Taking out a small business loan allows you to fund your business while maintaining your ownership and equity. But in order for lenders to take on the risk of lending to you, they usually want to secure one or more loan guarantees and some collateral.
In this article, you’ll learn what guarantees and collateral are and what’s required so you can make informed decisions when applying for loans.
What are guarantees?
Guarantees are a contract that requires a person or a business to pay a loan. When your business takes out a loan, you sign a promissory note. This agreement requires your business to pay back the loan based upon a repayment schedule. Beyond this, there are several other third-party guarantees that are usually involved to make the loan less risky to give. The four most common loan guarantee types include:
- SBA guarantee: If you take out an SBA loan to fund general costs related to starting and running a business, your lender receives a guarantee from the SBA for the loan.
If your business can’t make payments on your loan and your lender is unable to be repaid through other types of guarantees and collateral, then the SBA will repay the lender. This safety net helps limit the amount of money the lender could lose if the loan defaults, but it’s really the option of last resort. The first and more important guarantee, associated with all small business loans, is the personal guarantee.
- Personal guarantee: The personal guarantee is the main way that lenders require you to make sure a loan is paid off. The personal guarantee contract, in essence, says that you, the business owner, will be responsible for all outstanding principal and interest if your business defaults on the loan. If that happens, it means you will need to personally begin making the monthly principal and interest payments for the loan.
The personal guarantee also puts all your personal assets on the line — meaning you’re required to pay this loan, and if you can’t, the lender needs to consider you personally in default. Anyone who owns more than 20% of the business, or is a managing member of the business, might also be required to sign a personal guarantee.
- Corporate guarantee: A corporate guarantee may be required if your business operates in multiple locations, or if you own multiple related businesses. It’s very similar to a personal guarantee except that a corporate guarantee pledges one business to repay the debts of another in the event of a default.
Corporate guarantees are all about minimizing cash flow risk. Lenders will look at the same financial information that they use to assess the business that’s actually borrowing the money. If you’re looking to borrow money for a new business, the stable cash flows from another business can help to make lending those funds to your new business slightly less risky.
- Third-party guarantee: For small businesses, a third-party guarantee is when a person that’s not the business owner signs a guarantee pledging to personally take up the repayment responsibility if the business is unable to repay the loan. The third party is usually a close family member of the borrower who is willing to help out with the risk.
How loan guarantees factor into global cash flow
Cash flow is the first way that lenders determine whether a business is able to take on a loan. Your lender wants to see that your business is making more money each month than your monthly loan payment, or will in the near future. Using loan guarantees, lenders can take a deeper look at what’s known as global cash flow.
Global cash flow factors in the income and expenses of the personal guarantors and any third-party guarantors, as well as cash flows from any corporate guarantors. This global cash flow gives the lender a real understanding of the holistic amount of cash that is available to make loan payments.
Let’s take a look at an example. A new startup has monthly loan payments of $4,500. The owner has a $5,000 monthly salary from another job, $3,500 in monthly expenses, and a related company that earns $7,500 per month.
|Business cash flow||$(6,000)||$(5,000)||$(4,000)||$(3,000)||$(2,000)||$(1,000)||$ –||$1,000||$2,000||$3,000||$4,000||$5,000|
|Global cash flow||$3,000||$4,000||$5,000||$6,000||$7,000||$8,000||$9,000||$10,000||$11,000||$12,000||$13,000||$14,000|
In this example, if the business alone were to be responsible for the loan payments, it would take seven months for them to have enough cash flow to make the loan payments. By adding in the personal guarantee and corporate guarantee and looking at the global cash flow, there’s enough cash flow to cover the loan payments in just three months.
From a practical perspective, only the business would be making these loan payments until a lender enforces these guarantees, but knowing that they’re available makes giving the loan less risky.
The difference between guarantees and collateral
Collateral is the variety of assets that are pledged to a business loan. If you pledge these assets to a business loan and that loan defaults, those assets can be sold by the lender to recoup the money that’s still owed to them.
At first glance, collateral and guarantees might seem the same. After all, a guarantee does mean that your personal assets could be sold to pay off a loan. The difference is that with collateral, a very specific asset (like a house that you own) is directly tied to the loan with a lien. This allows the lender to have an alternative repayment method with a more certain value, and it also enables them to access and liquidate it quickly.
Not all collateral is the same. Some assets have more value than others to a lender. Generally, real estate is considered the most valuable collateral, and inventory is one of the least valuable types of collateral. Lenders use discount rates to figure out how much collateral is worth to them as compared to the money they’ve lent to you. Here’s an example of how a lender could apply their discounts to your available collateral:
|Item||Discount rate:||Actual value:||Value to lender:|
Once lenders apply their discounts to the collateral that’s available, they’ll determine if there is enough collateral to cover the total amount of money they’ve lent to you.
In the scenario above, the total value of the collateral after discounts would fall just short of covering a loan of $500,000. If you’re borrowing an SBA loan, the lender cannot decline your loan because you don’t have enough collateral available to cover the amount of a loan; however, the lender is obligated to thoroughly look at all collateral available and secure as much as possible to safeguard the loan.
Ultimately, your lender will make many of the decisions necessary to determine what guarantees and collateral are needed to secure a loan, but knowing more about guarantees and collateral can help you prepare for what your obligations might be if you decide a business loan is the right option for your company.
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