Today’s Globe and Mail reports online a comment from the leader of the Ontario New Democratic Party, Howard Hampton, regarding the bailout of the three North American automobile manufacturers. It says:
“Ontario NDP Leader Howard Hampton said he would like to see the government take some shares in the companies in return for the loans.
“If, worst case scenario happens and one of these companies goes under, you’ll want some assets.”
A clearer example of someone NOT understanding how the system works couldn’t be found. As a shareholder, the shareholders are entitled, upon a dissolution or a bankruptcy, to a division of the equity of a company. However, while the equity comes from “some assets”, it is only those assets which are left over after all of the creditors have been paid.
If the auto makers need bailouts – and that is the case for Daimler-Chrysler and G.M. (but in Canada, for the moment, not for Ford) – then that means that they are insolvent. Insolvency, as defined in the Bankruptcy & Insolvency Act, is the inability to meet your financial obligations as they come due. In other words, you can’t pay your bills. So, if their liabilities exceed their assets, then there are no assets left to pay the shareholders. It’s therefore all well and good for Mr. Hampton to say that the federal and provincial governments should take shares, but if the shareholders are the last ones to ever get paid (and likely wouldn’t ever get paid if the “worst case scenario” happens) then the shares are worthless pieces of paper. Instead, the governments should have the opportunity of converting their loans (ie. debt) into shares (ie. equity) if and when the auto manufacturers turn the financial corner.
So, what does this mean for your business? Well, again, it is great for you to have all sorts of shares in the company or other forms of equity. But, if things start to go downhill, then your shares mean that you have a one-way ticket to the back of the line behind the other creditors. Instead, you should think about making loans to the company rather than taking an increased equity position in the business. To make things even better, have the company grant security for the loans and have that security registered with the personal property security registry. That way, if things do go badly, you may not have a position at the front of the line, but you will not be guaranteed to be at the back of the line. Similarly, the loan agreements can give you the right to convert your loans into equity later on if the business does well. That way you can cover the good and the bad times.