Lending to high-tech companies is tricky business. There are complexities and pitfalls associated with these loans that can become major problems for lenders who are not properly prepared.
Indeed, lending to high-tech companies without understanding the unique challenges associated with them resembles walking blindfolded through a field of landmines. However, those with a solid understanding of the issues can be extremely successful—numerous thriving banks are doing just that.
Let’s review the key challenges associated with lending to tech companies and how to navigate your way to success.
1. Due diligence
The principal challenge associated with lending to high-tech firms is the fact that many do not own hard assets of any value. Also, they often are pre-revenue or not yet profitable.
Most tech companies do not have inventory or expensive machinery that can easily be sold by a lender. They lack a sufficient flow of receivables to make the lender whole in a distress situation. Instead, many of these companies only own computers, office furniture, and maybe a few offsite servers, all of which depreciate and become obsolete very quickly.
This can present a significant issue for lenders because without hard assets or a source of receivables as collateral, many banks are not comfortable making loans to these companies. Lenders in the tech lending industry must instead rely upon a different set of criteria in their underwriting decisions.
First, the lender must have a thorough understanding of the prospective borrower's industry and where the prospective borrower fits within that industry. That includes an understanding of the borrower’s competitors and how they stack up in comparison.
There must also be a significant understanding of the strength of the borrower’s management team. This can be particularly important in a start-up situation. A strong management team can make or break a company.
Lenders must also take a serious look at the reputation and financial strength of the tech company's investors. In the early-stage tech community, the borrower’s investors typically play a large role. So it is important to understand who your prospective borrower’s investors are; whether they are willing and able to provide the financial support necessary for the borrower’s success; and what the investors’ track record is in regard to working through challenging times with their other portfolio companies.
All of these are critical considerations that must be thoroughly examined when considering a loan facility to a tech company. To best conduct this level of due diligence, lenders should conduct on-site meetings with the prospective borrower; meet with and speak to the key investors; evaluate the business plan, and conduct detailed research regarding the specific market and industry of the borrower.
Lenders can also mitigate risk by including financial covenants and other restrictive provisions in the loan documents; requiring borrower’s primary bank accounts to be maintained with the lender; loan structuring (such as invoice-by-invoice financing); and retaining the right to require reserves.
2. Valuing intellectual property
Intellectual property and the licensing of others' intellectual property to the borrower’s business ranks high in the lender’s challenges.
Intellectual property is often one of the most valuable assets of a high-tech company, and understanding the borrower's ownership can be critical. This often requires a level of expertise that many traditional lenders simply do not possess.
Intellectual property can be difficult to value and can often be difficult to sell. So while intellectual property can be extremely important to the borrower’s success, in many instances it is not regarded as strong collateral.
3. Reputation is key
Reputation is key regardless of industry, but this is particularly true for lenders looking to establish themselves in tech lending.
When banks negotiate in a combative manner; are quick to call defaults; refuse to forbear or waive defaults; or are quick to take enforcement actions, it can destroy a bank's reputation in the industry and stop the flow of future deals. A surprisingly small group of lenders see the same investors, senior management, lawyers, and other participants in the process over and over. Word gets around.
Lending to a tech company often requires patience and a willingness to work through cycles of cash burn, followed by equity infusions, etc.
Developing a good relationship with the borrower’s officers and investors is also important because it helps a lender to identify problems early on and can help in working through the tough spots if a borrower runs into any problems.
4. Unique market terms
When making loans to technology companies, banks must also understand that the standard market terms of these types of deals differ from those in other deals.
For example, “Material Adverse Change” and “Investor Abandonment” events of default are common terms, as are warrants and, in many cases, financial covenants. Landlord consents and bailee agreements are not as critical in some deals. And legal opinions are rare when it comes to high-tech loans involving only domestic assets and entities.
Due to the nature of tech companies, change in ownership defaults are also structured differently, intellectual property licensing is very common, and mergers are typically not permitted without consent (which is given on a case-by-case basis).
Because these terms and others can be so different in tech lending, it is important to hire an attorney that specializes in representing lenders in the technology space and has enough experience to identify these issues and provide the appropriate recommendations.
5. Cost sensitivity
A final challenge to making loans to tech companies is the cost sensitivity of most borrowers in this space.
High-tech companies must be very cost conscious—as mentioned they are often pre-revenue or not yet profitable. Competitive factors pressure tech lenders to keep costs down. Additionally, tech companies often need or want to close quickly, so efficiency is critical.
There are many ways for lenders to keep costs down and close deals efficiently. These include:
• Obtaining thorough information about the borrower early in the process.
• Setting clear expectations from the outset.
• Staying actively engaged throughout the documentation and negotiation process.
• Asking the borrower for the reasons behind any requested changes to loan documentation, to help in finding a mutually acceptable solution.
• Being willing to say no, rather than allowing unnecessary negotiations over issues that could have been avoided from the beginning.
• Hiring and effectively utilizing counsel that has particular expertise and experience in this area.
About the author
David Lawson is Chair of the Commercial Lending Practice Group at VLP Law Group. Lawson represents financial institutions in a wide range of financing transactions, including structuring, preparing, and negotiating loan documents in connection with secured and unsecured credit facilities; loan workouts; and restructurings. He has represented financial institutions lending to high-tech companies, life science companies, and borrowers in a wide array of other industries. He can be reached at [email protected]
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