How can someone equity-strip a business with a collateralized loan when its credit is poor, its assets have questionable value, or the business cannot afford the interest payments?
Few businesses can completely encumber their assets through conventional
commercial loans. They may have poor credit or too little cash flow for
interest payments. And in today’s economy, getting loans is indeed
difficult. Fortunately, other obligations – as well as cash loans
– can serve as the basis for a lien. Liens are commonly used to
secure all types of obligations in the normal course of business, and
these liens are every bit as valid as cash loans.
Furthermore, a lien securing an executory obligation may be more advantageous
in some ways over a lien securing a cash loan. For example, there is generally
no negative tax or economic consequence from fulfilling or failing to
fulfill an executory obligation. You may also have no immediate interest
expense. We might structure a security agreement so that the lien is not
reduced or paid down until the obligation is fully completed. We can even
structure the agreement so that the lien amount increases until the obligation
is fulfilled. The secured obligation ensures that the asset never has
value to other creditors. Moreover, if your business doesn’t have
the cash to pay down a conventional loan, your ‘protected’
property will then be in danger of foreclosure. However, cash shortages
won’t affect your ability to fulfill non-monetary obligations, (or
rather you could arrange a monetary obligation with a ‘friendly’
entity) so foreclosure wouldn’t be a problem. Nor need you worry
about how you’ll get $500,000 to equity-strip a $500,000 business.
Cash loans are quantifiable. You can’t get a ‘large’
lien to secure a small loan. However, certain obligations are difficult
to quantify. You then have far greater leeway to structure an obligation
of ‘equivalent value’ to the cash value of the lien. How then
can you create a bona fide obligation to justify a valid lien on your
business or other property?
One advanced and innovative method to equity-strip a business, or any other
asset, is through the LLC capitalization technique. Two parties would
form a limited liability company (LLC) to run a business, whether to consult
or to invest. Each member can obligate the other, per written agreement,
to contribute capital (assets) to the company so that it has funds to
operate. One member contributes a smaller amount of assets up front to
capitalize the company. This would be in exchange for a small ownership
interest (usually 1-5 percent). The other member promises to make a large
capital contribution over time in exchange for an upfront majority ownership
interest in the company (95-99 percent). Because the first member contributed
his capital up front, and the second member contributed nothing –
the LLC liens the second member’s property to ensure that the second
member fulfills his obligation to capitalize the LLC over time. As long
as the LLC is not considered an ‘insider’ under applicable
fraudulent transfer law, the obligation is valid, its fulfillment demonstrable,
and the transaction ‘makes sense’ in a business context, you
can create a rock-solid lien against the second member’s property
or business to secure the executory obligation. Again, the ‘devil
is in the details’. It must be properly structured so it’s
not seen as a sham on the courts or creditors. This takes sophisticated planning.
There are other examples. Lease agreements often contain a lessor’s
lien clause. These liens are not part of an intentional asset protection
program; still these liens arise in the normal course of business. The
lessor wants to make sure that the lessee fulfills his lease obligations.
The lessor then encumbers the lessee’s accounts receivable, furniture,
equipment, inventory and other assets. Of course, in this situation, the
lessor isn’t actually trying to protect the lessee’s assets
against other creditors, yet that is exactly what the lessor is accomplishing.
The best type of lessor’s lien, of course, is one held by a friendly
lessor. You can then draft the lease and lien terms that best suit your needs.
You have other options. For example, you may sell property from one business
to another business and lease it back to the original business. This ‘lease-back’
arrangement has two benefits: You protect the property by titling it to
a separate entity, and when you lease the property back to the original
entity, you can place a lessor’s lien on a second asset. For example,
an LLC could sell an office building to a second LLC, lease the building
back to the first LLC and place a lessor’s lien on the first LLC’s
accounts receivable. As simple as the concept appears, a lessor’s
lien in this or similar circumstances still requires skillful implementation.
The goal is to transfer the original asset into a separate entity in a
way that it won’t be considered a fraudulent transfer.