Lenders sometimes charge an “interest rate” that varies with the profits of the borrower’s business. So, rather than an interest rate of 5% per annum of the principal amount, the rate of return might be 5% of the borrower’s before-tax profit for that year. This can be attractive to the lender, as it gives them a share in the borrower’s “upside” if the business does well. (What about the “downside” of the business not doing well? Lenders often contract for a minimum rate of return, perhaps a fixed rate of interest, with the profit-based return as a kind of bonus.)
Lenders need to be aware that this type of arrangement can end up prejudicing their ability to recover their loan, in two possible ways.
First, if their borrower becomes bankrupt, s. 139 of the Bankruptcy and Insolvency Act applies:
Where a lender advances money to a borrower engaged or about to engage in trade or business under a contract with the borrower that the lender shall receive a rate of interest varying with the profits or shall receive a share of the profits arising from carrying on the trade or business, and the borrower subsequently becomes bankrupt, the lender of the money is not entitled to recover anything in respect of the loan until the claims of all other creditors of the borrower have been satisfied.
Being postponed behind all other creditors usually means receiving no payment whatsoever, so this provision essentially invalidates these types of loans, in a bankruptcy.
Secondly, even where there is no bankruptcy, such a loan might be characterized as a capital contribution, rather than a loan at all. The distinction between these two types of transactions can be complicated and difficult to discern ahead of time, but in essence a capital contribution is more of a stake in the business than simply an arm’s length loan. Where an advance is characterized as a capital contribution, again the law postpones any payment on it until all other creditors are paid in full.
Careful consideration should be given to any creative lending arrangements, to ensure that they don’t end up punishing the lender.