Collateral

What is collateral?

Collateral (German: Sicherheiten or Kreditsicherheiten; also called security) refers to rights that give a lender access to specific assets, or to the assets of a third party, if the borrower defaults. They form the second route of repayment. The first is repayment from ongoing cash flow, measured by debt service capacity, that is, the ability to pay interest and principal from the running business. The principle is familiar from private home financing: if the owner no longer pays the instalments, the bank can have the house realised through the registered land charge (Grundschuld).

German law distinguishes two groups. Security rights in rem (Realsicherheiten) give the creditor a right in a specific object that is effective against everyone, for example a land charge, a pledge or transfer of ownership by way of security. Personal security creates an additional claim against another person, for example under a surety (Bürgschaft) or a guarantee.

Collateral is regulated in a security agreement (Sicherungsvertrag) alongside the loan agreement. It determines which claims are secured, when the lender may realise the collateral and when it must release it. The security provider is whoever provides the collateral: the borrower itself or a third party, for example a shareholder. In financing rounds, in the review by investors and buyers (due diligence) and in company sales, the collateral shows which assets are freely available and which creditors rank first in a default.

The most important forms of collateral for loans

Land charge (Grundschuld)

The land charge (Sections 1191 et seq. of the German Civil Code, BGB) encumbers a plot of land in such a way that a specified sum of money is to be paid to the beneficiary out of the land; it is entered in the land register. Unlike the mortgage (Hypothek), it does not depend on the existence of a particular claim; the link to the loan is established by the security purpose declaration (Sicherungszweckerklärung).

Transfer of ownership by way of security (Sicherungs­übereignung)

In a transfer of ownership by way of security, the borrower transfers ownership of movable items such as machinery, vehicles, servers or inventory to the bank (Sections 929, 930 BGB). It retains possession of the items and continues to use them. The items must be clearly identifiable. It is not expressly regulated by statute and is not visible to the outside.

Global assignment (Globalzession)

In a global assignment, the company assigns all present and future receivables from deliveries and services to the bank, often limited to certain customer groups (Section 398 BGB). It is usually agreed silently: customers continue to pay the company until the bank discloses the assignment in the event of enforcement. Receivables that fall under an extended retention of title of suppliers are excluded. In that case the supplier remains the owner of its goods until payment and has the receivable from their resale assigned to it in advance. A global assignment that also covers these receivables may be contrary to public policy and therefore void.

Pledge of shares and accounts

Shares in a GmbH (German limited liability company) can be pledged (Sections 1273, 1274 BGB). Because the pledge follows the rules for a transfer, it requires notarial certification under Section 15(3) of the German Limited Liability Companies Act (GmbHG). If the articles of association require consent for assignments (transfer restriction, Vinkulierung, Section 15(5) GmbHG), this generally also applies to the pledge. Pledging of shares is common in acquisition financings, that is, loans for a company purchase, and in holding structures. In the event of realisation, it allows access to the company as a whole. Bank balances and securities accounts can also be pledged.

Surety and other personal security

With a surety (Sections 765 et seq. BGB), a third party undertakes to answer for the borrower's debt. For loans to smaller GmbHs, banks often require a direct surety (selbstschuldnerische Bürgschaft) from the shareholders. The shareholder is then liable for the guaranteed amount with private assets, although for the debts of the GmbH otherwise only the company's assets are liable (Section 13(2) GmbHG). Sureties given by close relatives without income and assets of their own may be void under Section 138 BGB because of financial overburdening. Guarantee banks (Bürgschaftsbanken) assume default guarantees for part of the loan for a fee if the company lacks collateral of its own.

Lending value, over-collateralisation and release of collateral

Banks do not count collateral at book or market value but at a lending value after haircuts, which is meant to reflect the proceeds achievable in a realisation under time pressure. Real estate that can be used by third parties and receivables from solvent customers receive smaller haircuts, specialised machinery and inventory high ones; self-developed software is often not counted at all. The part of the loan not covered by lending values is called the unsecured portion (Blankoanteil). For it, the bank demands a higher risk premium.

The counterpart is over-collateralisation, in which the collateral is worth far more than the loan. Revolving global security covers a constantly renewing stock, for example in a global assignment or the transfer of ownership by way of security of an entire warehouse stock (Raumsicherungsübereignung). For these, according to settled case law, the security provider has a claim to release even without an express clause. It arises when the realisable value of the collateral exceeds 110% of the secured claim, and not merely temporarily (coverage limit). If the estimated value of the collateral exceeds 150% of the claim, it is presumed that this limit has been exceeded. The banks' general terms and conditions also provide for an obligation to release; which collateral is released is then chosen by the bank, taking the customer's interests into account.

An express release clause, under which collateral is released pro rata as the outstanding debt falls, makes the release predictable. The company itself must assert it. If an encumbered item is to be sold, the company and the bank often agree on a collateral swap: the bank releases it and receives other collateral of equivalent value.

Several lenders: collateral pool and security trustee

If several banks finance a company, they often bundle their collateral in a collateral pooling agreement (Sicherheitenpoolvertrag), which regulates the distribution of proceeds; in a restructuring, suppliers sometimes join as well. In syndicated loans, a security trustee, usually one of the participating banks, holds the collateral for all lenders. The basis is a security trust agreement (Sicherheitentreuhandvertrag).

Collateral at technology companies

The assets of young technology companies consist mainly of software, data, customer relationships and the knowledge of the team. Rights in software and intellectual property rights can indeed be pledged, but the realisation proceeds depend on whether anyone can develop the technology further. Lenders therefore rely on collateral whose value does not depend on the continued existence of the business. This includes pledged balances, receivables from solvent customers, sureties and the liability exemption of a development bank in the case of the innovation loan. Providers of venture debt, that is, loans to companies backed by venture capital investors, often require accounts, receivables and intellectual property rights as collateral. A negative pledge is often added, that is, the undertaking not to grant collateral to other creditors.

Collateral in insolvency and company sales

In the insolvency of the borrower, security rights in rem entitle the holder to separate satisfaction (Sections 49 to 51 of the German Insolvency Code, Insolvenzordnung, InsO): the secured creditor receives the realisation proceeds ahead of the other creditors, less statutory cost contributions. For collateral that a shareholder has provided for a loan to the company, Section 44a InsO applies. Under it, the lender can claim proportionate satisfaction from the insolvency estate only for the amount for which it fails to recover on this collateral. Collateral that was granted subsequently for loans already in existence can be challenged by the insolvency administrator, depending on the timing and circumstances of the grant (Sections 129 et seq. InsO).

In a company sale, the collateral is released at closing with the repayment of the loans; the banks' release declarations are often a condition to closing. In an asset deal this is particularly important, because machinery transferred by way of security legally belongs to the bank and cannot be transferred free of encumbrances without its release. In due diligence, loan and security agreements and land register extracts are therefore reconciled.

Worked example: lending value of collateral and release

A manufacturer of laboratory equipment with its own control software takes out an investment loan of EUR 1.5 million. It offers the transfer of ownership by way of security of its production facilities with a book value of EUR 800,000 and a global assignment of its customer receivables with a balance of EUR 1.2 million. The bank applies, by assumption, 30% of the book value of the facilities and 50% of the receivables; receivables of EUR 150,000 overdue by more than 90 days are disregarded.

• Lending value of the facilities: EUR 800,000 × 30% = EUR 240,000
• Eligible receivables: EUR 1.2 million minus EUR 150,000 = EUR 1.05 million; lending value EUR 1.05 million × 50% = EUR 525,000
• Total lending value: EUR 240,000 + EUR 525,000 = EUR 765,000
• Unsecured portion: EUR 1.5 million minus EUR 765,000 = EUR 735,000, that is 49% of the loan
• Solution: A guarantee bank guarantees 50% of the loan, that is EUR 750,000, and thereby covers the unsecured portion.
• Four years later: outstanding debt EUR 500,000, receivables balance EUR 2.0 million. Threshold for the presumption of over-collateralisation: 150% × EUR 500,000 = EUR 750,000. The nominal value of the receivables alone is four times the outstanding debt.
• Coverage limit: 110% × EUR 500,000 = EUR 550,000 realisable value. After the bank's haircut, the receivables already reach EUR 2.0 million × 50% = EUR 1.0 million.

The collateral thus far exceeds the coverage limit, and the company can demand the release of the excess part. Possible are the release of the facilities and a restriction of the global assignment to part of the customers; under the bank's terms, the selection is made by the bank.

Distinctions: collateral, guarantee facility and covenants

• Guarantee facility: Here the bank itself acts as the security provider, for example with a rent guarantee towards the landlord, and has its right of recourse secured by the company.
• Covenants: contractual conditions without access to assets, which apply before any realisation of collateral takes place.

Common mistakes

• Planned with book values. Lending values, depending on the type of asset, lie far below book or market values; financing planning on the basis of book values overestimates the possible credit line.
• Unlimited surety signed. A maximum amount, a time limit or lapse on reaching certain key figures are often negotiable.
• No release clause. Without a contractual provision, release as the outstanding debt falls remains a matter of negotiation, and assets stay tied up longer than necessary.
• All collateral with one lender. A company that gives all receivables and facilities to one bank has no room left for a second lender or factoring, that is, the sale of receivables.

Frequently asked questions

Are there loans without collateral?

Yes, but rarely for young companies. Unsecured loans are granted mainly to companies with high earning power and good creditworthiness. Otherwise, a guarantee bank or the liability exemption of a development bank can partly replace missing collateral.

When is collateral released?

On full repayment of all secured loans, or earlier under a release clause. Because security agreements often secure all claims of the bank, the release of collateral often takes place only when no loans are outstanding.

Does the managing director have to give a personal surety?

There is no statutory obligation. Banks demand personal sureties mainly from young or small companies with little equity. As earning power grows and after equity rounds, a limitation or replacement can often be negotiated.

What role does collateral play in a financing round?

An indirect one. Equity investors receive no collateral but examine which assets are already encumbered, whether shareholders have given personal sureties and whether the bank must consent to a capital increase or a change of shareholder.

The Roemer Capital view

For clients, we keep a collateral overview: which collateral is held by which lender for which loan, with lending value, outstanding debt and release rule. This overview is the basis for demanding releases, approaching a second lender or showing in a financing round which assets are free.

In the sale process, we agree with the client's law firm which release declarations must be available at closing, and we build the repayment of the loans into the purchase price calculation. Personal sureties of the sellers deserve separate attention in this: they must lapse at closing, otherwise the sellers remain liable for loans of a company that no longer belongs to them.