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If you’re considering taking out a small-business loan, you have two options: a secured loan or an unsecured loan. A secured small-business loan is backed by some form of collateral. An unsecured small-business loan isn’t backed by collateral. Simple, right? Not always.
Here are three terms you need to understand to better compare small-business loans.
What is collateral?
Collateral is an asset that a borrower pledges to a lender to secure a loan. It can be a physical asset, such as a home, business real estate or equipment; or non-physical assets, including accounts receivable or cash in the bank. Most online lenders don’t require physical collateral. Many do, however, take a lien on a business’ assets — and that’s a form of collateral, too, says Mitchell Weiss, an executive-in-residence at the University of Hartford's Barney School of Business.
When lenders “say they’re not taking collateral,” Weiss says, “that’s really not accurate if they’re taking a lien.”
What is a lien?
A lien is a lender’s way of legally enforcing its right to seize a borrower’s business assets if the borrower hasn’t repaid a loan. Many online lenders file Uniform Commercial Code (UCC) liens with state secretaries of state when a borrower first takes out a loan. If a business takes out multiple loans, the first lender to file a UCC lien has first priority over the business’ assets. The second lender to file a UCC lien can’t collect until the first lender removes its lien.
Lenders can file liens on specific assets, but many file blanket liens, which give them rights to any business assets necessary to recoup the unpaid loan. A business’ assets can include real estate, equipment, accounts receivable, money in the bank, patents and even computer code, says Molly Otter, chief investment officer at Lighter Capital, an online revenue lender for technology companies.
What is a personal guarantee?
A personal guarantee is a written agreement that a business owner signs, pledging his or her personal assets to repay a loan if the business entity can’t. Personal assets can include an individual’s home, car, cash and even retirement savings.
“A personal guarantee is cash you’re willing to lose,” says Ronnie Phillips, an economics professor at Colorado State University. “Nobody’s going to loan to you if you’re not willing to invest… [but] if everything is successful, you don’t lose it.”
Personal guarantees alone don’t secure a loan. However, if a lender has filed a UCC lien and has a borrower’s personal guarantee, the lender has “an a la carte menu” of the borrower’s personal and business assets, and can go after either to recoup an unpaid loan, says Kevin Hoult, an advisor at the Washington Small Business Development Center in Port Angeles, Washington.
As you’re comparing small-business loans, ask lenders if they require a personal guarantee or collateral, and if they file a lien on your business’ assets. You can always review loan agreements with a small-business advisor, such as the ones at your local Small Business Development Center or Score Association chapter, to ensure that you understand the business and personal assets you’re putting at risk.
Image via iStock.