How to Use Trade Secrets as Collateral for a Loan

Patents, trademarks, and copyrights are intellectual property assets capable of creating a monopoly by registering with the federal government.  In exchange for this monopoly protection the owner of the asset publicly discloses the full nature of the asset.  Owners can then use these assets as collateral to raise capital.

What is a Trade Secret?

But how does a company obtain financing from a lender when the intellectual property they posses is trade secret? A trade secret is defined by the New York courts as:  “a formula, process, device, or compilation which one uses in his business and which gives him an opportunity to obtain an advantage over competitors who do not know or use it.”  A couple of classic examples are KFC’s secret blend of 11 herbs and spices or Coca-Cola’s secret formula.

 Using Trade Secrets as Collateral

Trade Secret Law is how an intellectual asset such as source code for a computer program that exists as an unregistered copyright can remain legally protected.  Since there is legal protection for trade secrets, trade secrets can be used as collateral for a loan.

For example, if a lender wants to make a loan to a start-up software company, then it is likely the company does not have any real assets other than the source code for the computer program that can be used as collateral for a loan.  As a lender it is important to remember a computer program may involve several different types of intellectual property.   While source code is eligible to be registered with the U.S. Copyright Office, a company may choose not to register, because it would mean disclosing their source code to the public and in some cases this would simply be impractical due to constantly updating code.

What Does a Borrower with a Trade Secret do to Obtain a Loan?

A prudent lender will want to know whether or not the company has sufficient protections in place to ensure the trade secret remains a trade secret.   A lender will want to see a company has taken active steps to securing the trade secret by encryption, firewalls, and executed employer-confidentiality and non-disclosure agreements with employees, contractors, and customers with access to the source code.

 How does a Lender Collateralize a Trade Secret?

A lender to a software start-up will want to ensure adequate protection of their collateral (source code) in the event of a default and foreclosure of the loan.   Unlike patent, trademark, and copyright that are governed by federal law, trade secrets are governed under a state’s Uniform Trade Secrets Act.   Therefore a lender will want to file a UCC-1 financing statement with the secretary of state.    The UCC-1 statement needs to be carefully drafted to ensure the collateral description is sufficient and specific to the asset being collateralized.  However, if a lender is placing a lien on all of the company’s intangible assets, then there is no strict requirement under the UCC that they be separately indentified.

DISCLAIMER: **The information appearing in this article does not constitute legal advice or opinion.  This article is for informational purposes only.  Melwani & Chan LLP only provides advice and opinion upon engagement with respect to specific factual situations.**