Wednesday, March 23, 2016

Unsecured Business Loans: Myth or Reality?

Somewhere along the line while launching a business, almost every entrepreneur has heard that it takes money to make money. Every day, aspiring business owners are pursuing angel investors, courting venture capital firms, and applying for small business loans to raise the capital they need to achieve their business goals.  

But in that pursuit of financing, especially debt financing, many would-be entrepreneurs are surprised to find that it often takes money to borrow money, too!

In most cases, small business lenders require that a borrower’s business loan is secured—meaning that some high-value asset is promised as potential repayment for the value of the business loan in case your business can’t repay its debt.

Secured vs. Unsecured Business Loans: What’s the Difference?

So what exactly is the difference between secured and unsecured business loans? 

If you take the terms literally, you might assume that all secured business loans require some form of collateral or personal guarantee, while unsecured business loans aren’t guaranteed at all. But the truth isn’t quite so simple—and this distinction is where business owners often get themselves into trouble.

To illustrate this point, let’s run through a few “true or false” statements about secured and unsecured business loans.

1. Secured business loans require the borrower to offer some high-value asset, like a house or other real estate, as collateral.

True. This is the big distinction between secured and unsecured business loans!

2. If I take out an unsecured business loan and my business fails, I can’t be held personally liable for repaying the loan.

False. Even if you haven’t offered a particular asset as collateral, your loan agreement probably includes a personal guarantee that would let your lender pursue any assets you own as repayment for your loan.

3. Unsecured business loans give the borrower more protection than a secured loan would in the event of a default.

False. This is a common misconception, actually. In reality, with a secured business loan, the lender can only seize the single collateralized asset as collateral. Meanwhile, a lender has much more free reign to pursue any assets you own—now or in the future—with unsecured business loans.

Why Unsecured Business Loans Are A Myth: Lenders Need Collateral

The notion of collateralized bank loans dates back as far as the 1800s, but they became a central tenet of business lending after the surge of business failures in the late 1980s and early 90s. Since then, offering collateral has become the most popular way of securing a business loan.

To put it simply, collateral is a specific asset or set of assets that gets liened against a small business loan. If a business fails to make regular payments on the loan, lenders can obtain a court order to seize that property from the borrower and liquidate it for repayment of the loan.

If your business has assets—like expensive computers or manufacturing equipment, real estate, vehicles, or valuable inventory—you might be able to use those assets as collateral for the loan. But if your business does not have owned assets to offer as collateral, lenders might expect you to collateralize your loan through personally-owned assets, like your family home.

The “Unsecured Business Loans” Misnomer

Run a simple Google search and you’ll come across dozens of results offering options for “unsecured business loans.” By now, though, it’s probably a bit clearer to you why that term is actually a bit if misleading.

While there are a few alternative lenders out there who offer truly unsecured business loans—also known as “signature loans”—with no collateral or personal guarantee, these options are few and far between, require outstanding personal and business credit to qualify, and make up for the lender’s increased risk with exorbitant interest rates.

Most of the time, when a lender says they offer unsecured business loans, they really mean their loan doesn’t require a specific piece of collateral you need to offer. That’s great news if you don’t have a family home, large piece of equipment, or other high-value personal or business property to offer. But it doesn’t necessarily mean you’re off the hook in terms of liability in the event of a loan default.

There are a few other avenues lenders can take to protect their investment in case your business can’t repay its debts—and those options can pose an even greater risk to your personal finances than if you had offered your family home as collateral for your small business loan.

Other Ways Lenders Protect Their Loan Investments

As you’ve figured out by now, even lenders who offer these so-called unsecured business loans have alternative means of protecting their investments. Here are the main ways these lenders will try to ensure their investment in your business loan if you can’t offer collateral.

Personal Guarantee

A personal guarantee is an agreement with your lender that puts your personal assets on the line, essentially making you the loan’s co-signer. If your business were to fail, you would be personally responsible for repaying the loan. This means creditors can claim your personal assets (like your home, investment accounts, and so on) as repayment.

But while putting up collateral on a loan requires you to stake one or a few particular assets—like a house or other property—to guarantee your loan, a personal guarantee leverages any and all financial assets that you have now… Or even assets you might obtain in the future.

