, Fletcher Building or Ryman Healthcare, the risk that I take on – regardless of what might happen to the company – is limited to the money that I paid to acquire the shares.
The same principle of limited liability applies regardless of whether the company is listed on the stock exchange or is a small company with one shareholder and director; however, certain actions taken by the shareholders and directors can negate this benefit. I’ll list them first, then explain what they mean:
- Providing personal guarantees to company suppliers or lenders
- Advancing money to the company
- Withdrawing money from the company, other than as dividends or wages
- Breaching directors’ duties
Providing personal guarantees:
A personal guarantee may be requested by a supplier or lender to a company. The grantor of the personal guarantee will then become liable for the debt should the company be unable to pay.
Personal guarantees are particularly common with lease agreements, bank loans and large corporate suppliers. Suppliers will often incorporate these into their terms of trade which will require the director to sign twice, once on behalf of the company, and once as the provider of the personal guarantee.
The request for the personal guarantee will usually be made of the company director. To this end, careful consideration should be given as to who the company directors will be. *BE AWARE: Whilst there can be many positive reasons for including both yourself and your partner as directors, your collective wealth could be at risk if you are both then required to provide personal guarantees. There may be benefits in having only one of you as a director of the company.
*TIP: Personal guarantees are also something that can potentially be negotiated with a supplier. Rather than signing a personal guarantee for a lease of five years without negotiation, for example, you could ask the landlord if they would consider removing this or limiting it – perhaps to the equivalent of three or six months’ rent. Similarly a supplier may consider waiving the personal guarantee if you agree to a lower credit limit.
Advancing money to the company:
Any money advanced by the shareholder or director to the company is an unsecured loan unless it is specifically documented as something different. *BE AWARE: Should the company fail, you will be included as an unsecured creditor and would only receive repayment from the company once other secured and preferential creditors have been paid.
*TIP: If you are considering advancing funds to your company, you should discuss this with your professional advisors and consider securing the funds that you are advancing by way of a General Security Agreement (also known as a GSA).
Withdrawing money from the company other than as dividends or wages:
There are a number of different ways that you can receive funds from your Company.
- Declaring a dividend
- Being paid as an employee with PAYE tax deducted and paid each month
- Taking drawings which may (or may not) later be cleared by a shareholder salary
*BE AWARE: It is this third option, in particular, which can often leave company shareholders and directors exposed. Specifically, any funds that have been withdrawn prior to any salary being declared, or in excess of the salary, are a loan which is repayable to the company. This creates what is known as an overdrawn shareholders’ current account. Should the company fail, a liquidator will immediately issue a demand for its repayment.
Breaching directors’ duties:
Whilst it is a wonderful feeling to list “company director” as your occupation on your social media profile, the title comes with some significant obligations as set out the Companies Act 1993. The directors’ duties are listed quite simply as:
- To act in good faith and in the best interests of the company
- To exercise powers for a proper purpose
- To comply with the Companies Act 1993 and company constitution
- Not to trade recklessly
- Not to incur obligations unless there are reasonable grounds to believe that the company can perform those obligations
- To exercise the care, diligence, and skill of a reasonable director
Whilst these seem fairly simple and straightforward, their meaning and interpretation has been hotly contested in our courts, resulting in a wealth of case law guidance on what represents a legitimate business decision and what is a breach of directors’ duties.
Any person who is listed as, or who acts as, a director will be subject to these duties. *TIP: I would suggest that no person should consent to being a director of a company unless they are prepared to actively act as the director and be responsible for the company’s decision making processes.
*BE AWARE: A breach of these duties can lead to a director being held personally liable for any losses suffered by the company.
Whilst a company structure offers some great benefits, care needs to be taken and consideration given as to how it should be structured and managed. This will vary from company to company. What worked for your cousin, neighbour or friend may not be right for your business. Therefore, it is important that you seek professional advice from an appropriately qualified advisor.
The good news is that there are a number of these across the Venus network!
Lynda Smart – Director, Rodgers Reidy
Find out how Lynda can help you here: https://www.rodgersreidy.com.au/our-people/lynda-smart
The writer is a licenced insolvency practitioner typically involved at the end of the company lifecycle when the issue of limited liability comes to the fore.
*The material contained in this document is provided only as an information source and is correct at the time of writing. The material is a generalised summary of the key issues and is not intended as a substitute for specific professional advice and should not be relied on for such a purpose. Independent professional advice should be obtained before relying on any aspect of this material.