Startups and debt (V): Security interests in future business revenues
In the previous four articles in this series (see here) we looked at the key role of professional investors at startups, though also at the setbacks of the exclusive dependence of these types of companies on equity and the advantages debt would have for them. The environment, as we saw, is also a favorable one for borrowing. We described the difficulty to provide general recipes for getting debt and a few not very promising routes. In search of more successful mechanisms, we examined venture debt as a suitable route for startups. Our latest article researched routes going beyond venture debt and determined in particular the importance of security interests for raising debt. In view of the characteristic structure of startups’ balance sheets we also saw the need to find innovative security interests within the reach of these companies, especially in certain new types of intangibles.
Security interests in future revenues
Here we continue our search for new security interests able to be provided by startups . Other items of property worth some thought as to whether they can be pledged or encumbered are accounts receivable and rights to payment generally. In our latest article we discussed the option of monetizing tax credits in certain cases. Although the broader challenge posed by accounts receivable lies in that theoretically young growing companies do not yet have a revenue stream from their services.
So how can security be extracted from here?
Pledging future payments
Technically we have to go to future payments (none are present and on the balance sheet, or, if there are any, the y are small amounts) and see whether they can be used to build security. The company’s business model and business plan most likely identifies in sufficient conceptual detail who the company’s customers will be and its revenues (advertising or purchase prices of its products and services stating the types of customers they will target or even identifying them, due to being fewer, in B2B models).
The problem is that, even if we have a clear idea in business terms of what type and who our customers will be, Spanish law is reluctant to allow an assignment or pledge of payments that are simply future rights. To validly create a pledge of those payments, Spanish law requires there to exist, at least when the security interest is created and in all cases before the company creating it enters insolvency, if that should happen, a contract or other legal relationship from which the future invoices or payments will arise. This principle is defined in article 271.3 of the revised Insolvency Law.
Unfortunately the wording of this article is not exactly the same as article 90.1.6 of the previous Insolvency Law before it was revised by Legislative Royal Decree 1/2020, of May 5, 2020: the difference lies in the tense of the verb, “have arisen” instead of “will arise” referring to future payments and the point when the insolvency order is made. This difference clouds the meaning to some extent, although there are many reasons to conclude that the correct way to read the law has not changed. In other words, a pledge of future payments will survive in the event of insolvency proceedings on the startup, as long as, when the pledge is created, contracts or legal relationships exist from which those rights will arise, even if the rights arise after the insolvency order.
Actually, it would not make sense to construe that any future rights arising after the insolvency proceeding will not be captured by the pledge, even if they come from contracts made before the proceeding, because, if this were so, what point is there in requiring, as the new article 271.3 does, that the contract from which they arise does have to be made before the insolvency proceeding? Or is it conceivable then that the payments may appear before the actual contract from which they stem? That can never happen so it is absurd to cling to the belief that the payments must arise before the insolvency proceeding and, by emphasizing this, the original contract also.
In other words, even though the service has not yet been provided or the invoice issued, the revenue that will be generated when this occurs will be captured by the pledge, in the lender’s interest, as long as there exists, before the company becomes insolvent should that occur, at least a supply contract or other contract or relationship that is the source of those services, invoices or revenues.
Special regime for factoring future invoices
There is a special regime for factoring transactions performed by credit institutions that allows the assignment or discounting of future payments even if the contracts or relationships from which the future payments stem do not yet exist, as long as the future rights put to use arise within a year from when the pledge is created (admittedly this is perhaps too short a period for our purposes).
That one year period may be extended without limit, however, if the debtors for those payments have already been identified. In other words, it is valid to carry out with a bank or other similar institution an assignment or discounting of future payments from identified individuals or legal entities, even if at the time the assignment or discounting transaction takes place there is no signed contract with them. This is relevant where due to the type of services involved the list of potential clients is a short one.
This special regime stems entirely from additional provision three of Law 1/1999, of January 5, 1999.
