Recent years have witnessed a significant expansion in the ability of venture-backed companies to raise debt financing, as both the number of lenders offering such products and the aggregate dollar volume of such debt transactions have increased. Commonly known as venture debt, these transactions are typically structured as senior secured loans accompanied by preferred stock warrants to boost lender returns.
As competition to put money to work in a vibrant market has increased, venture lenders have sought to differentiate themselves by offering streamlined documentation processes, foregoing material adverse change defaults, and reducing interest rates, fees and warrant coverage.
In addition, venture lenders often agree not to take the borrower’s intellectual property (IP) as collateral in favor of the borrower’s agreement—commonly known as a “negative pledge”—and not to pledge its IP assets to others.
Such negative pledges have become increasingly popular in the venture debt markets, as borrowers perceived that their IP, often regarded as the crown jewels of the company, was insulated from the secured party’s reach, while lenders took comfort that other creditors should not have direct claims to the borrower’s IP senior to their own.
In our view, lenders make material concessions in terms of having fewer post-default options when accepting negative pledges of IP. At the same time, however, our experience shows that the benefits of having negotiated for a negative pledge are ultimately lost for many borrowers, as lenders can subsequently expand their collateral package to include the borrower’s IP, particularly in distress situations.
The balance of this article analyzes the consequences for venture lenders and their borrowers of accepting negative pledges of IP instead of the first-priority perfected lien traditionally required with respect to these assets.
Remedies for Lenders with IP Collateral
Lenders whose collateral includes the borrower’s intellectual property can exercise the full range of post-default remedies under Revised Article 9 of the Uniform Commercial Code (UCC). These streamlined remedies may enable a lender to access the collateral to obtain repayment within a period of weeks or months, often without having to go to court. These remedies include:
• Repossession. Secured parties have the right, so long as there is no breach of peace, to take possession of the collateral or they may render the collateral unusable and dispose of it on the debtor’s premises. IP collateral that could be subject to such repossession includes, among other things, computer hard drives containing source code.
• Direct collection. Secured parties may notify account debtors, or others obligated on collateral, to make payments directly to the secured party. In the IP context, secured parties may require the licensees of the borrower’s IP to make payments directly to them. Account debtors ignore such instructions at their peril, as the UCC further provides that, after receipt of such a notice, account debtors may no longer discharge their payment obligation by making payments to the original party to whom payment was due.
• Disposition. A secured party can also sell the collateral at a public or private sale, subject to compliance with the requirements of the UCC, which include that every aspect of the disposition be commercially reasonable.
• Foreclosure. Secured parties may accept the collateral as full or partial satisfaction of the debt owed, so long as the consent and notice requirements set forth in the UCC have been satisfied. Foreclosures conducted judicially offer lenders protection from subsequent attack by competing creditors, as they cannot be challenged as commercially unreasonable as a matter of law.
• Judgment. Though costly and time-consuming, lenders can still file suit against their borrower to reduce their claims to an enforceable judgment. Secured parties may follow this route when the value of the collateral is less than the debt so as to avoid having to take a second action to obtain access to the borrower’s other assets.
Lenders make material concessions in terms of having fewer post-default options when accepting negative pledges of IP.
Lenders with liens on the borrower’s IP often can apply the collateral, or the proceeds thereof, to their outstanding obligations within a period of weeks or months and, importantly, without having to go to court. The benefits of having a lien in the borrower’s IP continue in the case of the bankruptcy of the borrower, as a prepetition secured creditor is typically entitled to the full value of its collateral or adequate protection of its security interest during the proceeding, while an unsecured creditor normally will have no special priorities with respect to payments or collateral and usually finds itself with the lowest priority creditor claim.
Consequences of Negative Pledges of IP
Lenders who accept negative pledges in lieu of liens on the borrower’s IP don’t have the streamlined remedies available under the UCC. Instead, such lenders must go to court to obtain recourse to the borrower’s IP. Such litigation may include some or all of the following:
• Initiation of the suit. A lender must first prepare, file and serve a complaint to initiate its lawsuit against the defaulted debtor.
• Pre-discovery motions. After responding to the complaint, the borrower may file motions seeking to dismiss or otherwise limit the lender’s suit, or file a counter-suit against the lender, including on theories of lender liability. These motions may be followed by the lender’s own motions.
• Discovery. Next, each side seeks information and documents from the other side relevant to the preparation of each side’s case, a process which may last for many months or, in extreme examples, years.
• Post-discovery and trial. After discovery is complete, the parties may file a new round of motions, all of which must be decided before a trial can be held.
• Judgment and beyond. Even after entry of a judgment by a trial court, the borrower may exercise its right to appeal. Where no appeal is taken, plaintiffs may still need to engage the local sheriff to levy upon the judgment debtor’s assets in order to obtain satisfaction of the debt.
Lenders without a lien on IP face a costly and time-consuming battle to obtain access to such assets and are disadvantaged in bankruptcy given the lack of priority afforded generally by a negative pledge. Moreover, litigation is, by definition, a public process which can have adverse reputational impacts on the lender. The time, expense, and adverse publicity associated with going to court can serve as a powerful impetus for the lender to settle for less than the total amount owed, even where the liability of the borrower for the debt is plain.
From the borrower’s perspective, the delay associated with the requirement that lenders first seek a judgment under negative pledge structures provides leverage during loan workouts. At the same time, however, by reducing the value of the available collateral and complicating the exercise of post-default remedies, negative pledge structures increase risk for lenders and can increase facility costs for borrowers in terms of interest rates, fees and warrant coverage.
In our experience, many borrowers who initially negotiate for negative pledges ultimately fail to insulate their IP from the lender’s reach. Specifically, venture lenders frequently decline to declare an event of default immediately following the borrower’s first default, particularly for technical or non-monetary breaches. Instead, such lenders use the default to obtain a new lien on the borrower’s IP as part of the process of waiving such default, with the result that the lender obtains a lien on the borrower’s IP before it is needed in earnest. In these cases, borrowers pay the higher costs associated with the negative pledge structure without getting the promised benefits, as their IP is ultimately added to the collateral.
Even with negative pledge structures, loan covenants may still limit the license or transfer of the borrower’s IP—restrictions which become especially important to borrowers during work outs as the borrower looks for assets to dispose of to raise cash. Moreover, lenders can exercise their consent rights respecting IP transfers to obtain a repayment—or even prepayment—of their loans. Even where the venture loan documents allow licenses or other dispositions of IP, the proceeds of such transactions will typically be subject to the lender’s lien, with the result that the full scope of the lender’s UCC remedies is restored. As a result, borrowers and lenders both need to carefully consider the consequences of using negative pledge structures when negotiating the terms of venture debt facilities.
Thomas K. Gump is a partner in the New York and San Francisco offices of Pillsbury and he may be reached at firstname.lastname@example.org. Jessica R. Berenyi is an associate in the finance department of Pillsbury’s New York office and she may be reached at email@example.com. George P. Haley and Andrew Smith also contributed to this article.