A few years ago, I wrote in my blog that the registration of a limited company without share capital is possible in several countries. The aim is to lower the threshold for entrepreneurship and it has certainly done so. Now that we look at it from a practical point of view, the flip side of the ease of incorporation has been highlighted by the difficulty of closing the company. In other words, if a limited liability company has been set up without a clear plan for its future, or if circumstances have changed irreversibly as a result of covid-19, the idea of dissolving the company may have arisen. The associated liquidation process, with its costs and the time it takes, has come as a surprise to many entrepreneurs. The country-specific corporate law usually states that if the Board of directors finds that the company’s equity capital is negative, they shall without delay take action. For example, in Finland you must make a notification to the Trade Register of the loss of share capital. There is more time in some countries to correct the balance, for example by the next annual closing of the company bookkeeping.
In practice, negative equity usually appears when the “total equity” line in the company bookkeeping balance sheet shows a figure under zero. Many small company has been set up without share capital, has no other equity invested and might be making a loss. In such a case, a loss of even one euro results in negative equity, which could lead to problems. It is quite easy to make a loss and the issue of negative equity can sometimes come as a surprise to the entrepreneur. The traditional situation is that of a start-up company with a short first financial period, financed with a loan. There may be liquidity for payroll and other expenses, but sales invoicing has not really started yet. The outcome for the period is a loss = negative equity. I encountered a slightly more peculiar situation recently in the connection of a car finance. A small company that employs its sole owner well and is able to pay a normal salary. In addition to the cash salary, a car benefit was utilized by buying a car on the company’s balance sheet with 100% financing. Some EBITDA margin is generated and there is enough cash to cover the repayments, but the annual depreciation of the car will bring the result down so badly that the equity is strongly negative.
There are a number of situations, as described above, where a small business can run into a negative equity problem. There are also accounting means that can be used to improve the situation without stepping into the grey area. For example, expense entries should not be aggressive and the overall periodization of costs can make a difference; whether it is actually an expense for next year or an investment for future years. The periodization of income and expenses for companies receiving various project grants is an art in itself, and expertise in this area is important in avoiding negative equity. However, the easiest action point is to invest sufficient equity in the company as early as possible. This does not have to be in the form of share capital since there are more flexible ways to be utilized. Alternatives can be sought, for example, by bookings a meeting with Digibalance Consultancy Service, where the issue can be examined directly on the basis of the client company bookkeeping.
Why should a negative equity be avoided? It is difficult to give an exhaustive answer to this question, but first of all it creates the situation mentioned at the beginning, where further action is required. If the notification to Trade Register is needed, there is also a need for further action to remove the entry in the register at a later date. This will entail accounting work and costs, i.e. it will also be an administrative burden. The notification in itself may also create complications to run the business. Purchasing goods or services on invoice may become more difficult. If you go to the bank to apply for a loan, this entry in the trade register may put an end to all discussions. The same result is faced if you show a balance sheet showing negative equity, even if there is no registration requirement for that. There might also be the risk that board members will be personally liable for damages or other problems the company may have.
The conclusion is very clear: even a small company should avoid negative equity because of the effort and risks involved. However, it does not automatically remove all the conditions for doing business.
Author Mikko Ilves the Chairman of the Board of Digibalance Group