Lenders need to protect their investments. It's the reason why loan processes can involve weeks of due diligence. It's also why many lenders have to secure the loan – if you can't meet your monthly payments, they sell assets you've put up as collateral to try and cover their loss.
This security usually involves a lien, which is a legal filing that allows the lender to claim a piece of property in the event of a default. The lien acts as the vehicle for securing business assets to cover a loan.
"Liens secure a [financial] obligation," said Stuart Wolfe, a lawyer who represents banks with the firm Wolfe & Wyman. "A lien can't exist without an obligation. If you pay off the financial obligation on a traditional mortgage on your house, the mortgage or deal of trust goes away because it has nothing to secure."
Liens can be placed on real estate, equipment or pretty much any other type of personal property.
"'Personal property' might sound like it refers to real estate, but it is a legal term that refers to equipment, vehicles, jewelry, furniture and any other things a person can own," said Jane Muir, an attorney who specializes in commercial litigation, contracts and general counsel.
The most important thing to note about liens is that they are legally binding. In the event of a default, the lender will claim whatever property it has liens on to cover the loan. There are different types of liens that can be invoked in different scenarios, but when it comes to small business loans, liens are agreed upon by both the lender and borrower and involve either real estate or personal/business property. In most instances, liens function to secure your loan in the event of a default, which drives down your interest rate.
"The less security or liens you give the lender the more you're going to pay as a borrower on the loan," Wolfe said. "You're generally not going to find real financing opportunities where there's zero liens."
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How liens help your business
Liens help drive down costs for the borrower. They provide a piece of property to help offset the risk of the loan. They can also be useful if you're looking to finance specific projects or purchases.
"If a business needed equipment to expand, a bank might extend a loan to purchase the equipment and the loan would be secured by a lien," Muir told Business News Daily. "The money the business earns from the use of the new equipment pays off the loan over time, instead of having to pay one lump sum for the expansion."
Depending on your business's financial situation and available collateral, lenders may still charge high interest rates, but collateral and liens function to provide favorable loans. If you're interested in financing, know that just about anything can be secured with a lien. However, while it is possible, it may be difficult to find financing by placing multiple liens from different banks on one asset.
"While it may be possible, it is not likely that the same collateral could secure multiple loans, because most lenders would not agree to accept encumbered property as collateral," Muir said.
Multiple liens can end up on the same piece of collateral if a lender isn't diligent when it scrutinizes a business's financial history, according to Muir.
As with any major financial decision, it's important to understand the risks involved with your loan agreement. Before you sign, make sure you have a clear understanding of what the lender is going to place liens on. If you default and there's a lien on your home, for example, this can have obvious major implications.
"Just like any debt, it is important to weigh the risk and understand that defaulting on the loan could be an expensive choice," Muir said.
Another risk area is with personal guarantees. Personal guarantees are legally-binding agreements that say you will pay back the loan if your business can't meet its payments. While it is different from a lien, lenders can still establish liens through personal guarantees.
Wolfe provided an example where a business is taking out a loan with a lender, has a lien on a business asset and the business owner signs a personal guarantee. The business owner may be required to accept another lien on personal assets to secure their business's loan in the event of default. If the business defaults on the loan and the business's collateral doesn't cover the loan, the lender can then liquidate the business owner's personal assets it holds liens on to cover the loan.
There are several ways to finance your business. By working to get a traditional loan, you'll have to provide extensive financial information, put up collateral and adhere to lengthy reporting requirements. You can also explore other financing methods, like SBA loans, equity financing, crowd funding, and mergers and acquisitions.
"If you are in a high-risk business, consider inviting investment rather than incurring debt," Muir said. "Investors accept certain risks that lenders do not accept, and if there is a possibility of default, it may be preferable to share the risk with others."