Asset Backed Loans

You may not realize that you've encountered asset-backed loans before with a mortgage or car loan. Learn how company equity can back personal loans as well.

Asset backed loans are everywhere. Asset backed means that if the borrower doesn't pay back the loan, there's an asset that can be seized (and presumably sold) by the lender. A mortgage is an asset backed loan. A car loan is too.

Asset backed loans are now available to help startup employees get access to cash before their company IPOs or is acquired. Before diving into the specifics of how those loans are typically structured, it's helpful to detail how these instruments work generally.

Asset Backed Loans 101

Asset backed loans are built around collateral - the assets that can be seized if the loan isn't paid back. When a loan or one of the interest payments isn't paid on time, we say that the loan is in default. What constitutes default for any given loan is dependent on the terms in the loan agreement. Once in default, the lender can seize collateral.

Some loans also allow for personal recourse where the lender can seize other borrower assets to compensate for any loan losses. Non-recourse loans are inherently riskier for the lender - and less risky for the borrower - because there are fewer options to limit losses if the borrower doesn't pay.

Lenders typically manage that risk in three ways - being deliberate about the collateral, limiting the loan-to-value ratio, adjusting the interest rate, and charging fees. The keys to collateral are both its stated value and the ability of the lender to rapidly sell it for cash if needed. If the value of the collateral fluctuates a lot or it's hard to sell quickly, the lender will need to be more conservative with the loan.

Loan-to-value (LTV) is how big the loan is relative to the value of the collateral. An LTV limit of 30% is not uncommon for startup equity loans. That means that if the equity is worth $100, the lender will lend up to $30.

An interest rate is usually expressed as an annual percentage rate (APR), the yearly rate charged for a loan. A lender will charge a higher APR to offset risk. 

Fees generally come in three flavors - originating, servicing, and exit. As their names imply, originating fees are charged when you open the loan, servicing fees are charged over the life of the loan, and exit fees are charged when the loan is closed. Different loans may have a different mix of fees and some - like servicing costs - may be bundled into the interest rate and essentially invisible to the borrower.

Asset Backed Loans for Startup Equity

Asset backed loans for startup equity are unusually risky loans for a lender. They're relatively new instruments so the few specialist lenders that offer them have generally issued loans with very conservative terms. For a borrower, that has meant these loans are more expensive than you might expect if you're already familiar with more mature markets like mortgages or auto loans.

Prism is changing that with loans that are a better fit for startup employees.

Asset backed loans for startup equity tend to be consistent in how they're structured, but there can be exceptions. Most are collateralized by the startup equity, and the loan repayment can be triggered early by a liquidity event (e.g. IPO, SPAC, acquisition) for the startup. When a liquidity event for the company takes place, the borrower pays back the loan in full, using proceeds from the liquidity event.

For employees, this means you can borrow cash today that you don't repay until there's a liquidity event for your company.

Relative to more mature markets like mortgages, loans for startup equity tend to be at low LTVs, higher interest rates, and only made against equity from startups that the lenders think have a high likelihood of completing a successful liquidity event in the next five years or so. It's a balancing act for any lender - they want to extend more loans, but they need to manage risk carefully.

Is An Asset Backed Loan Right For Me?

It depends (of course). An asset backed loan can be a wonderfully powerful tool, but it comes with risks. 

Asset backed loans are among the very few ways that startup employees can use their startup equity to get cash pre-IPO and keep ownership of their equity. That means they continue to share in the upside as the company grows and becomes more valuable. It can be a powerful tool to help employees exercise options earlier than they may have otherwise and materially reduce how much they pay in taxes. You can learn more about how much it can help here (hint: a lot).

Ultimately, there's no free lunch. The loan is a bet by the borrower that the future share price, when the liquidity event happens, will be large enough to allow them to sell some shares to pay back the loan. There is always a possibility that the share price will be depressed at exactly the wrong time and the borrower will be forced to sell more than they had intended, possibly all of the shares they own.

The borrower’s bet cuts both ways - if the company goes bankrupt before the liquidity event, then the borrower may be off the hook, depending on the structure of their loan.

It's up to you to determine if that's a reasonable risk. You have to weigh it against your need for cash and the other ways you may potentially get access to cash , all of which come with their own tradeoffs.

If you decide that an asset backed loan is a good fit for you, Prism is here to help.