What's a Stock or Membership Interest Pledge?
Updated: May 17, 2020
A pledge is a way to use your equity in a corporation or LLC as collateral to secure a debt.
Let's say you want to buy stock in a main street business, but you don't have enough money to pay cash for it. Instead, you pay the purchase price by giving the seller some cash and a promissory note for the balance. The seller probably will want some collateral to secure the debt. That's reasonable. It's common for you to enter into a contract (a Pledge Agreement) by which you give the seller a lien on your stock and the right to foreclose on your stock and take back ownership of the business if you default on the promissory note.
Your stock certificate usually is held in escrow until you have paid off the debt. The seller's attorney or your attorney might be the escrow agent. You will deliver the pledge agreement and your certificate to the escrow agent. The seller and you probably will have to sign an escrow agreement with the escrow agent, too.
You retain control over your stock while it is pledged and in escrow. You can vote your stock and receive distributions as if it were not pledged.
If you are the buyer, you might try negotiating an automatic reduction in the number of shares pledged when you pay down your debt by taking the position that each payment you make should free up a proportionate amount of stock from the pledge. For example, if the purchase price for 1,000 shares of stock is $100,000, and you paid $10,000 in cash at closing and delivered a promissory note for $90,000 on which you will pay $500 per month, you could argue (a) that your $10,000 in cash purchased 100 shares of stock that should not be pledged, and (b) each time you make a $500 payment, you purchase an additional 5 shares that should be released from the pledge. You want to avoid the risk of making most of the payments, and then losing your entire ownership if you default at the end of the pay period.
If you are the seller, you don't like the automatic reduction idea, however, because it might result in your becoming a part owner of the business with the buyer upon his default. Why would you risk the possibility of getting into business with a someone who already has failed?