Single Stock Lending - Lending against unlisted or start-up shares

Lending against collateral in the form of unlisted shares carries substantial risks.

When the collateral shares are listed, if the borrower cannot repay the loan, the shares are seized and sold into the market at a suitable discount to the prevailing market price.?In contrast, when the collateral share are unlisted, this step becomes vague and undefined. The lender has to find a way to structure the loan so that the shares can be sold.?This means pre-arranging one of more third-parties who would buy the shares.?

?This can happen in two principal ways:?

1. Buying a put option.?The lender can search for a third-party or a group of such their-parties who are prepared to accept the shares against a certain payment if the borrower defaults on the repayment of the loan.?This requires that (i) a suitable third-party is identified; (ii) the third party can adequately collateralise the put option it sells to the lender; (iii) the underlying shares can be seized and delivered against the put option without any legal impediment and without the need to first offer them other shareholders (pre-emption rights); (iv) the borrower has the legal capacity to pledge the underlying shares. This structure involves a lender who provides the loan, but hedges itself by buying a put option from third-parties.?The cost (premium) of the put option should be reflected in the terms of the loan through an increased spread.?The put option premium is an incentive for the seller of the put option.
2. Sub-participated loan. In this case, a single loan is created against the pledge of the shares, but the loan is sub-participated to several third parties.?In the case of unlisted start-up shares, where the borrower is a founder, this could mean splitting the loan between other equity investors in the start-up - which could comprise several private equity of venture capital investors.?The attraction of this format is that all lenders have the same loan documentation and each pays their pro-rata share of the loan.?As investors in the start-up, the lenders should all have a good idea of the risk and be prepared to increase their risk to the shares.?For this lending format, it must be ensured that (i) the founder has the legal capacity to pledge the underlying shares; (ii) the lenders can legally appropriate (seize) the shares in the event that the borrower cannot repay the loan; (iii) there are no pre-emption requirements to offer the shares to other shareholders, such pre-emption rights are waived by the other shareholders, or the lenders are happy to respect the pre-emption requirements (which could lengthen the recovery process several weeks).?With this method, the lenders directly face the borrower.

Both the above constructs also require that a method is agreed at the outset for valuing the shares as and when it comes for their delivery against the put option in exchange for cash to repay the loan.?A certain number of shares are pledged at the start of the loan based on an agreed LTV (loan-to-value).?The value of these shares should, at all time, be theoretically adequate to repay the loan. This means that a specialist accountancy firm should be used to value the shares on yearly or six-monthly intervals.?Otherwise, the lender and the borrower can pre-agree in the loan documents another mutually acceptable method for valuing the shares.?Every six months or one year, there will need to be a re-evaluation of the collateral shares adequacy to ensure that enough shares remain pledged against the loan. If not, the number of pledged shares would need to be increased.

A point that is often missed in these lending cases is the question of why the borrower needs the loan.?If the purpose of the loan is to make an investment, it may be possible to bring the target investment into the collateralisation framework and improve the financing terms.

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