Structured Finance for Startups

Structured finance has traditionally been associated with large corporations seeking innovative ways to raise capital. However, in recent years, startups have increasingly explored structured finance as a viable financing option. This article explores the legal and commercial considerations that you should bear in mind when determining if structured finance is appropriate for your startup. We will also compare structured finance with securitisation.

What is Structured Finance?

Structured finance is a form of long-term financing that enables startups to further grow. By its nature, structured finance is a sophisticated financial technique that involves creating complex financial instruments that your startup issues to investors. It encompasses a range of financing methods. These include, collateralized debt obligations (CDOs), credit default swaps (CDS), and asset-backed securities (ABS). Unlike traditional loans, structured finance allows businesses, including startups, to access funding while customising the terms to suit their unique circumstances.

Case Study 

Your startup, ABC Ltd, develops and sells software solutions to the healthcare industry. Currently, ABC Ltd has entered into licences with more than 500 customers. The total value of these licences over their life of 10 years is £20m. In other words, your customers will make steady payments to ABC Ltd over the next ten years. 

You want to raise £15m in financing to develop a new product. 

Aside from licences, your business does not have many other valuable assets. This means lenders will not loan you the £15m because ABC Ltd does not have many fixed assets. Nor do you wish to raise equity financing because that would dilute your shareholding. 

With the help of a financial adviser, you can package up the future cash flows into a special purpose vehicle (SPV). You will then direct all future payments under the licences to these SPV. On this basis, ABC Ltd can issue securities in the SPV to investors, who will in turn pay ABC Ltd money up front. 

In other words, this structured financing essentially allows ABC Ltd to unlock the value of the future cash flows by promising to direct future payments to the investors. 

Structured Finance vs Securitisation

You may hear structured finance and securitisation used interchangeably. Generally speaking, securitisation is one form of structured financing. The above case study is an example of a securitisation. 

However, there are some distinctions:

Nature of Securities Issued to Investors 

Structured finance exists to meet the needs of issuers (e.g. ABC Ltd) as well as the investors. As a result, the securities can be tailored accordingly. Under a securitisation, the securities (notes) essentially act as an IOU where investors are entitled to the future cash arising under the licences (or trade receivables generally). Other kinds of structured finance securities may include derivatives, convertible notes, and complex debt structures. This is to attract investors. 

Collateralisation 

In structured finance, collateral refers to the underlying assets that generate future returns for investors. Under securitisation, these are the income producing assets (e.g. licences). Structured finance more generally can use other assets like debt obligations, fixed assets, and other income streams as collateral. 

Investor Profiles 

Structured finance may appeal to a broader range of investors, including institutional investors and private equity firms. This is because it describes more diverse investment opportunities. As a form of structured finance, securitisation attracts investors interested in predictable and stable cash flows generated from specific assets. If your startup has a sophisticated and customised financial structure, you might prefer structured finance to attract investors looking for tailored investment options.

Legal Considerations for Startups

When contemplating structured finance, you must be mindful of the legal aspects involved. These may include compliance with securities laws, contract negotiation, risk assessment, and regulatory obligations. Proper documentation, due diligence, and adherence to regulatory requirements are crucial to ensure a smooth and legally compliant structured finance transaction.

You will need to instruct legal advisers due to the complex and risky nature of structured finance.

Commercial Considerations for Startups

Structured finance may be appropriate for startups that have established a strong financial track record, a clear business plan, and long-term growth potential. If your startup has a solid customer base and predictable cash flow you are better positioned to attract investors interested in structured finance arrangements. The ability to demonstrate low risk and potential for future growth significantly enhances a startup’s prospects of obtaining structured financing.

Additionally, you should consider the following commercial factors:

Size and Growth 

Structured finance is more suitable for larger startups that have established a significant customer base, consistent revenue streams, and exhibit growth potential. If your startup is in the early stages of development, it may not be able to rely on structured finance. This is due to your startup likely not having the necessary scale and predictable cash flows. However, if your startup has an established market presence and a proven business model, structured finance can provide opportunities for further expansion and growth.

Asset Base and Collateral 

You should assess the quality and diversity of your startup’s assets that can be used as collateral in structured finance transactions. These assets could include tangible assets, intellectual property, contracts, or even future revenue streams. A diversified asset base reduces risk and increases the attractiveness of structured finance to potential investors. 

However, collateralising multiple classes of assets can greatly increase the complexity of the structured financing. This in turn translates into increased costs, which your startup will have to incur. 

Fees

Structured financings are complex transactions. They involve multiple investors whose interests are managed by professional trustees and other advisers. Likewise, you will need to instruct your own legal and financial advisers. As the issuer under the structured financing, your startup will bear the brunt of these costs. In many cases, you can capitalise these fees into the total financing value. However, you will have to pay a portion of the fees upfront. 

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Key Takeaways 

Structured finance offers larger startups a flexible and innovative financing approach tailored to their specific needs. If your startup has established cash flows and growth potential it is likely that you can rely on structured financing. Legal and commercial considerations are critical before embarking on such financing options. You must carefully assess your startup’s financial position, risk profile and long-term goals before committing to structured financing. 

If you need help determining if structured finance is right for your startup, contact our experienced startup lawyers 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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