Creating contracts or legal relationships with the startup’s future clients
So, returning to the general regime, what can be done if there is as yet no contract between the company and its clients and these clients have not been individually identified either (take mass clients for example)? What we find is a startup that has a clear idea of the types of clients it wants to target and the type of service it wants to provide to them, but has not yet completed the necessary technology or other requirements to operate. Would there be any way to put its future revenues to use by providing them as security in exchange for finance enabling it to complete that technology?
To achieve this it would legally be necessary to perfect a contract with the “client” or build a legal relationship under which, in the future whenever operationally possible, the services will be provided and invoiced. See how the role of a distributor going between the startup and end clients may need to be brought into play here as someone with whom they can sit down and design that contract or relationship.
The reply to that question will depend on each case and on the creativity or inventiveness of the parties or their advisors. The startup needs to think about how, rather than the cash flow from its clients, it can use in advance at least the business ties or transactions that are able to announce or secure future sales and real revenues. Any sufficiently specific and explicit agreement with future clients or even with third distributors may serve as a basis for these purposes.
We return here to the difference announced in the second article in our series between a biotech startup seeking to create a drug and another tech firm building an app that will be used by the general public. The first type have the option of using, by way of a contract or relationship, future license agreements and other instruments associated with the pharmaceutical industry. The other, however, operates in different environments.
Need for a sufficient degree of certainty and obligation
This is another subject to be explored in greater depth, although it opens up some very interesting avenues. One of the key issues to be determined is the degree of obligation that the future client or the distributor needs to acquire in relation to the future purchases (which will be invoiced) to allow it to be said that there is already a contract or legal relationship from which the right to payment will arise. For example, will a simple expression of interest by the future client be enough? Or a purchase with the right to repent? Would it be sufficient legally for future users to enroll in a kind of club for future clients, without any obligation?
If this were possible, the startup could apply for finance and pledge the future revenues that will arise from any of those possible instruments. The answer lies perhaps in the level of obligation acquired by the client or the strength of the causal link between the sales that will be made and those prior transactions, or in other words, whether the basic elements are present that are required in the Civil Code for the existence of a contract. Bear in mind here that a contract is valid, even if it is subject to a period of time plus conditions, as long as the condition is not purely the debtor’s choice (described as a purely optional condition). Allowing a contract or relationship subject to a period and conditions opens up alternatives.
Mechanisms that legally and commercially attract lenders
It may be seen here how the legal question intertwines with commercial and business elements because all in all this is a matter of bringing the company as close as possible to its future clients and pre-selling, or at least arousing the future client’s serious and documented interest in, a product or service that the company is able to describe but cannot yet supply because development work remains to be completed. By making efforts in this direction a company will be building its own success.
It is true that the company additionally has to convince the lender to believe not just in the technical and legal efficiency of the pledge of future rights being offered to it, but also and more than anything else in the company's own ability to complete the remaining development work and actually achieve those announced or promised revenues. In fact, the pledged payment will never arise if the company does not supply the product due to a technical or any other type of inability. The lender's decision will depend more on this last element and the technical and legal efficiency of the security will, perhaps, be a secondary concern.
Practical and legal issues to be examined in each case
In operational terms, an issue that has to be dealt with and regulated is the need or otherwise, as the future revenues actually arise, are collected, and therefore cease to exist, to renew or ratify the pledge recurrently.
Some thought is also needed from a commercial angle on the potential issues associated with notifying the company’s debtors of creation of the security. Notifying debtors of the pledged right is not a requirement, at least under general law, for the pledge to be enforceable and may pose logistic and commercial complications. However, because debtors, who have not been notified of the assignment, will discharge their obligations by paying the startup not the lender, notification mechanisms, or contingent ones at least, and sweep account systems need to be in place to get the collected funds swiftly to the lender.
Factors in common with other mechanisms
All these elements are connected with the points we discuss in the next article in the series consisting also of the pre-sale of products and services through tokens and crowdfunding transactions generally because both cases involve the company acting in advance, by searching for and attracting people willing to provide loans or advance funds against the expectation or right to receive the product sold by the startup or the cash flow from its purchase by third parties.