Topics:Business Loans 101
If you're shopping for a business loan, you've likely come across two common elements of the business loan application process, whether you're working with a traditional bank or non-traditional online lender: business collateral and personal guarantees. Read on to find out what they are and in what circumstances your lender will require them in your business loan agreement.
Collateral, in general, is a guarantee to a lender that if a borrower defaults on the loan — meaning they cannot pay the balance of their debt — the lender can take the pledged assets.
Collateral tends to be physical items or financial assets. For example: a home, cash, property, etc.
Collateral is important because it protects the lender. Without collateral, a lender would never really be able to ensure that they would get any amount of their money back. Because of this, the higher the worth of the collateral, the bigger the loan can be because the lender knows that they will be able to be paid back one way or another in an amount that is equivalent to the amount loaned.
Business collateral follows this same purpose — it is a guarantee to the business lender that the borrower will either pay them back or surrender their collateral.
With business collateral, the assets that make up the collateral are usually business assets including the following:
The collateral used in business collateral for loans is not usually personal items from the business owner, but rather assets involving the company itself. When you pledge collateral, your personal or business credit rating doesn't matter as much to your lender because they have something tangible to lean on if you default.
With business collateral, the owner of the business is responsible for managing the loan and making payments. They are also responsible for the surrendering of business assets to the lender if the loan defaults. Often, owners will also have a personal guarantee on the loan as well as business collateral to cover them financially in the case of a defaulted loan.
A personal guarantee also follows the principles of collateral; however, a personal guarantee allows for a lender to seize personal assets as well as business assets if the business goes under. The business executive or partner promises in writing to repay the credit issued to a business, assuming personal responsibility for the balance if needed. In the event of default, you are backing the business.
A personal guarantee is like a double layer of protection for a lender. If the first layer — business collateral — fails to pay back a defaulted loan, a personal guarantee is there to pay it back.
The kind of assets that personal guarantees operate on are things like the following:
A business owner does not have to be the one who makes the personal guarantee on a loan. Personal guarantees can also come from people outside of the company. In that case, it is like this individual or company is co-signing a lease. They agree to pay back any debts that are owed if the person or business taking out the loan cannot afford to repay the debt. To find an alternate guarantor, you can ask friends or family members if they will let you leverage their asset in exchange for a percentage of your business.
If the idea of a personal guarantee makes you uneasy, you're definitely justified in that feeling. While a common provision in small business lending, a personal guarantee can put your personal or family finances in jeopardy. Only you can weigh the risks and determine if the business credit is worth the benefit.
Certain loan types, like traditional lines of credit or SBA loans, require a personal guarantee if you're a small business.
But, in general, a lender's requirement (or not) that you pledge collateral or a sign personal guarantee depends on the robustness of your company. Can you demonstrate that your business has a high tolerance for risk and will pay its financial obligations no matter what? Remember, these conditions are in place to protect the lender.
To reduce the need for pledged collateral or a signed personal guarantee in the eyes of your lender, your business should have one or more of the following:
Of course, startup companies generally lack the above and may require startup-specific financing to avoid the need for collateral or a personal guarantee.
If your credit score is particularly high, you may be able to obtain an unsecured working capital loan or line of credit based solely on your creditworthiness.
An unlimited guarantee or unconditional guarantee means the guarantor is required to pay all amounts due until paid in full.
However, some lenders will work with you on establishing custom terms via a limited personal guarantee that may reduce the dollar amount, time and/or percentage of the loan. For example, you can guarantee a certain dollar amount rather than the entire loan, such as the last $100,000 of the loan credit.
Another way around a personal guarantee is to work with a vendor extending business credit with net-30-day terms for smaller cash needs. The relatively small term length doesn't allow for huge loan amounts, but the idea is that the risk of loss to the lender is smaller with such a quick turnaround time and borrowers are motivated by its positive or negative impact to their business credit profile. Even startup companies can generally work with a net-30 vendor.
Whether you're just starting your business or require capital for an already thriving one, many lending companies can meet your needs. And while some require a personal guarantee or collateral within the loan terms, many companies are flexible in their requirements according to credit scores, time in business, and other factors as explained.
View the top ten business lending companies or jump straight to the following company pages for specific needs: