Secrets of Bonding #35: Good Loans / Bad Loans

When it comes to Performance & Payment Bonds, there are two kinds of Stockholder Loans – and they can have a big effect on the underwriting.

The first step is to figure out if such loans are in the picture.  Where do you look?  You find these loans on the company financial statement: the Balance Sheet.

The Balance Sheet consists of Assets and Liabilities.  Money owed to the company is an Asset. A loan receivable would be an example.  If a stockholder borrows money from the company, the loan is an Asset on the company Balance Sheet and a Liability on the stockholder’s personal financial statement.  It is a Stockholder Loan Receivable. Assets are good to have – so is this?

Nope, it’s the “Bad Loan.”

Liabilities: Some examples are Accounts Payable, Bank Debt, and Accrued Taxes. If Liabilities are a burden, can a Stockholder Loan Payable be the “Good Loan”?

Yes it is!  Sounds crazy?  Let’s find out why.

Surety underwriters evaluate the financial strength of the company. When we review the assets we consider their strength and reliability.

  1. If a stockholder borrows money from the company, it has been “removed” in a sense – which hurts the bonding.
  2. In addition, we assume that in a worst case scenario, the stockholder will chose to not pay the loan back.  Be realistic: If they thought the company was headed for bankruptcy, would they throw more money down the hole?  Underwriters think that in such cases the loan will not be paid back and for these two reasons the Stockholder Loan Receivable (Asset) it is the Bad Loan.  When underwriters disallow the asset, they deduct an equivalent amount from Net Worth so the Balance Sheet balances.

The Stockholder Loan Payable is the Good Loan.  Can you guess why?  It’s a Liability. Are some liabilities actually good?

The liability side of the Balance Sheet has two main sections, Liabilities and Stockholders Equity aka Net Worth (NW).  Net Worth represents the portion of the assets owned by the stockholders as opposed to outside creditors, such as the bank.  Stockholders Equity is all money owned by the stockholders and owed by the company. (The company itself doesn’t own anything!)  Underwriters like NW because it is debt owed to the stockholders who are also indemnitors to the Surety.

The key to making the Stockholder Loan Payable most beneficial is to Subordinate the loan to the surety, which may enable it to be considered Stockholder’s Equity rather than debt.  The Subordination moves it from the liability section (bad) to the Stockholders Equity section (good).  When a Stockholders Loan Payable is Subordinated and considered Equity, it’s the really Good Loan!

Caution: Not all sureties have the flexibility to recognize this subordination procedure – so you’ll just have to ask.  We’re proud to say that we do.

So there you have it.  To summarize: Stockholders should not borrow from the company.  These loans are disallowed by underwriters and hurt the bonding capacity.  Clients who have such loans on their books should pay them down as quickly as possible.

Money they loan to the company (Stockholder Loan Payable, a liability) is helpful; it shows they supported the company when funds were needed.  However, for the debt to be considered Equity, it must be Subordinated – which locks it in the company for the long term.  Review Secret #20 “Subordination Agreements” or ask us for a copy.  A Subordinated Stockholder Loan Payable can be the Good Loan.

Good Loans / Bad Loans: Now you know!

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it! Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

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