It does not matter where or how you get funding for your company, the number one ball you need to keep an eye on is the U.C.C. For what happens with the UCC has potential to cause an effect on other funding events. By having a clear understanding of what the UCC is for, and what your current UCC filing situation is, you may avoid last minute headaches down the road.
The UCC, or it’s proper name, the Uniform Commercial Code has two functions. It came from the old days when nobody knew what collateral was being used for what loans. Someone could take the same piece of property and borrow against it six times. Each state adopted this new code whereby a lender would file a document to the State Government notifying all comers that they had a legal security interest on said collateral. Eventually there came a time when all 50 states had different UCC rules and while it was great for attorneys, it was a mess if you registered a company in one state and operated in another. More recently the U.S. adopted a Federal UCC statute, and for the most part, the rule of law is the same across the country.
The first function of the UCC is to be the gatekeeper. Whenever a commercial finance company is considering lending capital against some collateral, one of the first things they do is search the state where the company is formed to see if a UCC is filed. If you were going to use your accounts receivable as collateral on a line of credit, the lender would file the UCC-1 and all would know the A/R is spoken for. So it’s a sign letting everyone know about first dibs on your property.
The second function is to recognize the rights of the secured party. This primarily comes into play when a company is filing bankruptcy and liquidating its assets. The Court would recognize each successive secured party and when everything is sold and collected, they get paid in full and the unsecured vendors get to split up what is left.
Here is why this is vital, if you had done a transaction where you owed someone money and a UCC was filed, it would prohibit you from borrowing further until steps were taken regarding the secured parties. Now it’s important to understand this can become very complex. Your company may have multiple UCC’s filed, but they are recognized in order of seniority based on the filing date. There are definitely lenders and investors who have no problem being in second or third security position.
For example, a VC might invest in a company and file a UCC against the business assets. At some point later the company goes to a bank and secures additional funding. Usually the VC will “subordinate” their first position to the lender, stay in second position and everything runs along smoothly.
But another example would be, you are just starting out and get a little line of credit from your local bank. Now you have used up that line and are looking for additional working capital. Or better yet, your company qualifies for an SBA guaranteed term loan and again you start looking for additional capital. When you contact a lender and find out you cannot qualify for any form of capital unless you pay off your existing loan, you’ve essentially lost your access to outside commercial capital.
The point of this article is, this should not come as a surprise to you. The strategy of knowing your UCC status will be very important in the growth of the company. There are two things to be aware of when dealing with this issue. You must give permission for an entity to file a UCC. But this can be done in a very innocuous fashion, like signing a term sheet that includes language like “right to file notices evidencing their priority” or the use of the words “financing statement.” You rarely see the actual letters UCC. Sometimes you go to lease a piece of equipment and in the leasing documents you don’t realize you allow the leasing company to file a UCC on “All Business Assets.” The worst case scenario here would be paying off the lease in full in order to borrow from another lender. In all cases, if you’re not sure, ask before you sign anything.
The second aspect to realize is that the UCC is a negotiable instrument. The collateral is spelled out in the language filed in the financing statement. So you could be talking with two equipment leasing companies and one is planning on filing all assets and the other is willing to outline the specific piece of equipment only. You use the knowledge of the UCC as a negotiating tool when securing capital.
Being a business owner who is even aware of these three letters is an important step to utilizing financing as a tool to gain access to growth capital.