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Out of necessity or choice, founders of early-stage startups often personally finance company operations through loans. Founders may pay for startup costs with the expectation of eventual reimbursement.
However, unless founders formally document the expenditures as loans to the company, they risk leaving themselves out of the startup’s list of creditors and therefore without valid repayment claims if the company is sold or winds down.
This article discusses why and how founders should document personal loans to their Delaware startups.
Examples of founder loans
For the purpose of receiving the right to repayment, a loan can include any expense or amount paid with the expectation of reimbursement. Startup founders often personally pay for business expenses with the assumption that they will receive repayment for all or part of the costs – but without proper documentation, this can needlessly complicate repayment options.
As a starting point, a best practice is to use company cards or accounts in the company’s name to pay for business expenses. This avoids the risk of informal loans.
However, in practice, this doesn’t always happen: a startup’s bank account may not be ready or sufficiently funded to cover necessary costs.
Instead, founders may use personal credit cards, direct bank transfers, or other means of payment to finance business expenses. Founders may also directly transfer funds from personal accounts to the company bank account to facilitate a payment.
In a startup’s early days, common examples of founder loans include using personal funds to pay for business software contracts, product development, incorporation lawyers, filings fees, and website costs.
As the startup grows, personal funds are sometimes used for taxes, employee wages, or travel, meeting, and other business expenses.
Importance of documenting founder loans
As part of an exit or wind-down event, company assets are sold and remaining proceeds are distributed pro rata (proportionally) to creditors and investors by order of claims preference. Outside of their potential role as company employees with owed wages, founders do not receive preferential treatment as company creditors – the priority of claims is governed by state law and agreements between the company and creditors and investors (Dunne & Uzzi, 2023).
As a result, it’s important that founders document personal loans to the company through formal agreements just as they would with any other creditor. If founders disregard the claims priority and repay themselves preferentially and/or without proper documentation ahead of creditors and investors, these stakeholders may challenge the payment and seek a reversal.
Founders as company directors owe two primary fiduciary duties to their startup and its beneficiaries: the duty of care and the duty of loyalty. Within the context of repaying creditor claims including personal loans, founders should take extra care to abide by their fiduciary duties.
Creditors and shareholders may apply close scrutiny to the repayment process; if founders stand to receive proceeds from an exit or wind-down event, they may not be seen as disinterested in the distributions process. Properly documented loan agreements reflecting founders’ rights to proceeds can help demonstrate financially just decision-making.
Order of creditors
Outside of bankruptcy, state law and agreements between the company, creditors, and investors govern the priority of claims (Dunne & Uzzi, 2023).
In Delaware, creditor claimants typically have the right to be paid in full ahead of shareholders. If funds are insufficient, creditor claimants should be paid according to priority and then ratably (8 Del. C. § 281). Delaware code is clear about the order in which obligations should be repaid – secured creditors, unsecured creditors, then equity interests.
If founders properly document their personal loans to the startup, in most cases they would be included in the unsecured creditors’ category. This can be important in a number of situations, such as when funds available after payment to creditors would otherwise be allocated to investors or other shareholders.
Documenting founder loans
It’s worth reiterating that the simplest way to pay for company expenses is to use a company credit card or bank account; business costs are paid for directly by the company and there is no loan.
If a founder must make a purchase on behalf of the company, then the founder should document the loans at the time they are made. The full set of documentation ideally includes a signed loan agreement between the company and the lender, receipts reflecting the business expenses, and bank records.
Loan agreements
At a minimum, loan agreements should clearly state the amount of the loan, the name of the lender, and the loan maturity date (date the loan must be repaid by).
The name of the lender should match the name of the person who paid for the expenses being reimbursed (for example, if the founder’s spouse, family member, or friend transferred money or made business purchases, the loan agreement should be in that person’s name). The loan agreement should be signed by both the lender and an officer of the startup – in some cases, the founder may be both parties.
Receipts
Founders should save copies or screenshots of all receipts of purchases made on behalf of the startup. In case there are later challenges to the credit, receipts help substantiate the reason for the loan.
Bank records
There are potentially two types of bank records that reflect founder loans to a startup: a record of a founder transferring money to the company bank account and a record of the company transferring money back to the founder as a repayment. The bank records show as line items in the ledger of the company’s bank account.
Founders should take screenshots or otherwise maintain access to the ledger to clearly track the movement of money. Combined with loan agreements and receipts, bank records are a powerful way to demonstrate loans between a founder and the startup.
Ratifying loan agreements
In the event that a loan from a founder to the startup wasn’t documented at the time it was made, it may be possible to document it retroactively. The practice of entering into an agreement or contract with an effective date prior to the present date is referred to as “ratification”. Ratification procedures are governed by the company’s state of incorporation (for Delaware, procedures are outlined in 8 Del. C. § 204).
Broadly speaking, ratifying an agreement should be approved by involved parties and not negatively impact third-party rights. The unique situation for startups is that, often, the founder is both the lender and the authorized company officer approving the loan. As a result, the key focus area for startup founders when ratifying a historical loan agreement should be the impact on third-party rights.
Critically, a ratified loan agreement should clearly and transparently indicate that it is entered into retroactively and that the agreement it documents is the same agreement that has been in place from the time that the funds were transferred to the company.
Some examples of when ratifying a loan agreement could be appropriate:
The founder pays for a number of small business expenses on behalf of the startup over a period of days or weeks. For administrative convenience, the founder sums the expenses and creates a single loan agreement for the total amount, ratifying it to the first expense date.
The company has no other creditors or investors whose rights could be adversely affected by the ratified loan agreement.
There is clear proof that a loan agreement was intended. The presence of receipts, bank records, and written communications may help substantiate the argument.
Some examples of when backdating a loan agreement is likely not appropriate:
There is no record suggesting an expectation of repayment.
The terms of the ratified loan agreement would differ from the terms of the originally expected loan.
Existing loan or investor agreements contain clauses restricting the company’s ability to enter into new loan agreements.
Creditors or investors may challenge the ratified loan agreements if they believe the founder breached their fiduciary duties to the startup when entering into them.
Due to the risks involved with ratifying loan agreements, it is often worth consulting a legal advisor for loans covering any material amounts.