As you start to apply for small business loans to start or expand your small business, you may be in the early stages of an entrepreneur’s high.
You’re excited about your business prospects, confident about your future success, and likely not thinking about the potential fallout that could come down the line if everything doesn’t go exactly as planned. And for the most part, that’s as it should be! It takes the relentless enthusiasm of an entrepreneur to make a business succeed.
That being said, the business loan application and approval process are likely to bring about a few wake-up calls that should make you pause and think about what you’re getting yourself into. Because along with checking your credit score, your business’ current revenue, and other factors, most lenders will want to secure their investment by requiring business borrowers put up some form of collateral.
In essence, any form of collateral is a lender’s way of hedging their bet. It means that if your business goes under or you default on your debt for any other reason, you don’t just get off scot free. Depending on the type of collateral involved in your loan agreement, you could potentially face serious financial fallout that impacts not only your business — but also your personal finances.
Before you sign the dotted line of any business loan, take off those rose-colored glasses for a moment and make sure you understand the potential impact of these three types of collateral that may apply to your business loan.
1. Asset–Based Collateral
Fixed assets are usually a borrower’s best options for putting up collateral because they create a hard limit on what the lender can seize in the event of a default. The assets you can use as collateral for your small business loan come in a couple different forms. The first one being the most common — your personal assets, or real property. Then there are the assets that you have a loan against, such as inventory financing, equipment financing, and invoice financing.
When we talk about real property, we’re talking about collateral in the form of your assets such as the equity on your home, equipment, cars, boats, motorcycles, or other personal assets that can cover the costs of your debt if you’re unable to make your payments.
Inventory financing is an asset-based form of lending in which your inventory is used as collateral. Should you be unable to make your loan payments, the lender has the right to seize your business’ inventory as repayment for your debt.
Similar to inventory financing, equipment financing allows you to use your equipment as collateral. This includes any equipment you use to run your business such as computers, printers, copy machines, and the like.
With invoice financing, you can use your unpaid invoices, or accounts receivable, as collateral. Lenders will give you a percentage of the money you’re owed and take a fee once the invoice is paid. With this type of financing, the amount you’ll be eligible to borrow, will be based upon the amount of money you have coming your way.
2. Personal Guarantees
In some cases, borrowers may be in a situation where they don’t have fixed assets of high enough value to form adequate collateral for a loan. In these cases, many lenders will require borrowers to sign a personal guarantee. These guarantees can be intimidating to borrowers — and with good reason. Depending on the type of guarantee, you may essentially be signing away all of your current and future wealth or earnings as available to your lender until the loan is fully paid.
There are two different types of personal guarantees that can be attached to your loan — either an unlimited personal guarantee or a limited personal guarantee. The distinction between these can make a huge difference for your personal finances in the event of a default, so it’s important that you understand them both before you sign.
Unlimited Personal Guarantee
If you sign an unlimited personal guarantee, you’re telling the lender that you’re responsible for paying 100% of the remaining balance of your loan, giving the lender the right to seize any and all assets that will help cover the costs of the loan.
Unfortunately, with an unlimited personal guarantee, your assets are not limited to your business. If you default on your loan, you stand to lose your house, your car, your retirement fund, your children’s college savings, or anything else of value. And if you are married, some unlimited personal guarantees can also impact your spouse’s assets.
Limited Personal Guarantees
With a limited personal guarantee, you share the burden of loan repayment amongst any shareholder with a 20%, or greater, stake in your company. A limited personal guarantees, however, breaks down a little further with either a several guarantee or a joint and several guarantee.
A several guarantee means that each shareholder already knows what they owe in the instance of a default. The percentage each shareholder is responsible for will typically, correlate with their stake in the company.
A joint and several guarantee, however, means that each shareholder listed on the agreement stands to be 100% responsible for the entire debt owed. This means that if one of your shareholders disappears or doesn’t have enough personal assets to cover their portion of the debt, the lender can legally come after you to cover any of the remaining debt.
Instead of, or even in addition to, requiring collateral or a personal guarantee, most lenders will also file a lien on your business as a means to guarantee payment. By filing this lien, the lender obtains legal rights to seize your company’s assets or collateral should you be unable to make your loan payments. These assets can include, but are not limited to real estate, equipment, and accounts receivables.
If you have multiple loans, you are likely subject to multiple liens. The first lender to put a lien on your business has first dibs on your collateral — then once that lien is removed, the next lender can collect their collateral, and so on and so forth. The lower a lender is on the totem pole, the higher their risk for losing money in the instance of a default, and the less likely you are to get approved for their loan.
A Uniform Commercial Code (UCC) lien is often placed on your company when you take out a loan, protecting the lender in case of default. In fact, it can be placed on your business as part of a lender’s underwriting process, meaning you could have a UCC lien on your business without even knowing it! To find out if you have a UCC lien on your business, call your state’s Secretary of State office.
When a lender puts a blanket lien on your business, they have the rights to any form of collateral your business owns in order to pay off your debt.
This type of lean offers great protection for the lender, but as the borrower, you stand to lose everything should you run into any money problems and cannot afford your small business loan payments. Some UCC liens can be placed on specific assets, so you need to know what type of lien the lender is looking to place.
Make sure you read the fine print of any small business loan agreement before signing on the dotted line. Even if a lender doesn’t require physical collateral or a personal guarantee, they may take their collateral in the form of a lien. Regardless of the scenario, taking on debt always involves some amount of risk for both the lender and the borrower — so it’s important to understand what you stand to lose.