Corporate finance, which arises through a typical or atypical company, through profit participation certificates or even through subordinated or seller loans, is for most business owners already well-known and proven instruments that provide their companies with good liquidity outside of traditional bank financing. A largely still unknown element of corporate finance, however, is the participatory loan as part of mezzanine financing instruments. This is a special form of loan for corporate or equity loans. The lender grants the borrower a loan and receives a share of the company’s profits or sales instead of a fixed rate or capital or interest repayment. That is why one speaks of a profit loan.
If, for example, a partnership needs additional capital, this can be obtained from certain partners, here the partners. In return, the partners themselves have the right to participate in the success of the company. The partners who are not fully liable in any case enjoy the advantage that the loan itself does not extend their liability. The difference between a participatory loan and a silent company is often difficult to determine, but the main reason is the lack of influence on the company’s business. Therefore, participation of the partner in the loss of the company is always excluded.
The main advantage of a participatory loan lies in its simple investment model and it is also extremely inexpensive. Since this form of loan can be optimally adapted to the needs of a partnership, this form is particularly suitable as a so-called bridge financing. Bridge financing is financial resources that are made available to a company with the aim of improving its equity ratio. They often also serve as bridging finance in preparation for an IPO. The bridge financing is designed in such a way that it can be permanently replaced by equity or debt. If only equity capital is used for bridge financing, the equity ratio is improved. If an IPO is planned, the profit from the IPO is usually used to cover bridge financing.
In the case of a participatory loan by the borrowing company, there is no say whatsoever in terms of management or company decisions. Nevertheless, the parties have the option of agreeing any control rights for the lender. Since both borrowers and lenders can interpret their contractual arrangements very differently, the participatory loan is often equivalent to an atypical silent society. The boundaries are almost fluid, and some of them can no longer be determined exactly. The advantage for the company is that it only has to pay interest to the lender if it is doing well. In principle, the lender may not be involved in the loss of a company. In addition to profit sharing, an interest payment obligation can also be contractually agreed.
Partial loans also benefit many companies because the structure of power within the company is not affected by the granting of the loan, because the lender cannot exert any influence on the business decisions. It only has certain control rights. In addition to a partner, a partner-managing director of a GmbH can also participate in the GmbH with a participatory loan in addition to his regular contribution. A fixed percentage is always agreed with regard to profit or sales. As a result, the repayment amounts for the loan also change depending on how the profit develops. The loan itself can be granted to both partnerships and corporations. For the company, such a loan has the advantage that it only has to pay interest if it can also operate profitably with the capital made available. Conversely, if the company operates successfully, the investor has the advantage that he can achieve an interest rate that is above the capital market interest rate.
The use of participatory loans
The participatory loan is a special form of loan as a form of financing. It is a question of financing by a natural or legal person in a company or an individual businessman who borrows a certain amount of money. However, the borrower does not receive an interest claim – as in the case of an ordinary loan – this is rather a share of the company’s profit or turnover. One therefore speaks of a shareholder loan or a profit-sharing loan that a partnership receives from its shareholders. The company only receives additional capital from its shareholders. Some of the loan itself has a fixed but relatively low base rate and is therefore not always distinguishable from a silent company.
If there is an inflow or outflow of capital, this does not trigger a shift in the power structure of the overall shareholders. Rather, the shareholders receive interest that is generally based on the company’s success. The advantage is that in most cases this interest rate is significantly higher than that for alternative investments. There is also a partial loan in the event that companies have fixed equity. And that denies their shareholders or part of them a right of withdrawal. The partners experience a further advantage in that, despite the loan being granted, they do not experience any expansion of their scope of liability. As a result, they remain non-fully liable partners.
As a result, there is no direct company participation in the participatory loan, so neither parts nor shares in a company are taken over. This has the advantage that there is no significant influence on business decisions for the borrowing company. Since the approval of participatory loans is only object-related or project-related, there is no need to examine them in accordance with the capital guidelines as prescribed by the banks.
