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.