If you’re considering a loan with a personal guarantee, it’s important to note that not all guarantees are created equal. Take the time to investigate what kind of personal guarantee you’re signing and how the terms could impact your financial future.

Unlimited Personal Guarantee

When you sign an unlimited personal guarantee, you’re agreeing to let the lender recover 100% of the loan amount in question, plus any legal fees associated with the loan.

If your business fails or you default on your loan for any reason, your lender can hire lawyers to gain a judgment in their favor, then go after any or all personal assets you have: your life savings, your retirement, your kid’s college fund, your house, your car—even your spouse’s personal assets could be up for grabs. Whatever it takes to cover the full cost of the loan, plus interest and legal fees (which can be inflated), will be theirs to seize as repayment for the loan.

These guarantees are called unlimited for a reason. They basically offer the borrower zero financial protection if their business isn’t as successful as they planned.

Note, though, that the amount of collateral a lender can seize and liquidate is directly connected to what you still owe of your loan. So if you’re only looking to take out $5,000 to stem some cash flow shortage, you don’t have to worry about giving up everything you’ve ever owned.

Limited Personal Guarantee

As the name suggests, limited personal guarantees set specific parameters on what can be collected from you in the event that you default on your loan—usually in the form of a set dollar amount.

Limited guarantees are most often used when multiple business partners take out a loan for the company together. According to SBA standards, anyone with a 20% or greater stake in the business should be part of the guaranteeing process. These guarantees help define each person’s piece of the debt pie if the company defaults on a business loan.

Limited guarantees aren’t without their own hangups, however. Before you agree with your business partners to sign a limited guarantee, check whether you’re signing a several guarantee or a joint and several guarantee.

  • Several Guarantee: With this type of limited personal guarantee, each party has a predetermined percentage of liability. You’ll know from the beginning the maximum you might owe in a worst-case scenario, which will be a fixed percentage of the loan—usually proportionate to your stake in the company.
  • Joint and Several Guarantee: This type of limited personal guarantee is comparatively higher risk than a pure “several guarantee,” because in this case each party is potentially liable for the full amount of debt. The lender can’t recover more than it’s owed, but it can seek up to the full amount from any of the parties listed on the guarantee. So if your business fails and then your business partner disappears or doesn’t have sufficient personal assets to cover his or her portion of the loan, your lender can come after you for both your stakes in the guarantee.

Regardless of the type, signing a personal guarantee greatly increases your personal risk when applying for a business loan. It’s the business financing equivalent of going “all in” at the poker table, so you’d better be sure of your hand before you make such a commitment.

Blanket Business Lien

To the extent that a personal guarantee puts your personal assets at risk of seizure in the event of a default, a blanket business lien does the same for any assets on your business’s balance sheet.

A business lien is a legal claim included in the fine print of almost all small business loans—including unsecured or so-called “signature loans”—to help protect lenders in case a borrower defaults. When lenders file liens for unpaid debts, they can sell a business’s assets in order to collect the money owed to them.

While some business liens target specific assets within a business—like the assets purchased with the principal from the loan—a blanket business lien gives the lender freedom to pursue any and all assets on your balance sheet, regardless of their connection to your loan. If a lender files a blanket lien, they can essentially bankrupt your business in pursuit of repayment for the principal and interest on your loan. (Again, if the debt owed on your loan is large enough! These are important factors to understand, but don’t let them scare you away from debt financing—if you’re smart about preparing how to use that money, then you shouldn’t run into any problems.)

The Benefits of Collateral-Free Loans

After considering all of the pitfalls and alternative risks of a personal guarantee or business lien, you might be thinking, “Why would I ever take out a loan without offering collateral?!”

And you’d have a point. Often, borrowers set out to obtain a business loan without putting up collateral… Only to find themselves at even higher risk than if they’d just put up the collateral in the first place!

In most cases, the only good reason to choose a personal guarantee over a specific collateral agreement is if you just don’t have enough collateral to offer.

A Good Alternative: Self-Securing Business Loans

By now, you might be thinking that the idea of getting a business loan without signing your life—or a major personal asset, at least—away is an untenable pipe dream.

But wait! There’s hope! If your business needs happen to fit the parameters, there are a few business loan options where the loan acts as its own collateral—meaning, in most cases, that you won’t need to offer additional collateral or a personal guarantee.

Here are a few self-securing loan options worth considering:

Equipment Loans

If your funding needs involve purchasing equipment for your small business, equipment financing could be a great choice. A small business equipment loan can be used for virtually any equipment need—from computers to production machinery, vehicles, and more.

Equipment loans work almost identically to a standard car loan: the amount you can borrow depends on the type of equipment, the price, and whether it’s new or used. Pretty intuitive.

Interest rates for equipment loans are generally fixed between 8-30%, although newer startups or those with poor credit histories typically receive higher rates.

These loans provide a perfect loophole for borrowers looking to avoid collateral or personal liability because the equipment itself acts as the collateral for the loan. If you default on the loan, the lender will seize the equipment, but your personal assets will be safe. And if your business has failed, you probably won’t be needing that equipment anyway!

Invoice Financing

If you own a service-based business, you know that the process of getting paid can be a little more complicated. You do the work, issue an invoice, then wait for payment… And wait, and wait, and wait… Sometimes for as long as 30, 60, or even 90 days—and that’s if the client pays on time! Then there are the inevitable delinquent payments, which can wreak even more havoc on your company’s cash flow.

With invoice financing, accounts receivables lenders advance you cash in exchange for the opportunity to collect on unpaid invoices on your behalf. Typically, invoice financing companies will give about 85% of the value of your invoices up front. The balance of the value, around 15%, will get returned to you at the end of the collection period, minus the fees retained by the company for its services.

If you’re a B2B company—and cash flow issues from unpaid invoices are a big reason why you’re looking for a business loan in the first place—then invoice financing is a great way to get capital without having to sign a personal guarantee. Because the invoices themselves act as the collateral, the most that can be collected is the initial amount of the invoice if the client never pays. While it’s never fun to lose money you worked for, it hurts a little less knowing that you wouldn’t have gotten paid either way. (Plus, sometimes the burden is on the lender to collect, rather than on you. While this can be pretty convenient, it’s not always ideal—you might not necessarily want a third party mediating with your customers, after all.)

Realizing the Risk of a Business Loan

In the grand scheme of everything you need to do for your business, all this talk of secured vs. unsecured business loans—and the potential risks of defaulting on your loan—can be easy to ignore.

After all, nobody goes into starting a new business with the anticipation that their venture will fail.

But the reality is that even while the delinquency rate on business loans reached a historical low in 2015, statistically speaking, at least one in every 100 business loans funded by traditional banks will default. And even this low percentage is more so attributed to the exceedingly high eligibility standards held by traditional banks than the reality of the small business landscape, in which only about half of all small businesses survive longer than 5 years.

So while we don’t yet have comprehensive data about defaulted loans within the less regulated alternative lending market, we can assume that a pretty significant portion of those now-defunct businesses had at some point taken out debt financing. That means the risk of defaulting on a business loan is very real for business owners—especially those who fail to qualify for financing from a traditional bank.

Acknowledging this risk isn’t meant to scare entrepreneurs away from pursuing debt financing—but it is important to think about all the factors involved before signing on the dotted line for a new business loan. How confident are you in your business model? What type of loan have you been able to qualify for? What assets are you leaving open for seizure from your lender or a collections agency in the event of default? These questions shouldn’t go without serious consideration.

Be Wary of the Unsecured Business Loans Myth

At the end of the day, all these technicalities and loopholes surrounding the terminology between secured and unsecured business loans can be broken down into another common adage: “When something looks too good to be true, it probably is.”

If a borrower offers you an unsecured business loan without collateral, look for the catch. Will you be signing a personal guarantee? Does the fine print mention a UCC or blanket lien? Is the interest rate incredibly high to compensate for the risk? Does the lender have a reputation for being shady? If you do enough digging, you’ll wind up discovering that there is no such thing as a truly unsecured business loan. Stick to borrowing smart, planning ahead, and paying back on time, and you shouldn’t have a problem growing your business.

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