Tech Lending: Why Are Tech Companies So Hard to Value?
This article is the first in a series providing an overview of critical considerations for commercial lenders contemplating whether to finance a tech company and how such loans can be secured.
Historically, commercial lenders have favoured lending to businesses rich in tangible assets that can be used to provide security for loans. However, commercial lenders have become increasingly interested in lending to tech companies. There has been an upward trend in the amount of cash flow-based and asset-based lending to the sector.
Providing debt financing to tech companies often presents unique challenges. Due to several factors, tech companies – especially startup and early-stage businesses – are inherently difficult to value. This difficulty can be a stumbling block for creditors trying to evaluate lending risks for a company. It can also make securing collateral to mitigate those risks more complicated.
First, lenders must contend with the phenomenon of the “hyper-growth phase.” Tech startups often have an initial growth rate that vastly exceeds the standard expansion rate of other businesses. Other times, they fail spectacularly. The increased uncertainty that results from this phenomenon makes it especially hard to value the growth potential of tech companies and understand what it might mean for the business’s long-term viability.
More complicated issues of valuation arise when it comes to a tech company’s assets. Like all companies, tech companies have a variety of assets – tangible and intangible. Unlike other companies, intangible assets tend to make up a much larger share of a tech company’s valuable property and typically account for their most valuable assets. This can cause challenges for prospective lenders, given the inherent difficulties associated with valuing intellectual property. Moreover, early-stage tech companies may not have begun working with legal counsel to develop an effective intellectual property strategy, a crucial step in positioning the company to reap the rewards of its creative labour.
Accurately valuing intellectual property assets as collateral requires understanding how to assess those assets’ marketability and commercial potential. It also requires an awareness of the various pitfalls and risks unique to such assets. Financing secured principally by intellectual property assets demands a different kind of due diligence than traditional forms of collateral, and this can take time and effort to complete.
Despite these challenges, however, lenders should not be deterred. Although tech companies’ assets can be hard to value and their risk profiles unique, lending to these lucrative companies can be profitable if done correctly and with the necessary information to make sound business judgments.
If you require assistance with any matter or question related to tech lending, please reach out to a member of our Financial Services Group.
