Every time a lender approves a small business loan, it’s an indication of their confidence in your ability to make the regular payments. Nevertheless, one of the questions every lender will want answered is, “What if things don’t work out as planned?” This is where personal guarantees, collateral, and liens come into the equation. Many lenders, including most traditional lenders like banks and credit unions, use personal guarantees, collateral, and liens to protect the funds they lend from default.
A Personal Guarantee
Regardless of how long you’ve been in business, it’s nearly impossible to avoid a personal guarantee when you apply for a small business loan. Basically, a personal guarantee allows a lender to pursue your personal assets should you default and they decide to take action against you.
Many lenders like to see a little skin in the game. And, like a down payment, if you’re personal assets are at risk should you default, your lender feels more confident you’ll do everything in your power to make sure you don’t default. It’s important to understand that you shouldn’t assume this is just one more “formality” to get a small business loan. If (and it’s likely they will) your lender requires a personal guarantee, they will take it seriously and will come after your personal assets if your business assets aren’t enough to satisfy your debt should you default.
Much like an auto loan or your mortgage where your lender holds the title of your car or home until the debt is paid, lenders often require some form of collateral when they offer a small business loan. Think of it like temporary ownership of you asset while you repay the loan. This means you are allowing your lender to take possession of your collateral to satisfy the debt should you default. It’s rare today for a business owner to get a traditional small business loan without some form of collateral.
Lenders that do require collateral are looking for:
- Assets that are easy to value
- Assets that are easy to liquidate
For that reason, things like heavy equipment and real estate are often preferred as collateral over inventory, computer hardware, and office equipment.
Creditors use liens to serve as public notice of a debt you owe. If you fail to pay a creditor, a lien allows them to sue to collect the outstanding obligation. If the creditor wins, the lien allows them to seize your assets to satisfy the debt.
When a creditor files a lien it’s recorded with the Secretary of State and enables the lien-holder to take a first position in the distribution of your assets should there be other creditors who have unsecured interests or liens that haven’t been filed. In most cases, the lien will be automatically removed when the debt is paid.
Lenders use personal guarantees, collateral, and liens to minimize their loss should you default on your loan. As a general rule, most lenders don’t like to resort to such extreme measures, but they will to protect their assets.