Getting a small business loan lets you grow your company without giving away control to anyone or handing over a part of ownership to shareholders. Loans come with an amount due on a certain date, and lenders normally expect at least one guarantee or signer on the loan to say they will pay it if the company cannot. If you default, or cannot make payments, you may also have to give the lender a right to take control of a particular asset. Knowing your guarantees ahead of time lets you decide what you are willing to do to get a loan.
The Four Common Types
The typical guarantee is a written contract by which a person or other business promises to pay back a loan if the main borrower cannot. Every loan has at least a promissory note signed by the business, with a set repayment schedule. If you are not generating enough cash, though, to prove to the bank you will pay it back, they may ask for an extra guarantee on the deal. Lenders ask for these to cut their risk and build confidence they can get their loan back. The four common types are below.
Getting an SBA-backed loan protects the lender in a loan, but it should not be your first concern. The agency has an order of steps to follow if a loan defaults, and the last of these are to ask for its guarantee as an insurance policy. It only goes into effect when the business has drained every asset of value, including the collateral the lender holds, and all other guarantees. For a lender, therefore, an SBA guarantee is an extra level of comfort they will get their money back. If your business cannot repay the loan and you default, lenders usually turn next to your personal guarantee to cover at least part of what you still owe.
A personal guarantee is often a lender’s main assurance of getting their money back if you stop making payments or default. In a personal guarantee, you commit your own personal income and assets to secure your loan if you cannot pay it back. On a personal guarantee, you are still liable for the principal balance and interest and must take over making the monthly payments yourself. If you default on those, too, the lender treats you as personally in default. Lenders may also ask for one from all the owners with more than 20 percent of the company, along with any member-managers.
A corporate guarantee is common when a business has multiple locations or related companies. In this case, one legally assumes responsibility for another’s debt if it defaults. A lender reviews the annual income and profit and loss statement of the new company as well as that of the established one. This way, the lender looks at the stable cash flow of the parent company as a way to offset the borrowing risks of the younger, less proven one.
A third-party guarantor is someone who does not own part of the business, but is willing to sign the loan and promise to pay if the business can’t. The third-party guarantee is often a spouse, parent or other close relative who agrees to share the risk.
Global Cash Flow
The first test lenders use to decide if a borrower can afford a new loan is cash flow, or the borrower’s ability to make the loan payment each month. Ideally, you can show the bank you have enough cash coming in to pay back the loan now, or that more income is coming. With a personal guarantee, or third-party or corporate guarantee, you add the guarantor’s income as cash coming in to what your business brings in, and subtract their expenses to calculate the total the lender sees as able to cover the payment. Lenders call this global cash flow. Say your startup owes $4,500 a month and you earn a $5,000 salary with $3,500 monthly living costs. If you have a separate business that clears $7,500 a month, these two plus your company’s earnings may be enough to prove you can afford your new loan.
In practice, the lender expects the business to repay the loan each month and only asks the guarantors to step in as last resort. So the guarantees can help the lender believe you are even more likely to be able to cover the payments.
Providing Collateral
With collateral, you pledge assets and agree to let the lender sell these items to get its money back if you default. You may think a lien is just like a personal guarantee. After all, they both pledge your assets. Liens are different from guarantees because a lender has a lien on a single asset - your home, for example - while a personal guarantee opens all of your personal assets to seizure in case the company defaults.
The lender does not assume all your company’s assets or those you give as collateral are worth the same. Property, particularly real estate, is a top choice. Other options with less set value include inventory.
In real life, a lender discounts the value of collateral and compares this to the total loan amount. Say you want a $500,000 loan but your lender only values what you own at slightly less. On an SBA loan, the lender cannot automatically reject you for lacking enough collateral. It must review any collateral you can give to secure the loan as best it can.
Whether you need an SBA guarantee, personal guarantee, corporate or third-party guarantee, and what asset or assets you will give as collateral, are among the many calls the lender has to make. Knowing the guarantees you give now lets you know what you owe if your business ever needs to fall back on them. Make sure to review these fully before you sign a loan agreement.
About Delancey Street
Delancey Street is a premier, and award winning, business debt settlement company that helps business owners nationwide. Our goal is simple: help you escape debt in a safe and legal manner. Based out of New York, we can help in 49 of 50 states. We tell you how it is; because your business and future is on the line.
