Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Founders Use Second-Lien Loans for Pre-Exit Liquidity
Transcript
- Lucas: Luna, let's talk about a funding move that's getting popular among founders who want to cash out a bit before they actually exit. It's called a second-lien loan — and it's a way to get liquidity without selling shares or triggering a taxable event. Luna: I've heard about these in the context of companies with big private valuations. How does it work in practice? Lucas: So picture this: You're a founder of a SaaS company doing about $50 million in revenue, growing maybe 30% a year. A private equity firm values you at $400 million. You've got a lot of paper wealth, but your cash compensation is modest. You want to buy a house or diversify some wealth, but you don't want to sell shares and trigger a capital gains tax, and you definitely don't want to signal that you're exiting. Luna: Right, because insider selling can spook the market or your own employees. Lucas: Exactly. So you go to a private credit fund — there are dozens now, from firms like Blue Owl or Ares or even some family offices — and you borrow, say, $10 million. That loan is secured by a second lien on the company's assets. But the real collateral is the expected exit proceeds. Luna: So the lender is betting that you'll sell the company within a certain timeframe and they'll get paid back from the deal? Lucas: That's the bet. The loan typically has a maturity of three to five years, and an interest rate that's floating — right now we're seeing coupons around SOFR plus 600 to 800 basis points. So all-in, maybe 11% to 13%. Expensive, but not crazy for unsecured or second-lien debt. Luna: And if the exit doesn't happen in time? Lucas: That's the risk. Most of these loans are full recourse to the founder personally. So if the company doesn't sell, you're on the hook for $10 million plus accrued interest. And there are acceleration clauses — if the company's valuation drops below a certain threshold, the lender can demand repayment. So it's not for the faint of heart. Luna: Which makes sense why we're seeing more of these now. Valuations are sky-high — I mean, Databricks just raised at an $188 billion valuation. But timelines are uncertain. The Paramount-Warner Bros. merger just got paused by a judge. Exits are unpredictable. Lucas: Exactly the environment where a founder might want to derisk personally without forcing a sale. And the loan structure is flexible. Some lenders will let you defer interest — payment-in-kind, or PIK — so you don't have to come up with cash every quarter. The interest just accrues and gets paid at exit. Luna: So the loan grows over time. If you borrow $10 million at 12% PIK for three years, you owe about $14 million at exit. That's a big bite if your equity value doesn't grow as fast. Lucas: That's the math. And that's why founders usually only do this when they're pretty confident in a near-term exit — say within two years. It's basically a bridge loan against your own success. We've seen it in a few notable cases: the founder of a cybersecurity company that sold to Palo Alto Networks a couple years back used a second-lien loan to buy out a co-founder's stake before the deal closed. Luna: Let's compare this to a tender offer or a secondary sale. What are the trade-offs? Lucas: With a tender offer, you're selling actual shares. That means you realize a gain and pay taxes — probably 23.8% federal capital gains plus state. You also dilute your ownership and potentially signal to the market that you're cashing out. With a loan, you don't pay taxes because you haven't sold anything. You just have a debt. And your ownership percentage stays the same. But you've added leverage to your personal balance sheet. Luna: And if the company's value drops below the loan amount, you could be underwater. You might even have to file for personal bankruptcy if you can't repay. Lucas: That's the nightmare scenario. So this is really for founders who have high conviction in their exit timeline and a strong relationship with a lender who understands the business. It's not a product you get from a bank. It's a bespoke deal negotiated with a credit fund or a family office that specializes in founder lending. Luna: And the documentation is key — things like negative covenants that restrict the founder from taking on other debt, or from selling the company below a certain price without the lender's consent. Lucas: Right. The lender wants to protect their position. So they'll often require a minimum valuation at exit, or they'll have a say in the sale process. You're basically bringing a partner into your exit strategy. But for many founders, that's worth it to get liquidity now. Luna: What about the tax implications on the loan itself? Is there any risk of it being recharacterized as income? Lucas: That's a great question. The IRS could argue that if the loan is not genuinely recourse — if it's effectively non-recourse because the lender doesn't intend to collect from you personally — then it might be treated as a constructive sale. But most properly structured loans are clear: it's a real loan with personal liability. The interest is not deductible unless the proceeds are used for investment purposes. And if you're