Most startup companies need some sort of capital investment to help them to get started. If they have an investor—someone willing to give the new company money in exchange for a percentage of ownership in the new company or a share in the profits—the business owners will likely be asked to sign what is called a “Security Agreement” in return for the new capital.
As I’ve written about before, it is imperative that business owners get these documents correct in the beginning, so they don’t have to deal with legal issues down the road. Here are the basic nuts and bolts of Security Agreements:
As many Americans have learned in the past 6 years or so, there are many different types of “indebtedness,” each of which has various pros and cons. For security agreements, the borrower—usually the startup company—can either be personally liable for the debt, or if they find an “angel investor”, only the startup company is liable for the debt. What’s the difference? It’s subtle, but has huge consequences.
If you’re personally liable for a debt, the person loaning the money can come after you, personally, for payment on the loan. If they can show to a court that you or your company is “in default,” the lender is allowed to take all of the assets of the company and your personal assets. Your personal assets include everything from your personal checking account(s), your savings, even IRA and 401K accounts, not to mention physical assets such as your car, your house, and that original mint condition Amazing Spiderman comic book that’s hung up in your personal bat cave home theater-basement.
But what if you are not personally liable for the debt? If only your company is liable for the debt, then in the event of default, the lender (investor) is only allowed to come after the assets of the company. The company owners (assuming you hired a good attorney to draft your startup documents) are shielded from any liability to repay the debt. Sure, the company can lose all of its money and assets (inventory, company name, etc.), but the business owners are free to walk away from the company without losing their children’s college fund . . . or the Spiderman comic, for that matter. And they can create a new business and start again at the beginning.
The Secured Property
This is where we specify whether the borrower is personally liable and exactly which assets the lender is allowed to take in the event of a default. This is the “collateral.” If you want to borrow your friend’s extra car for a week, and the car’s worth roughly $5,000, you might offer to give him your Rolex watch as “collateral.” The Rolex watch is, basically, the secured property in your informal (unwritten) security agreement.
When it comes down to actual legal documents, the Secured Property section usually specifies various items owned by the business and/or the business owners personally (depending on whether they are personally liable for the loan).
In my experience, this is one spot where online legal service documents present a problem. As we’ve discussed before, template documents provided by companies like LegalZoom offer customers pre-negotiated documents that are not at all tailored to fit their unique situation. I have seen template Security Agreements that list as the secured property “any and all assets owned by the borrower.” That means that, if the borrower were to go into default at any time (more on this below) the lender could have the local sheriff take all of the borrower’s assets! This may have made sense if a Warren Buffet type investor was investing in a very small startup company, but for a small loan where everyone is on equal footing and bargaining power, it is ridiculous.
Just like the Rolex watch example, above, the secured property (collateral) should be proportionate in value to the loan amount. If I loaned someone my $5,000 car for a week, I would not expect him to sign a security agreement stating that I could take his house if he totals the car.
(Author’s note: if it’s a cash loan, and the secured property taken ends up being sold for more than the cash amount of the loan, the person making the loan would have to give back the remaining amount once the loan was repaid, minus attorneys fees and other expenses involved. So for example, if Tom loaned Jerry $20,000, Jerry signed a security agreement listing his house as the “secured property,” and Jerry defaults on the loan, Tom could sell Jerry’s house to get back the $20,000, but most of the remaining money from the house sale would go back to Jerry).
That’s all for this week, check in next time when we go over default claims, and the importance of filing your security agreements publicly.
Jonathan Sparks is the principal attorney at Sparks Law. He helps small to medium sized companies with their legal issues, general counsel and registered agent services.
– Jonathan Sparks, Esq.
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