Startups and debt (IV): The importance of security interests and new intangibles
In earlier articles in this series (see here) we looked at the key role of venture capital funds, the reasons and setbacks associated with startups’ exclusive dependence on equity rounds, together with the advantages that debt would have for them. We also determined that this is a promising environment for borrowing. Then we looked at the difficulty with providing general recipes for raising debt finance and a few routes that do not seem very promising for startups, such as commercial banks and their ordinary channels and conventional bond issues. In our latest article we explored venture debt as a suitable debt financing mechanism for startups. And here we analyze the importance of security interests and of thinking up ways to use new intangibles.
Importance of security interests
In our search for new debt financing mechanisms, we need to return to an element already mentioned in relation to venture debt that will pave the way to those other mechanisms, or might even be a necessary condition. By this we mean security interests. Venture debt lenders require first priority security interests in the startup’s tangible and intangible assets.
By doing this lenders try to mitigate the high credit risk they assume and reduce, if not the likelihood of nonpayment (meaning the chances of the debtor defaulting on any of its payment obligations), at least the severity of the loss that it will involve. This is achieved by obtaining security interests in the company's assets or rights which will enable them, in the event of default, to enforce their rights and obtain recovery.
In the mind of a venture debt provider, obtaining those security interests may be a secondary element because it is the greater or lesser belief in the successful performance of a later round or of a sale as a source of repayment that will prompt their decision to lend and the sum they offer. Security interests are always asked for, but they are probably not the only determining factors.
If, however, we want to go beyond venture debt and loosen further the connection between the repayment of debt and equity rounds, the security interests provided by the startup will be the most important element for lenders. Needless to say we are talking here about proprietary interests, meaning mortgages or pledges on the borrower’s property and rights, not about personal guarantees by founders or shareholders.
Providing security interests as a key to obtaining other forms of credit
Security interests can help startups secure other debt financing mechanisms apart from venture debt. This sits within the classic paradigms of corporate finance taking the view that the least solvent company can get credit if it can provide security interests. So, if the startup can provide a more robust package of security interests it can expand its options for getting debt financing. This may be one of the levers to turn the cogs of the machine. Which means there is much to be gained by deepening the search for valuable and effective security interests.
Security interests can be provided in a whole range of the startup’s property and rights
Startups have to be prepared to provide first priority security interests in all their assets; which translates into pledging or mortgaging bank accounts and their balances, any invoices or receivables, their tangible assets, and any intellectual property that the company owns.
Pledging tax credits
Rights to receive tax refunds may be included among their receivables. A few specialized lenders offer to buy (at a discount) startups’ rights to obtain tax credits in respect of R&D expenses incurred in the development of their products or services, which is another expression of the ability to use (and monetize) tax credits.
Startups have a short supply of assets to provide as security so we have to think up innovative security
We know, however, that startups have few assets and no or very low revenues. So it is worth giving thought to the range of security interests that can be provided, beyond the paltry number of options produced in the first count, so as to make the selection as robust as possible. This thought process may lead us to new or borderline scenarios and concepts, or even to identify cases that would need changes to the law.
Let's start with intangibles. Among the company’s intangibles, it may of course grant lenders interests in brands, patents, utility models, industrial designs and copyright or software rights.
Security interests in new types of intangibles. Trade secrets
Security interests in brands, patents and a few other kinds of intellectual property are now time-honored legal concepts. Alongside these rights, however, and often in their absence (startups generally may not yet have finalized these distinctive signs or created these patentable inventions), it is worthwhile to explore different and lesser known types of intangibles that a company in its early stages does have.
One of these may be trade secrets, a very recent concept offering greater flexibility than patents and consisting of the ability to obtain a proprietary right and exclusive use of the elements making up the company’s know-how on condition that they have tradeable value and severe measures are taken to protect their secrecy.
Legislation on trade secrets recently appeared in EU Directive 2016/943 on the protection of undisclosed know-how and business information (trade secrets) against their unlawful acquisition, use and disclosure. This directive was implemented in Spain in Law 1/2019, of February 20, 2019, on trade secrets.
A company will always benefit by identifying and documenting its secrets as a means of ensuring exclusive ownership of them; once they have done this, any secrets so recorded can be pledged or provided as security and consequently added to the package of security interests they are able to provide.
This chapter warrants a separate study to go more deeply into the substantive and procedural elements of the process of documenting secrets, as a prior step, and of subsequently perfecting security interests in them. In particular, thought should be given to the clauses that the instrument must contain, their recording in a public deed, the register on which they have to be entered, or to any other formality needed to perfect the rights and make them enforceable against third parties and, most importantly, the enforcement mechanisms for the security and for the creditor to realize their economic value.
Other innovative security interests in intangibles: 'sui generis' rights in databases
Other rights to be considered are so-called “sui generis” rights in databases, a relatively new intangible that a few startups may hold. It is similarly conceivable that, due to being an acknowledged right of the owner and having clear financial content, it should be possible to create a security interest in it. This concept is also worth studying in greater depth.
Interesting treatment of this right is given in the Spanish Supreme Court’s decision delivered on January 31, 2018 to settle the dispute between IMS Health and Infonis, which has been described by numerous commentators as a case of use and protection of pharmaceutical big data.
In our next article in this series we will continue considering new types of security interests that startups could grant to attract debt financing.