In early-stage companies, debt financing is often only used in the specific context of convertible loans. Traditional debt financing can be tough for companies that are in a growth stage, as many are either pre-revenue or focus on reinvesting revenue in growth, not servicing debt. Conversely, for companies that have free cash flow sufficient to cover interest payments or a future balloon, but not enough to fund a large-scale expenditure, debt may be a preferred option.
Debt is generally preferable to founders who don’t want to dilute their ownership, and many are willing to sacrifice a fixed cash outlay in exchange for keeping the upside potential of their equity. In particular, when founders perceive a short-term need for cash but anticipate a return on investment faster than the repayment of the debt, the cost of debt may be relatively low.
Types of Debt Financing
As we discussed in our last post, debt can be categorized in multiple ways. Today we’ll be focusing on the unsecured/secured distinction.
Loans that are not backed by assets are referred to as unsecured loans. In order for an unsecured creditor to collect on a defaulted loan, they would need to obtain judgment against the debtor. To address the increased risk and difficulty of recovering the loan value, creditors generally offer worse terms for unsecured loans, such as through higher interest rates, shorter terms, or restrictions on borrowing purpose.
Companies will generally only obtain unsecured loans because they are unable or unwilling to provide assets to obtain a secured loan.
In a secured loan, the debtor pledges assets as collateral, and the creditor places a lien on these assets. In most cases, specific assets are “pledged” by the borrower, such as real property like buildings, intangibles like patents, or even entire subsidiaries. If the debtor later defaults on the loan, the creditor has legal recourse to take possession of the collateralized assets.
Creditors offer lower interest rates on secured loans, although it often varies based on the type of collateral that’s been pledged. Generally, lenders prefer collateral that is easier to value and sell, especially if the lender is an entity subject to risk-weighted asset regulation like Basel.
Assets as Collateral
Accountants and lawyers love asset classifications. At the highest level, assets are either tangible (physical assets) or intangible (non-physical assets). While tangible assets can always be used to secure financing, intangible assets can only be used in certain circumstances.
Banks vs. Other Lenders
Banks are subject to regulatory requirements above and beyond many financial organizations. With respect to what assets can be used to secure loans, banks often do not accept intangible assets as collateral for loans.
While there are some industries for which this isn’t an issue (retail has inventory, manufacturing has equipment), the modern era of industry is heavily digital. If you think about your own company, what tangible assets do you have? For many companies today, the only assets in this category are laptops or monitors. Even if organizations are not fully remote, many lease their office space and therefore don’t have title to any real property in the form of buildings or land.
Specialty lending and financing companies are often the best fit for companies whose collateral is in intangibles. These companies generally focus on lending against a specific type of collateral, like IP, and are designed to operate outside of risk-weighted asset regulation frameworks.
Assessing Your Intangibles
Step 1: Discovery + Inventory
Before you can obtain secured debt, you’ll need to know what assets you own. Conducting an inventory of your tangible and intangible assets can be done manually, especially if it’s fairly limited. For larger, more established, or more distributed companies, automated solutions can help ensure that you don’t overlook forgotten or hidden assets.
Common tech intangibles include:
- Source code
- Machine learning models
- Domain names
Step 2: Confirm Ownership
Given that the entire reason for securing an interest in property (even intangible property) is to ensure that the creditor has a way of recovering the value of a loan that defaults, it’s essential that debtors actually own the intangible assets. If clear title or ownership rights can’t be established due to omitted or contradictory contract terms, then organizations can find themselves up a creek – both for borrowing and for future M&A transactions.
Step 3: Valuation
What are your assets worth?
There are varying ways to determine what an asset is worth. Some factors to consider in answering this question are:
- What was the actual cost to produce it (i.e., the historical cost)?
- How much would someone spend to create this asset today (i.e., the cost to rebuild)?
- How much would someone be willing to pay to acquire this asset based on their business?
With respect to methods of valuing intangible assets, the most common approaches are: