What is a security interest in connection with a convertible note?
Takeaway: A "security interest" is a lender's claim on a company's assets as collateral; it is a feature of traditional bank loans and is almost never granted in a seed-stage convertible note financing, as it would severely cripple the company's ability to operate and raise future capital.
Because a convertible note is a form of debt, investors will sometimes ask for a security interest to "secure" their loan. A security interest is a legal claim (a lien) on some or all of the company's assets, which serves as collateral for the debt. In a traditional bank loan, this is a standard requirement. For example, a bank might take a security interest in a company's accounts receivable or its physical equipment.
However, in the context of a seed-stage convertible note financing for a tech startup, granting a security interest to your noteholders is highly unusual, highly problematic, and should be avoided at all costs.
Why a Security Interest is a Major Red Flag
If you grant your noteholders a security interest in your company's assets, you are creating a massive obstacle for your company's future.
It Encumbers Your Intellectual Property: The most valuable asset your startup has is its intellectual property (IP). If you grant a "blanket lien" on all your company's assets, you are effectively giving your noteholders a claim on your patents, your trademarks, and your source code.
It Blocks Future Financing: No venture capital fund will invest in a company whose core IP is already being used as collateral for another loan. They will demand that the security interest be removed before they will invest. Similarly, no bank or venture debt provider will provide a senior loan to your company if the assets are already pledged to your convertible noteholders.
It Creates a Leverage Imbalance: It gives your noteholders an inappropriate amount of leverage. In a downside scenario, they could have the right to foreclose on and seize your company's core assets, effectively wiping out the founders and all other stakeholders.
Convertible Notes are Unsecured Debt
The market standard is clear and universal: seed-stage convertible notes are unsecured obligations. The investors are betting on the future equity value of your company, not on the liquidation value of its assets. They are venture investors, not asset-backed lenders, and they should be taking the commensurate risk.
If a potential investor asks for a security interest in connection with a convertible note, it is a major red flag. It signals that the investor is either unsophisticated and does not understand the norms of startup finance, or that they are being overly aggressive and attempting to secure a level of protection that is not appropriate for a high-risk, high-growth venture. In nearly all circumstances, you should politely but firmly reject any request for a security interest. Your company's assets, particularly its IP, must remain unencumbered to allow for future growth and financing.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.