However, even if a loan is not granted via business indicators, certain conditions are required for the borrower, in particular the project to be financed. Therefore, the granting of credit is made dependent on so-called economic studies, which confirm the feasibility of the planned project and the return expectations for the future. A company can only be financed through this form of loan if these forecasts are accurate. The main difference to the silent society is, however, that the silent society aims at the formation of a special purpose community, while the purpose of the participatory loan is always the mere granting of a loan.
This participation can accordingly be limited specifically to the business purpose for which the loan was granted. However, it can also affect the entire company’s activities. When granting a loan, the borrower is obliged to disclose his business evaluations, the profit and loss account and the balance sheet to the lender at regular intervals. Based on these numbers, the exact returns can then be calculated accordingly. In practice, there is often a contract that the lender can agree to regular installments in advance. However, a real security of the participatory loan is usually not agreed.
Therefore, money that is received as a participatory loan is always “repayable money” if only the interest, but not the repayment of the loan, is to depend on the success of the company. If a participatory loan agreement is drawn up in this form, it also fulfills the facts of the deposit business, which can only be excluded by qualified subordination. Since the interest rate is dependent on the profit of a company, disbursements in the event of loss situations are largely avoided – a clear advantage for all companies looking for capital.
The tax liability for participatory loans
Especially in economically tense situations, corporate loans are used in addition to the classic financing instruments as well as participatory loans. In this context, experts also speak of hybrid forms of financing. The forms of hybrid loans are very different. However, the most important form is found to strengthen the equity base.
The tax court sees this tax liability in the distinction between participatory loan and a normal loan. According to this, a partial loan is available if the lender is granted a share in the economic success of the company. In this context, participation in a liquidity surplus remaining at the end of the company is sufficient. This applies even if the participation in the surplus is not certain when the contract is concluded. But it must be possible. However, this may not be a normal loan in accordance with Section 43 (1) No. 7 EStG. In this context, the Münster Finance Court further stipulated that the remuneration should not only be paid in a fixed periodic amount, but rather had to consist of a share in the success achieved for the borrower. The remuneration can be both profit and turnover dependent.
The tax problem with this arrangement lies in particular in the delimitation between the various types of income tax income. This is because interest income, such as that deriving from loans, must always be declared as income from capital assets, while income from a participation in a company represents income from business operations. If companies use participatory loans, a differentiation is only possible in individual cases. On the other hand, when it comes to indicators of commercial income, management or other control rights associated with the profit sharing should be mentioned in particular.
Therefore, income from participatory loans must always be recognized in the context of income from capital assets according to § 20 EStG if the lender is not to be regarded as a co-entrepreneur or if the participatory loan is also not part of the company’s business assets. In addition, participatory loans in accordance with section 292 (1) no. 2 AktG always represent a net profit transfer agreement. Income from participatory loans are therefore part of income from capital assets in accordance with section 20 (1) no. 4 EStG, which in turn are subject to section 43 subs 1 No. 3 of the capital gains tax.
The borrower himself is obliged to show the participatory loan in his balance sheet as debt. In accordance with commercial law, the remuneration owed for a participatory loan is to reduce profits. If there is an additional performance-related remuneration for the lender and this can only be estimated at first (sections 249 (1) and 269 (3) HGB), a provision must be made accordingly. A prerequisite for the tax recognition of the loan interest as operating expenses is, however, that the contractual agreements are regulated as usual between third parties.
If the contractual agreements were concluded after December 31, 2008, the current income from the loan and any sales transactions are subject to the final withholding tax, regardless of their holding period. If the contractual agreements on the loan were made before January 1, 2009, payments by the borrower above the face value are taxable as another benefit and are therefore taxable at the general income tax rate. On the other hand, if the payments are made by third parties, a tax liability at the general income tax rate only arises if a sale is made within 12 months.
