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Startup Company Asset Collateralization

Assets can often be used as collateral for secured loans. This includes real property. This also includes personal property such as publicly traded securities, accounts receivable and inventory. Equity stripping involves encumbering an asset with legitimate secured debt in order to reduce its net exigible value and render execution unattractive for judgment creditors to pursue. The debtor also obtains the benefit of a liquid asset, namely cash, that would otherwise be trapped in the property. The cash in turn can be moved to other jurisdictions or transferred into exempt assets or other assets.

Equity stripping has various forms including commercial, controlled, contingent and cross-collateralization. Commercial equity stripping involves arm's length commercial lenders. Controlled equity stripping involves the use of trusted associates to create entities to act as lenders and controlled debt financing. It may involve the use of the device of an unregistered assignment of a commercial loan and related security from the original arm's length lender to a friendly creditor. Contingent equity stripping often involves the use of lines of credit secured by property which can be drawn down to effectively strip equity. Cross-collateralization involves agreements to use more than a single property as security for debt. This can create problems for creditors with claims against a particular owner and property.

It may be advisable, where possible, to have as little surplus capital invested in a startup as possible. This will result in the startup being thinly or undercapitalized. Shareholders in a startup can provide capital and operating funds to the startup by way of equity investment or debt. If funds are loaned to the corporation, the loan can be made on a secured basis. If secured by way of a general security agreement or mortgage over the assets of the startup, the repayment of the loan to the shareholders can be made in priority to outstanding debts that rank behind the security of the shareholders. Such security should be granted and registered contemporaneously with the advance of the funds. The loan is effectively supported by the security taken so secure repayment.

 To the extent that the startup requires an operating line of credit, an institutional lender will likely insist as a term of borrowing that the shareholder loan and security be subordinated to the lender's indebtedness. The priority over subordinate charges and unsecured claims can be maintained.

There are also indirect methods for converting assets into cash. Such methods give a new meaning to the expression "reverse equity mortgage". A debtor may borrow cash and increase his or her debt obligations and secure those obligations by mortgages or security agreements against the equity in the assets. This will effectively reduce and even eliminate the equity in those assets leaving little for an unsecured creditor to seize. The borrowed funds in the hands of the debtor may not be readily exigible or traceable.

Many corporate statutes prohibit the granting of financial assistance while a company is insolvent except in limited circumstances. This prohibition has been successfully relied upon to challenge security granted to a related party.