using it to buy a house, it's personal interest, not deductible. So the tax benefit is really just the deferral — you don't have a taxable event until you sell. Luna: So it's a liquidity tool, not a tax shelter. Lucas: Exactly. And we're seeing more of these because the private credit market has exploded. A decade ago, this kind of financing was rare. Now there are funds with billions dedicated to founder loans. It's become a standard option for founders at companies with valuations above $100 million. Luna: If these conversations are useful for what you're building or running, we hope you'll consider supporting the show. Listener support is what keeps it ad-free and focused on the real mechanics of exits. You can do that at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small gesture that goes a long way in helping us keep this independent. So thank you to everyone who already has. Luna: Now, back to the loan structures — I want to ask about a specific scenario. What happens if the founder gets divorced or dies before the exit? Does the loan survive? Lucas: Those are the kinds of events that trigger acceleration clauses. Typically, death, disability, or divorce are all events of default. The lender wants their money back. So the founder's estate or ex-spouse would have to come up with the cash. That's another reason to have a clear estate plan if you take one of these loans. Luna: Let's talk about the lender's perspective. What do they look for in a founder? Lucas: They want a founder with a strong track record, a company with clear exit potential — either through an IPO or a strategic sale — and a valuation that's defensible. They'll often ask for a board observer right or a consent right on major transactions. They're not looking to run the company, but they want to be in the room when exit decisions are made. Luna: And the interest rate reflects the risk. If the company is a rocket ship like an AI startup with huge growth, the rate might be lower because the exit is more certain. If it's a slower-growing business, the rate is higher. Lucas: Exactly. The spread can vary a lot. I've seen deals as low as SOFR plus 400 for a top-tier growth company with a clear IPO path, and as high as SOFR plus 1000 for a company in a cyclical industry with uncertain timing. It's all about the perceived risk of the exit not happening on schedule. Luna: How does this compare to a typical venture debt facility? That's also secured by assets, but it's usually for the company, not the founder personally. Lucas: Venture debt is lent to the company — it's on the company's balance sheet. The second-lien loan we're talking about is lent to the founder personally. So the company's creditors have priority over the company's assets. The founder's loan is a personal obligation, secured by a second lien on the company's assets, but it's really the founder's personal credit that matters. It's a very different risk profile. Luna: So for a founder listening who's considering this, what's the first step? Lucas: Talk to a few specialized lenders. There are firms like iBank, Atalaya, or Runway Growth that do this. Also, get a good lawyer who understands this space — the documentation is complex. And be realistic about your exit timeline. If you're not confident you can sell or go public in two years, the interest compounding may become a problem. Luna: And if you do take the loan, what's the best use of the proceeds? Paying yourself a dividend? Buying out a co-founder? Lucas: Typically, it's for personal liquidity: buying a home, diversifying into other assets, or funding a new venture. Some founders use it to buy out a co-founder who wants to leave — that can be clean because the loan proceeds go directly to the departing founder, and the remaining founder's ownership increases without any taxable event. Luna: That's actually pretty elegant. You get more control of the company, your co-founder gets liquidity, and neither of you pays taxes until a real sale. Lucas: Right. And the lender is happy because the departing founder's shares are cancelled or transferred, and the remaining founder has a stronger incentive to execute the exit. It aligns interests. Luna: One thing that strikes me is that this whole concept only works because we're in a high-valuation environment. If the market turns and valuations drop, these loans could become very dangerous. Lucas: Absolutely. That's the hidden risk. If you borrow $10 million when your company is worth $400 million, and then the market crashes and your company is valued at $200 million, you still owe $10 million plus interest. Your equity is worth half what it was. You might be personally underwater. Founders who did this in 2021 are feeling the pain now if their companies haven't exited. Luna: And that's why it's a tool for high-conviction scenarios. Not for everyone. Lucas: Exactly. But when it works, it can be a great way to get liquidity without giving up equity or triggering taxes. It's another arrow in the founder's quiver for managing personal finances alongside the company's trajectory. Luna: Good episode. I feel like I understand the mechanics now. Lucas: Me too. And as always, if you have a specific situation you're thinking about, talk to a professional. This isn't DIY territory.