It’s been a while since I did anything on the Due Diligence Handbook . The options section took so long that I just needed to recover. But now I have, and it’s time to continue on to the next section, which is on “Financing, Loans and Encumbrances”. So I’m sitting here, reading through the list of requests and thinking “wow, this is legalese central! My poor readers are going to die a thousand deaths!” Since I cannot have that, I thought I would start off with a little Legalese-English dictionary for the topic.
Bear in mind that all of the below are in very simplified terms. The intent is to give you a general idea of what the items are, and not turn you into a lawyer. I’ve also divided the terms into two batches because, well, wow, there are a lot of them.
Today’s word-theme? Situations in which other people have some claim to your stuff.
Encumbrances
I’m starting with this concept because it underlies the items which follow, or rather, the items which follow are all forms of encumbrances.
An encumbrance is pretty much what it sounds like. To encumber something is weigh down or burden it (thanks Merriam Webster). An encumbrance on an asset is something that encumbers that asset and “weighs it down”, that is, it limits your ability to market, sell or use the asset in a way you could if the encumbrance weren’t there.
In general, this is going to be where someone aside from the owner of the asset has a right or an interest in the asset. These can take many forms; some of the more common ones you’ve probably heard of include: security interests (liens), mortgages and easements. Some examples….
- Your bank has a mortgage on your house, so you cannot transfer ownership of your house without first getting their okay (and for that, you’ll need to pay off your mortgage).
- If you factor your receivables (more on that below), the factoring company has a lien on the invoices you have financed and the money will go to them first, and not to you.
- If there is an easement on your property which requires you to allow people to cross it to get from A to B, if you want to sell, you will have to tell the potential buyer “hey, everyone and their grandmother is going to be traipsing through your back yard”.
- You take out a loan and to back it up, you give the bank a security interest in your intellectual property. If you default on the loan, they can claim your IP and sell or license it. If you want to sell the IP, the bank might require that you pay the loan back as part of the sale transaction.
In short, in all of the above cases, the encumbrance is limiting your ability to fully control your property.
In order to make sure that other people know that ‘hey, this asset is not 100% free and clear—someone else has some rights in it’, encumbrances are often registered in public databases. The form and location of the registration will vary based on what the asset is. For example:
- security interests (see below) on assets are registered with the company registrar;
- mortgages, easements and other rights related to real estate will be registered with the land registry (“tabu”, here in Israel); and
- liens on patents are registered with the patent office.
And so on and so forth. For example, if you were to go the Companies House website in the UK, or the Companies Registrar here, and download a report on a company, in addition to information on they company’s address, shareholders and the like, there will also be a page listing out encumbrances.
And now…let’s look at some specific types of encumbrances.
Security interest (Liens)
Per Sharon Herman Hezroni of SHH Law Office, while there may be some fussy technical differences between “security interest” and “lien” and these technical differences may vary based on where you are, to a large extent they are interchangeable. So we are going to mash them up and reduce the number of definitions by one. 🙂
Security interests are what allow the whole concept of debt and obligations to work. Trust is lovely, but has no teeth and certainly doesn’t work in situations where you may not know the other party and their financial situation well or at all. Security interests provide the teeth and a more dependable form of trust.
Security interests are used in debt and other commercial transactions in order to provide the lender/ service provider/ other side of the transaction with some sort of guarantee or collateral—that is, security—that they will get whatever it is they are supposed to receive under the transaction, be that their money back, the services they have been promised, compliance with contract terms…whatever it may be.
To understand this concept, think of…a pawnshop. You need some cash and instead of going to the bank, you decide to go to your friendly neighborhood pawnshop. The owner says “sababa” and gives you cash. But this is a pawnshop; it doesn’t end there. You also have to give something. So maybe just sign off on a promissory note—an agreement in which you promise to pay him back? Yeah, nice idea, but not nice enough. See, the owner doesn’t know you and doesn’t know whether you are trustworthy and/or good for the money (or he does, and know that you are not). He’s gotta look out for number one, think about his own security! He wants something of yours that will guarantee that, one way or another, he’s going to get his money back. So you give him something of value—say some jewelry—as collateral. That is, you have granted him a security interest in your jewelry as a guarantee that you will fulfill your end of the contract. If you come back with his money on time, you get that jewelry back. If not, he’s going to sell it and use the money to cover the debt and his costs.
