You can fund your company with a small business loan while keeping ownership and equity. However, lenders typically need to obtain one or more loan guarantees as well as some form of collateral before they are willing to take on the risk of lending to you. Learn about guarantees and collateral in this article and what’s required so you can apply for loans with confidence.
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:
How loan guarantees factor into global cash flow
Lenders base their initial assessment of a company’s loanability on its cash flow. Your lender wants proof that your company is currently or soon will be earning more money each month than your monthly loan payment. Lenders can examine the concept of “global cash flow” in greater detail using loan guarantees. The personal guarantors’ and any third-party guarantors’ income and expenses, as well as cash flows from any corporate guarantors, are all taken into account by global cash flow. This comprehensive cash flow enables the lender to fully comprehend the total amount of cash available for loan repayments. Let’s take a look at an example. A new startup has monthly loan payments of $4,500. The owner makes $5,000 per month from a different job, pays $3,500 in monthly expenses, and makes $7,500 per month from a related business.
| Month | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 |
| Loan payment | $4,500 | $4,500 | $4,500 | $4,500 | $4,500 | $4,500 | $4,500 | $4,500 | $4,500 | $4,500 | $4,500 | $4,500 |
| 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 |
| Debt coverage | -1.3 | -1.1 | -0.9 | -0.7 | -0.4 | -0.2 | 0.0 | 0.2 | 0.4 | 0.7 | 0.9 | 1.1 |
| Personal inc. | $5,000 | $5,000 | $5,000 | $5,000 | $5,000 | $5,000 | $5,000 | $5,000 | $5,000 | $5,000 | $5,000 | $5,000 |
| Personal exp. | $(3,500) | $(3,500) | $(3,500) | $(3,500) | $(3,500) | $(3,500) | $(3,500) | $(3,500) | $(3,500) | $(3,500) | $(3,500) | $(3,500) |
| Corporate inc. | $7,500 | $7,500 | $7,500 | $7,500 | $7,500 | $7,500 | $7,500 | $7,500 | $7,500 | $7,500 | $7,500 | $7,500 |
| 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 |
| Debt coverage | 0.7 | 0.9 | 1.1 | 1.3 | 1.6 | 1.8 | 2.0 | 2.2 | 2.4 | 2.7 | 2.9 | 3.1 |
In this case, it would take seven months for the company to have enough cash flow to cover the loan payments if it were solely responsible for making loan payments. When the personal guarantee and corporate guarantee are included, as well as the overall cash flow, it is possible to see that the loan payments can be made in just three months. Practically speaking, only the company would be paying back the loan until a lender enforced these guarantees, but knowing that they are available reduces the risk of making the loan.
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. Inventory is one of the least valuable collateral types, while real estate is typically regarded as the most valuable. Discount rates are used by lenders to calculate the value of collateral in relation to the amount they have lent you. Here is an illustration of how a lender might use your available collateral to apply their discounts:
| Item | Discount rate: | Actual value: | Value to lender: |
| Real estate | 15% | $500,000 | $425,000 |
| New equipment | 25% | $50,000 | $37,500 |
| Used equipment | 50% | $30,000 | $15,000 |
| Accounts Receivable | 90% | $100,000 | $10,000 |
| Inventory | 90% | $80,000 | $8,000 |
| Total | N/A | $760,000 | $495,500 |
Lenders will assess whether there is sufficient collateral to cover the total amount of money they have lent you after applying their discounts to the available collateral. The total value of the collateral in the aforementioned scenario, after discounts, would barely be enough to repay a loan of $500,000 If you’re applying for an SBA loan, the lender cannot reject your application on the grounds that you lack sufficient collateral to cover the full amount of the loan; however, the lender is required to carefully review all available collateral and secure as much as possible to protect the loan.
Knowing more about guarantees and collateral can help you get ready for what your responsibilities might be if you decide a business loan is the best option for your company. In the end, your lender will make many of the decisions necessary to determine what guarantees and collateral are required to secure a loan.
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FAQ
Is guarantee the same as collateral?
What’s the difference between a personal guarantee and collateral? A personal guarantee is a signed document that guarantees repayment of a loan in the event that your business defaults. A good or owned asset used as loan security in the event that your company defaults is known as collateral.
What is considered collateral for SBA loan?
The SBA defines collateral in this way: “Assets such as equipment, buildings, accounts receivable, and (in some cases) inventory are considered possible sources of repayment if they can be sold by the bank for cash.” This definition is fairly simple and serves as a good guide for other traditional financing.
What does it mean for SBA to guarantee a loan?
The SBA does not provide funds to the borrower. Instead, the SBA guarantees a portion of the lender’s loan, subject to the lender meeting certain SBA-established requirements. The SBA repays the guaranteed portion of the remaining loan balance if the borrower defaults.
Is collateral required for an SBA loan?
For loans up to $25,000, lenders are not required to accept any collateral. The SBA mandates that lenders collateralize loans exceeding $350,000 to the fullest extent possible up to the loan amount.