The contractual components of a loan contract
The loan itself always comes from a declaration of intent and by adding the loan amount – usually by the bank. The borrower – the entrepreneur – subsequently becomes the owner of the loan amount, which he can dispose of at will. Accordingly, he then bears the risk of destruction or loss. The lender bears the risk of the borrower’s illiquidity.
The advantages and disadvantages of a participatory loan
A major advantage of the borrower is of course primarily the inflow of capital – be it as a bridge for a share move or in the event of a poor economic forecast if the house bank no longer wants to grant an ordinary loan. A disadvantage is that a third party gets an insight into the operation. This often creates fear of espionage. Another advantage is the additional financial burden compared to a normal loan, since the borrower not only has to “pay out” the interest, but also part of his profit to the lender. If the financial situation of a company is not so good anyway, such financing can also have a bitter impact.
In return, the lender has the advantage that he makes a much higher profit from lending than would be the case with pure lending. If the company does not make a profit, the lender will still share in the interest. Even if this is a speculative profit sharing, since the lender naturally wants to participate in the highest possible profit, there is no problematic disadvantage from the participation itself. The investor only generates income from capital assets within the meaning of income tax law. And even this tax treatment cannot necessarily be interpreted as a disadvantage.
The problem only arises in the event that the lender can exercise a certain influence or control rights on the borrowing company. In this case, the lender becomes a co-entrepreneur and thereby generates income from business operations. And that means that the lender has to pay trade tax in addition to his income tax. Overall, participatory loans offer a multitude of advantages, ranging from long-term terms, a low minimum interest rate to profit sharing by the borrower. In addition, participatory loans are not only independent of banks, but almost no guarantees or other real collateral are required for the loan itself.
Incentive loans are therefore particularly suitable for project finance, for business start-ups, for company takeovers, and for product developments and launches. In most cases, contract terms between 5 and 15 years are agreed, the loan itself is always repayment-free within the term, because the loan amount is only reimbursed in one amount when the contract expires. Subsequently, borrowers can again seek follow-up financing from their house bank, since the rating has improved significantly over the term due to the participatory loan. The terms are so long because the company profits are not very high in the first few years. So he waits for the development accordingly and then benefits at a later point in time when success sets in.
Since participatory loans are always reclassified as economic equity due to their subordinate status, this not only increases the equity ratio, but also significantly improves the company’s rating. But there are also advantages in that creditors and debtors are not united to form a real society. In addition, the parties always have the option of structuring their contractual components as required, so that, for example, a creditor’s right to monitor can also take place. As a rule, however, a certain fee is agreed for the use of the loan, in the form of a regular amount of interest to be paid and / or in the form of a profit sharing scheme.
Compared to other investments, the participatory loan also has the advantage that it can also be sold to the public without a formal sales prospectus. This has the advantage that the company seeking capital does not experience any delays due to the preparation of prospectuses and approval procedures by Astro Finance. Depending on the corresponding contractual arrangement, the sales department does not require a license under the German Banking Act; rather, only a license in accordance with Section 34 c of the Trade Code is required.
The financing instrument itself can be provided with a subordinate clause or a resignation behind other creditor claims (so-called subordination) with the advantage that the loan is then classified as so-called “economic equity”. This then turns them into “fake mezzanine capital”. Partial loans therefore also represent contractual money loan contracts – in contrast to property loans (Section 607 BGB) – in which the loan partner as a lender takes on a creditor position and receives an interest claim in return for this. Since a securities prospectus is not absolutely necessary for a participatory loan to a third party, a so-called legal entry threshold applies (section 3 (2) of the securities prospectus law. In this case, only 99 potential investors may apply or be addressed.
The disadvantage again lies in the fact that loans (money for interest) according to § 1 of the German Banking Act can only be granted or accepted by banks in the sense of their lending business (e.g. as deposits). However, this again does not apply to securities-oriented loans, they can be issued by anyone, including private individuals.