In lending, commercial and other non-pawnshop transactions, security interests take myriad forms and can be on everything from equipment and other physical assets, to real estate, to amounts due from your customers, to your intellectual property and to services you are due to receive from your suppliers. Basically, if it’s an asset, it can be used as security.
Let me give you some real-life examples….
- You buy a car using a car loan or enter into a car lease. In this case, the lender or the company leasing the car will have a lien against the car. If you stop making payments, they’ll come and take the car back.
- You buy machinery from a supplier and the contract includes a clause that the supplier has a lien against the property until it’s paid for. If you don’t pay the invoice, the may start a process to get the machinery back. (To learn how to manage your supplier payments so this doesn’t happen to you, see here ).
- You bring your car into a mechanic. If you don’t pay the bill once the repair is done, your car will stay with him (a mechanic’s lien).
- You enter into a line of credit agreement with a bank. The loan isn’t connected to any particular assets so there isn’t any specific item that the bank can point to and say “that was funded with our money, and if you don’t pay us back, we can come and get it”. So in this case, you agree to grant the bank a security interest in other assets, such as your equipment, your receivables or other property, as collateral. If you stop making payments, they can start a process to claim the assets they have an interest in.
- The government may put a lien on your bank account or other property if you don’t pay your taxes. 🙁
Fun fact: I once gave a mattress distributor a security interest in my “doll collection” as security for financing a mattress. It’s hard to say who was more stupid. Me, for financing a mattress or the distributor for accepting security in the form of four mass-produced Madame Alexander dolls. All was well, however. Eventually the mattress was paid in full and today the dolls are hanging out happily somewhere in my father’s attic. Unless they since have been eaten by mice, which is a distinct possibility. Fortunately, I’m good on the mattress front.
Fixed and Floating Charges
You can grant security interests (liens) in tangible, specific assets or in assets which are intangible and/or more fluid. Fixed charges are liens on a specific, tangible and/or identifiable assets such as cars, computers, patents or buildings. In the case of a fixed charge, you can make up a list of exactly what is covered, how many units are on hand, where the asset is located and so on. Floating charges, on the other hand, are likely to be on classes of assets where the specific asset identities, details and locations will vary over time. Examples are: intellectual property , where you are continuing to add and develop it; accounts due from customers where the specific invoices outstanding will vary from day to day; or merchandise inventory where the specific products on hand can change from minute to minute as your company operates and receives and sells goods.
Beyond the difference in the assets covered, there are differences in what you, as the business, can do with the assets subject to the lien. In the case of a fixed charge, you are likely to be limited in your ability to sell or transfer rights in the assets so long as the lien exists. In the case of a floating charge, however, you are able to use the asset as you would normally in your business (e.g. sell the inventory or collect the receivable) without any limitations. A hard stop would come in the case where you default on the agreement and the other side starts a process to collect on the lien.
Accounts Receivable Financing (Factoring)
Executive summary: loan in which you are using your accounts receivable (amounts your customers owe you) as collateral.
So, you sell stuff (yay!) and issue an invoice to your customer. And then you wait for payment. And you are waiting a while because your customer is a Big Important Company and a bit jerky about it, to be honest, and has draconian, 120 day payment terms. And this is a problem because you have to pay your own suppliers in the meantime, and your payment terms are 30 days because you’re neither big, important nor a jerk. So, yeah, some cash would kinda come in handy. Factoring can help you to solve this cash flow issue.
While factoring can take various forms, in general, you are pledging your open invoices to a factoring company (you’ve granted them a lien on them) in exchange for an immediate advance of a portion (generally 70-90%) of the amounts due. The factoring company will receive the amounts due from your customers directly; you’ll need to provide customers with an updated payment mailing address or bank account for transfers. As payments are received, the factoring company will transfer you the rest of the invoice amount, less their fee.
For a more expanded description, see here and here. The latter link is from the site of a company that is trying to sell you factoring services, so you’ll want to add a bit of salt to their sugary descriptions of the service. It’s a pretty thorough overview, so I’ve included it.
Mortgages
Executive summary: loan to purchase real estate in which you are using the real estate purchased as collateral.
A mortgage is a loan used for the purchase of “real property”, that is, real estate (land, house, apartment, offices, etc.) In the case of a mortgage, the lender receives a lien on the property you have purchased as security for the loan.
My thanks to the wonderful Sharon Herman Hezroni of SHH Law Office for her invaluable assistance with this article!