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Valuation is an essential part of every startup financing. While valuations are hotly negotiated during equity financings, they are crucial for secured lending. This article will explain the legal and commercial factors that may influence how a valuation affects the amount your startup can borrow under a secured loan.
What is a Secured Loan?
A secured loan is any form of debt financing that gives lenders security over your business and its assets. The assets secured by the loan are called collateral.
Security is a special right that allows lenders to seize your business assets if it defaults under the loan terms. This process is called enforcement. Lenders enforce their security rights only where they conclude there is little chance of repayment. It, therefore, is a last resort measure. In practice, it gives lenders the comfort they need to loan startups money.
How Are Secured Loans Structured?
A secured loan most commonly takes the form of a bank loan. For instance, your business may agree to grant security over its asset in exchange for a revolving credit facility with a high street bank. Alternatively, your business may agree to borrow a fixed sum and repay it within five years under a term loan.
Another way your business may borrow under a secured loan agreement is by issuing secured loan notes. These notes are like shares and mean that you are borrowing from multiple lenders. The loan notes will grant each noteholder a share of the total security over your assets.
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How Much Can My Startup Borrow Under a Secured Loan?
Lenders determine how much to loan your startup based on what it thinks it can repay. This is calculated by looking at your startup’s cash flow and ability to make interest payments. Lenders must also be confident that you can repay the principal sum of the loan at the repayment date. To prove this, you must demonstrate to lenders that your business model is sound.
It follows that secured lenders rarely allow a startup to borrow more than what the collateral value is. For example, if your business’ collateral is worth £100,000, a bank is not usually prepared to lend more than £100,000. Since lenders perceive startups as riskier, banks will not usually lend more than 50-70% of the collateral.
How is the LTV Calculated?
Each lender will have its lending criteria used to calculate the LTV. However, the lender will generally evaluate your startup at your expense, although the fees may be capitalised into the loan’s value.
In particular, the lender will look for a fair market appraisal of your startup’s valuable assets. This may include:
- property;
- machinery;
- computer and IT systems;
- intellectual property like trade marks;
- cash in bank accounts; and
- trade receivables.
In terms of valuation, it is easier to price tangible assets like property and machinery than intellectual property and IT systems. Many startups may not have considerable tangible assets. As a result, the valuation specialist may conclude that your valuation is far below what you think. While you may find this disappointing, it is helpful to consider that the lender needs to be reasonably confident that it can enforce its security over the collateral and recover the loan amount.
Granting Additional Security and Guarantees
If your startup is incorporated as a company, you may know that the law regards it as its legal entity. If it defaults on its debts, the lender has no recourse to its founders.
For this reason, it is common for lenders to require that the business’s founder grant security over their assets. This is called third-party security. For instance, the bank may require you and your founders to provide security over your house through a second mortgage charge.
Alternatively, your lenders may ask you to enter into a guarantee agreement. This is essentially a promise that if the business cannot pay its debts, you will make good any debts. If you do not, the bank can sue you directly for breach of the guarantee agreement.
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Key Takeaways
If you are obtaining a secured loan, collateral plays a crucial role since it provides lenders with the right to seize assets in the event of default. Lenders typically lend up to 50-70% of the value of the collateral, known as the loan-to-value ratio (LTV). Startups should be mindful of the importance of collateral value and maintain realistic expectations when seeking secured loans. Lenders conduct valuations to assess the value of collateral, often prioritising tangible assets over intangible ones. Because startups may not have sufficiently valued collateral, lenders may seek additional security from founders or guarantee agreements.
If you need help with your startup, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.
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