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Ask About Collateral

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By | May 26, 2012

Dear Toolkit,

You seem to be tolerant of dumb questions so here's a doozie. What's the difference between secured and unsecured debt? And how do you view personal guarantees for business debt?

Thanks,

Insecure Loanseeker

Dear Insecure Loanseeker,

In the old days, loans were often secured by pledging your firstborn son or a few goats -- but lenders found that this kind of collateral was hard to liquidate and, in addition, required care and feeding.

These days a secured loan is still a promise to pay a debt, where the promise is "secured" by granting the creditor an interest in specific property (collateral) of the debtor. (But the collateral is usually of a more marketable and maintenance-free nature.)

If the debtor defaults on the loan, the creditor can recoup the money by seizing and liquidating the specific property used for collateral on the debt. For start-up small businesses, lenders will usually require that both long- and short-term loans be secured with adequate collateral.

Because the value of pledged collateral is critical to a secured lender, loan conditions and covenants, such as insurance coverage, are always required of a borrower. You can also expect a lender to minimize its risk by conservatively valuing your collateral and by loaning only a percentage of its appraised value.

The maximum loan amount, compared to the value of the collateral, is known as the loan-to-value ratio. For example, a lender might be willing to loan only 75 percent of the value of new commercial equipment. If the equipment was valued at $100,000, it could serve as collateral for a loan of approximately $75,000.

An unsecured loan is also a promise to pay a debt. Unlike a secured loan, however, the promise is not supported by granting the creditor an interest in any specific property. The lender is relying upon the creditworthiness and reputation of the borrower to repay the obligation.

If the borrower defaults on an unsecured loan, the creditor has no priority claim against any particular property of the borrower. The creditor can only try to obtain just a money judgment against the borrower. Until a small business has an established credit history, it cannot usually get unsecured loans because of the business's risk.

"Personal guarantee" is the game that banks like to play during loan negotiations. The banker matter-of-factly states that a personal guarantee from all the owners of the business, and their spouses, is mandated by their routine lending policies.

A personal guarantee is a pledge, by someone other than the named borrower, that he or she promises to pay any deficiencies on a specific loan. Most guarantee forms require joint and several liability, meaning that each individual who signs a guarantee can be held responsible for the whole amount of the loan. Consequently, even if someone is only a 10 percent owner in the business, that person is personally liable for 100 percent of the amount being guaranteed.

In effect, when you sign a personal guarantee, you become personally liable for the loan, even if your business is incorporated. This means, of course, that your personal assets are the collateral for the business loan: your home, your cars, your stock, your life insurance, and so forth.

Now, with some lenders, the name of this game is "take it or leave it," and everyone they want to sign a guarantee must sign one or there's no deal. However, depending upon collateral and the creditworthiness of the business, room for negotiation may exist, particularly when dealing with smaller, community banks. Naturally, the banker is unlikely to tell you this. You won't know until you test the bank's degree of insistence on this point.

Always try to emphasize, if applicable, that your business has sufficient collateral to secure the loan and that a pledge of personal assets is excessive security. As your business matures and establishes a credit history, the lender's need for personal guarantees should correspondingly decline and you should continue to negotiate the issue of personal guarantees whenever the business seeks borrowed funds.

In addition, consider several other factors that may be negotiable in lieu of a personal guarantee, such as a higher rate of interest or points, borrowing a lesser amount or for a shorter period of time, maintenance of a higher compensating balance for the loan, or limiting the terms of the guarantee itself (e.g., setting a fixed monetary cap or a percentage of responsibility for the guarantee, or excluding certain personal assets from the scope of the guarantee).

If the giving of a personal guarantee cannot be avoided (and for most younger businesses, it won't be), try negotiating the terms of the agreement. Offer a limited personal guarantee, for instance, of 25 percent of the loan, or try to modify the capital or net worth minimums that can automatically trigger the personal guarantee.

Finally, if your personal portfolio contains sufficient assets to cover the loan, and your spouse independently owns other significant assets, be prepared to present a case for why the spouse's personal guarantee is unacceptable. A spouse cannot be legally compelled to sign a personal guarantee; however, a hypothecation agreement is commonly required. This agreement states that if the bank is required to act upon the personal guarantee of the business owner, the spouse has relinquished his/her rights in the jointly owned property held with the business owner.

If your business takes on partners or additional owners over time, try to get all new owners in the business to commit to a personal guarantee on any pre-existing loans. In a partnership, for instance, an incoming partner is usually not personally liable for pre-existing business debts; absent the personal guarantee, the new partner will not share the risk for those prior commitments, although he or she may be enjoying benefits derived from that loan.

As you can see, collateral comes in many forms from physical property to your good name and reputation, and it is sometimes negotiable--at least it never hurts to ask.

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