This article explores which types of small business loans are best-suited for different SME needs.
Secured Business Loans
When a business loan is "secured" it means that the business has pledged assets to protect the lender from the possibility of loss. The assets pledged are the "security" or "collateral." If the business were to default on the loan, the lender would have the right to seize the assets to settle the debt.
Because providing security lowers the lender's risk, it can help a small business to borrow large amounts for long periods at affordable interest rates. For this reason, businesses tend to use secured lending to fund business expansion plans, such as:
- Purchasing plant and machinery,
- Purchasing business premises (in this case, the secured loan would be a mortgage on the property),
- Setting up or acquiring another company.
The security pledged on a secured business loan is typically valuable assets that the company owns, such as plant, machinery, automobile fleets, or real estate. If the company owns financial assets such as securities – for example, if they have invested excess cash in U.S. Treasuries – those too can be pledged as security for a small business loan.
However, many SMEs don't have much in the way of physical or financial assets. What are their alternatives for raising finance for business expansion?
When a firm seeking a small business loan has inventory, the lender may accept that as security. Since individual assets that comprise inventory change over time, the security could take the form of a "floating lien" over the inventory. If the business defaults, the floating lien becomes a fixed charge, which gives the lender a priority claim on the recovery value of the inventory.1 (International business may avoid confusion by noting that "floating lien" is a term specific to the U.S. Floating charges are common in other countries, too, but are called charges.) Businesses may wish to obtain local legal advice before entering into any floating charge agreement.
Alternatively, a lender may accept invoices the business has already issued as a form of security, since this is money owed to the business. This is known as "invoice finance."
A loan-seeking small business owner also can pledge personal assets such as property or investments. The owner may also be able to provide a personal guarantee enforceable in a court of law.2 Both of these alternatives make the owner liable for the business loan. If the business defaults on the loan, the owner's personal assets may be seized in payment. Business owners may wish to obtain legal advice before pledging assets or guaranteeing business loans.
If the business is a partnership, and the partners are "jointly and severally" liable for a business loan, then any one of the partners can be held liable for up to 100 percent of the debt if the others are unable to pay.
Unsecured Business Loans
Secured loans can be great for long-term borrowing. But many small businesses also need short-term borrowing, for example to meet unexpected expenses or cover cash flow dips. Such short-term borrowing typically takes the form of unsecured business loans.
Unsecured business loans have no asset backing, and usually no guarantees. They are typically short-term and for fairly small amounts. They may have higher interest rates than an equivalent secured business loan.
Some types of unsecured business lending take the form of a "facility" – often in the form of a line of credit – rather than an outright loan. When a lender grants a facility, it allows the business to borrow any amount up to a limit. Interest is typically charged on the drawn balance under the facility. Unlike most personal lines of credit, an unsecured business facility may have an arrangement fee, and there could be monthly or annual management fees as well. Typical facility arrangements include bank overdrafts, credit cards, and revolving credit loans. Some facilities allow the company to exceed the limit temporarily, though a penalty interest rate may be charged.
Unsecured business lending is not unconditional. To protect themselves from losses, lenders assess the business's creditworthiness through a process of credit scoring. They may want to see a business plan,3 and they may also want evidence that the company has a credible revenue history, such as several years of accounting records. They may also take into account the personal credit scores of the business owner and other key business personnel.
SMEs that are unable to obtain affordable short-term finance, perhaps because of a short trading history, may qualify for assistance under the U.S. federal government's Small Business Administration (SBA) program.4 The SBA in effect provides lenders with a U.S. government guarantee for funds advanced, enabling them to lend at lower interest rates and for longer periods than would otherwise be the case. Although the loan is secured by the SBA, from the business owner's point of view it is an unsecured business loan.
