Many early stage companies in Canada are self-financed, either with founder loans, or loans from friends and family. Some founders consider protecting their loans against trade creditors and other lenders by entering a form of loan agreement or promissory note, along with a general security agreement and registering that security interest against the assets of the company. As the company grows, this can help protect your capital in the event your start-up goes insolvent, with you being able to have first dibs (assuming you have an enforceable first ranking security interest) over the assets of the company.
Even for companies with no physical assets of value, registering a security interest can still be worthwhile if the business has intellectual property (like software code, patents, trademarks etc.) that you may want to own and continue to use in the event your company goes insolvent.
Promissory Notes and General Security Agreements
In a fast-moving start-up, it is common for founders to make loans, or incur expenses (which are later documented as loans to the company) and overlook formally entering promissory notes (or other forms of agreement documenting the debt obligation) and a ‘general security agreement’ or ‘GSA’.
If entered, the promissory note outlines the specifics of the loan, for example, the total amount, the method and timeline of repayment, interest rate etc. and the implications of a failure to repay. Other forms of loan agreements, such as a revolving credit agreement or fixed rate/fixed term loan agreement can be entered, the latter often not being ideal for a founder that wants the flexibility as to when the company causes repayment.
A GSA, on the other hand, serves as a protective measure for the lender (in this case, the founder). If a situation arises where the company cannot repay the loan (i.e. it is insolvent), the GSA (if registered and perfected under the applicable legislation) can allow the founder (with some exceptions) to claim, seize and/or liquidate the company’s assets in order to recoup the loan amount (or more likely, part of it).
Take for example one client of mine, an e-commerce store sitting on inventory, that was forced into insolvency by a creditor. Because the founder had properly registered a security interest (pursuant to the Personal Property Security Act in Ontario or “PPSA”) over their inventory for loans made by the founder, despite the insolvency, the founder was left in a position where he had a legal right to the inventory, liquidated as repayment for his loans. The unsecured creditor (Facebook in this case), was left with cents on the dollar of the debt owing to them, after the inventory was liquidated.
However, the use of GSA’s and PPSA security interests can also be abused. For example, I had a client see me years after they signed a loan agreement (which I did not advise on) where investors secured loans they made to a start-up. In hindsight, the loan seemed to have been made with the expectation the start-up would never be in a cash position to repay it on time.
Verbal statements were made to the founder, when the loan was made, encouraging them to come back to the lender when the company ran out of money. Instead, when funds ran low and the lender knew the debt could not be repaid, the lender made a demand for repayment, forced the company into insolvency, and moved to take the assets (including things like software code under development, trademarks, and other IP) to go start a new company.
In that situation, the lender effectively stripped the founder of their equity because they acquired the assets as payment for the loan (in connection with liquidation proceedings), and started a new entity without the original founder. In this example, it became clear the lender actually preferred to take the assets instead of repayment of the loan because they viewed the ability to use those assets (a new and yet to be released software program) inside a new company as more beneficial than the repayment of the loan. Their intent was to put a new CEO in place and move forward with a new company to market the software without the original founder.
You can imagine how painful that outcome would be for a founder who put all the blood, sweat and tears into creating their start-up. It would equally be painful for other minority shareholders of the company, and even employees who held stock options in the original company.
As you can see, it quickly becomes obvious why the terms of any loan with a co-founder or other lender are important, and why secured debt can have a significant impact on the company’s trajectory. The lessons? (1) be very careful with taking on debt and giving up security interests in your company; (2) consider having your own GSA and PPSA registration (done by a lawyer) if you are lending to your own company; and (3) have a lawyer review the terms of debt financings and specifically seek advice on what will happen in the event of a default on the repayment of the debt.
To make things more complicated, there are various circumstances under both legislation and common law that may result in even your first ranking security interest being void, declared to have been improperly registered, or even bumped below other creditors, even though they did not have a prior registered security interest. Among other examples:
- In Ontario (and possibly other provinces) lawyers may be able to register a solicitor’s lien on account of payments owing to them;
- Legislation may also permit the registration of a purchase money security interest (a “PMSI”). In short, a PMSI allows a lender to provide a loan to a debtor and register a security interest over a specific asset the money is used to buy. In that situation, even if you had a prior ranking security interest over all the assets of the debtor, the holder of the PMSI can take priority in the receipt of funds from liquidating the asset in question (or repossess that asset); and
- Courts may, in rare circumstances, also arrive at equitable and common law grounds for declaring a third party to have a greater right to an asset or cash, including for example as a result of constructive trusts or tracing remedies.
Again, seek legal advice from a lawyer anytime you are registering a security interest or PMSI, or when you are trying to enforce your rights in relation to a loan or GSA.
Keep in mind also that enforcing your security interest, especially in the event of bankruptcy and insolvency proceedings involving multiple creditors, can be slow and complicated. Courts will also issue a stay of proceedings against an insolvent company while creditors rights are sorted out. Often to enforce a security interest requires the appointment of a receiver or liquidator (sometimes appointed by a court) to carry out the orderly dissolution of the business. Nevertheless, registering your security interest can be an important step to take to protect your capital.
Subordinating Debt
Even with taking all the steps to protect your loans, if you later seek loans or convertible debt from more sophisticated lenders, like banks and private equity investors, they may require, as a condition of their loan, to take priority in the event the company defaults on its loans; a process referred to as ‘subordination’. That is, you are subordinating your rights, in favour of another lender coming after you.
Whether you decide to subordinate your existing debts owing to you from the company requires careful consideration, as you would need to decide whether the benefits of an additional loan from the new lender or other third party outweigh the drawback of potentially losing your front-of-line position on being repaid your debt.
DISCLAIMER: The information in this article is not (and is not intended to be) legal advice. This is legal information only. Reviewing information about the law may help you understand whether you need legal assistance. Whether and how this information applies to your circumstances requires the assistance of legal counsel who can apply the information to your needs. Do not rely on this article to make decisions. You may contact Wires Law, and we would be pleased to determine whether our firm can assist you. No solicitor-client relationship is established until we confirm we can act for you in a legal services agreement. Read our Terms of Use for more information.
John Wires
Latest posts by John Wires (see all)
- The Use of Holding Companies - June 10, 2025
- Negotiating Cofounder and Shareholder Agreements - June 10, 2025
- Holding Bitcoin on Your Balance Sheet in Canada - June 9, 2025