If you’re at a rapidly-growing tech startup, exploring avenues to increase your liquidity without selling your shares or diluting your ownership can be a crucial strategy. One way is to secure a collateralized loan using your startup equity. Let’s walk through the layers of this approach and see how it works, its advantages and disadvantages, and the key decisions you have to make.
What are Collateralized Loans?
Before we delve into the intricate dynamics of using startup equity in securing loans, let’s first understand what collateralized loans are. In simple terms, a collateralized loan is a loan secured by an asset, also known as collateral. If the borrower defaults, the lender can seize the collateral to recover the loan amount.
Collateralized Loans and Startup Equity: How does it work?
If you’re holding equity in your startup, it essentially means you own a piece of your company. This equity can potentially be used as collateral to secure a loan. Here’s a general idea of how the process looks:
- Equity Evaluation: Unfortunately for startup equity holders, loans are offered by a limited number of companies for a limited number of startups that are typically pre-approved.
- Loan Agreement: Once the value is established, you can enter a loan agreement specifying the loan amount, interest rate, and other terms. Most of these terms like interest rate and length are fixed but the number of shares is your choice.
- Receiving Funds: Upon agreement, you receive the loan amount, which you are free to use on whatever you want whether its as a home downpayment or something else.
- Repayment: Unlike most loans, the repayment is secured by the startup equity when they have a liquidity option such as an IPO or share sales offering.
Pros of Collateralized Loans with Startup Equity
Using startup equity to secure loans comes with several benefits, such as:
- Flexibility and Control: You maintain control over your equity, as you’re not selling your shares but only using them as collateral.
- Speed & Availability: The process is generally quicker compared to raising funds through equity sales, saving you from a long-drawn sales process which is often not an option for startup equity owners.
- Tax-free proceeds: The proceeds from the loan are not taxable as capital gains.
Cons of Collateralized Loans with Startup Equity
Despite the benefits, there are downsides to this strategy, including:
- Limited by Equity Value: The loan amount you can secure is typically limited by the value of your equity. On top of that, the lender usually only will give you a cash loan up to a percentage of the equity you are willing to secure. They do this to cover their downside in case the equity loses value. For example if you have $5 million of equity they may allow you to take a loan for 50% of the value secured by shares or $2.5m
- Risk of Losing Equity: If your equity loses value, you risk losing more equity than expected., which could potentially mean losing control over your startup. On other hand this can be seen as a way to monetize equity that you may not value highly or simply want to diversify away from
- High interest rates: Startup equity loans can have high interest rates, which can make them expensive to repay unless you need the cash now or anticipate the equity appreciating rapidly
Which startups are these loans available for?
Unfortunately there are a limited number of companies which loans are available for. The list is below:
|Arctic Wolf||Array||Assap||Astera Labs||Attentive|
|Harness||Hinge Health||Instabase||Locus Robotics||Maven Clinic|
|Motive (Formerly KeepTruckin)||Navan (Formerly TripActions)||Postman||Project44||Redwood Materials|
Let’s jump into some commonly asked questions!
What are the prerequisites to leverage my equity for a collateralized loan?
Assuming your equity is in a company listed above, then it’s fairly simple. You have to own your equity by having exercised your options or have vested your RSUs. Critically the value of your equity for the loan amount is typically based on a pre-determined share value from the lending company and interest rate.
That leads to the next question.
What are the typical interest rates for collateralized loans with startup equity?
Typically the rates are between 10-30%, hence why its so critical to decide if a loan really makes sense for you.
What happens in case the equity decreases in value?
In this case, you may lose more shares than you expected as payback for the loan but critically that amount is limited to the number of shares secured against the loan. Most lenders will require you a loan against a percentage of the value of the shares you secure to protect their downside.
Let’s walk through how this would work in two situations, one where your equity increased in value and one where it decreased in value.
Case Study: Collateralizing $1,000,000 of Shares
Let’s examine a case where an individual collateralizes $1,000,000 worth of shares with a loan-to-value (LTV) ratio of 60% and a 20% interest rate in two scenarios where the value of the shares increase and decrease.
- Initial Collateral Value: The initial collateral value is $1,000,000, which is the value of the shares when the loan is secured.
- Loan Amount: With an LTV (loan to value loan amount) ratio of 60%, the maximum loan amount is calculated by multiplying the collateral value by the LTV ratio: $1,000,000 * 0.60 = $600,000. Essentially the loan provider is building in cushion so that if the asset decreases in value they have more assets to cover against their loan as they can’t take any assets beyond the collateralized assets. Critically, assuming a 20% interest rate, you could get a $500,000 cash loan against a $1M of assets with a 60% LTV. In equation form this looks like (Loan Amount * (1 + Interest Rate))/Loan to Value = Collateral Value or in this situation ($500,000 * (1 + .2))/.6 = $1,000,000
- 20% Price Increase: Now if your shares increase in value 20%, you could sell half the shares you collateralized to pay back the loan and keep the other half of the shares. After this increase in value, the collateral is worth $1,200,000 which is why you would need half of it to cover your loan, leaving the other half for you to keep. Now on the other hand, lets go through a down side scenario where the shares drop 50% in value.
- 50% Price Drop: After the share value drops by 50%, the new value of the shares is calculated by subtracting 50% of the initial value from the initial collateral value: $1,000,000 – ($1,000,000 * 0.50) = $500,000. You may have noticed, you owe $600,000 for the loan but the loan is limited to the shares its collateralized.
- Loan Repayment Amount: Since the loan collateral is limited to the pledged shares, the loan provider will receive all the shares you initially pledged which are now worth $500,000 to pay off the $600,000 loan. In this case, you came out ahead.
As you can see it’s crucial to carefully evaluate the potential risks and rewards before collateralizing shares for loans but can also make sense for those who need cash but don’t want to sell their shares or want to hedge against their shares becoming worthless.
Securing a collateralized loan using startup equity can be a savvy strategy to boost liquidity while retaining control over your startup. However, it comes with its set of risks, including the potential loss of equity. By understanding the different structures of collateralized loans and weighing the pros and cons judiciously, startup owners can leverage this financial tool to their advantage. If you want to learn more or take advantage of this yourself, you can set up time with us here.