Security and ranking

The term sheet will describe what ranking (typically senior) and type of security (typically all assets) the lender will take.

An earlier post described a balance sheet this way:

The company has assets (cash, accounts receivable, computers, furniture, intangible assets) which have been paid for (financed) with liabilities (accounts payable, accrued liabilities, deferred revenue, debt) and equity.

When a company is sold the assets will be divided among those the hold the liabilities (called the creditors) and the equity holders (shareholders).

Everybody has a ranking, an order in which they get paid. Founders who have raised venture equity will be familiar with liquidation preferences – the right of the preferred shareholders to be paid before the common shareholders (ie, founders).

Creditors will rank higher than the preferred shareholders. And within the creditors some will rank higher than others.

Here’s a simplified example with the top of the list being paid first and bottom paid last:

Senior secured lender

Junior secured lender

Trade creditors (accounts payable) and other unsecured lenders

 

Series B Preferred shareholders

Series A Preferred shareholders

Common shareholders

You will notice that the list above is roughly in the same order as a balance sheet with the first-paid at the top and last-paid at the bottom.

If a company hasn’t worked out there may not be enough assets to pay everyone. In that case two more groups will often have a claim on assets – the government (if there are any unpaid taxes) and employees (if there are any severance claims). Where and how much could be owed to the government and employees will vary by country.

Venture loans fall into the secured lender category. Venture loans for startups are often the first debt and will be the senior secured lender, paid before anyone else.

For more a mature company a venture loan may be in a junior secured position and paid second. When a loan has a senior and junior lender the two lenders will enter into a subordination or increditor agreement to detail how the lenders will work together regards principal and interest payments and how assets will be divided in a sale.

The stack of creditors and shareholders is pretty simple for startups. As companies grow it gets more complex. The best CFOs I have worked with will build a full “waterfall” spreadsheet model showing what everyone gets paid in various exit scenarios.