Financing is the lifeline of American enterprise.
Small businesses need to borrow money to grow, and there are thousands of lenders out there ready to dish out cash to budding companies. Yet financial hardship for businesses that stall out and fall short of expectations is never far away.
As payments are missed and the possibility of default looms, it's important to understand that the type lender, loan and business factor heavily into what the default process looks like. Regardless of your agreement, the ramifications can be catastrophic on both a business and personal level.
"Small business owners need to understand that their business financial decisions can have personal consequences," said Jay DesMarteau, head of commercial specialty segments for TD Bank.
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Loan default processes vary by state; the ones outlined below are standard in New York. Some alternative lenders, particularly those based in New York, will operate under New York law or use it as a standard in their loan agreements regardless of what state your business is located in.
Experts say business owners who know they're going to default on a loan should contact their lender as soon as possible. Depending on the type of lender, some may decrease rates, provide interest-only payment opportunities or adjust your loan terms until your business is back on track.
Understanding the default process can provide context so a borrower can be prepared for what a lender will require. The most important takeaway, however, is that when a small business owner is looking for a loan, the type of lender they decide to partner with can make all the difference if default occurs. [Interested in business loans and financing options? Check out our best picks.]
What happens when you default
If you work with a larger bank, the default process can take several months or even a couple of years. For smaller lending shops and alternative lenders, your assets can be frozen after just a few days of missed payments, depending on the lender. Simon Goldenberg is an attorney based in New York and New Jersey who specializes in debt relief for small businesses and individuals. He said that six months of missed payments is a common benchmark for triggering default.
Once you've missed a few payments, your lender will likely reach out to you to see what's going on with your business. This is an important period of bargaining that can mitigate immediate ramifications.
"The creditor will reach out to the debtor and say, 'Hey, look, you've missed a payment. Let's get that cleared up. What's going on in your life?'" Goldenberg said. "At the time of default, generally the full balance will become accelerated."
An accelerated balance means instead of owing your missed monthly payments and any accrued interest, you'll be on the hook for the full loan amount. From here, the lender will tack on any predefined fees outlined in your agreement, like collections fees, attorneys' fees or other various charges.
Now that your balance has been accelerated, fees have been added and your lender has failed to reach a resolution with you, the next step can vary widely. Goldenberg said that there are three common routes in default situations: the lender will set up a reasonable plan for you to pay back the loan, the lender will seize and liquidate your business or personal assets to cover the loss, or the lender will cut its losses and settle with the borrower for a defined amount.
Keep in mind that it's always in the lender's interest for you to make payments – they're a company that needs its investment back and will be willing to acquire it in the best way possible. This means some banks may be more willing to work with you.
"Once the account is in default, the debtor might have more of an ability to resolve the debt because the creditor might be willing to work with them – perhaps toward a settlement or perhaps an interest-free payment plan over a duration of time," Goldenberg said. "Those things could arise, but there's really no way to predict any particular case."
If you put up collateral to cover the loan, the lender may liquidate that and other assets to cover the loss. Whether a lender decides to litigate, seize, and liquidate assets depends largely on the relationship and terms it has with the borrower. In instances where there's no defined collateral, the ramifications of default can take a darker turn.
Defaulting on unsecured loans
Unsecured loans are loans without any defined collateral from the borrower. DesMarteau said it's rare that a traditional bank would approve a loan without some form of collateral to secure it. Unsecured loans are more common with arm's-length lenders than with standard banks.
In many instances of an unsecured loan, business owners will be required to sign a personal guarantee, which is a legally binding statement that allows the lender to file with a court to seize and liquidate personal assets to cover the loss.
"With the personal guarantee, that actually puts all the assets of that personal guarantor at risk of being seized if a judgment is obtained against them," Goldenberg said. "In other words, it's a business debt, it's unsecure, but once it's defaulted, the creditor has every right to go after that guarantor personally."
Defaulting on a loan where you've signed a personal guarantee means your credit score will be impacted for likely up to 10 years. If you default and you haven't signed a personal guarantee, your business's credit score will be impacted.
Personal guarantees serve a great purpose for some loan situations – it's an easy way to get funding when a business may not qualify for a loan from a traditional bank. However, it's important to understand the ramifications and the agreement structure before signing anything with a lender.
Goldenberg said that some merchant cash advance companies, which are lenders that provide cash advances against credit card receivables, may require borrowers to sign confessions of judgment. These COJs mean the lender can expedite the legal process, freezing assets or placing liens against personal assets immediately after default is triggered.
"Where you borrow your money can have a huge impact on what happens if you can't keep up with the agreed-upon payments," he said. "To borrow from an MCA that's going to file a confession of judgement on you a week after you've missed your first payment and then attempt to freeze all of your bank accounts, those are remedies that really would take commercial banks three months, six months, a year [or] maybe longer to get to that point."
Defaulting on an SBA loan
SBA loans are loans from banks backed by the government. It's a program for businesses that may not qualify for loans with banks or alternative lenders because of financial hardship. If you default on an SBA loan, you're still on the hook for covering the lender's loss. DesMarteau said that SBA loans almost always require collateral, which can be liquidated in the event of default.
"Because of these more favorable terms, however, the SBA requires the business owner to pledge all available collateral, often including a person's residence," he said. "If the business owner defaults, the government organization might force a liquidation of all collateral to repay the debt."
Resources, strategies and why the type of lender means everything
The best thing you can do as a borrower is contact your lender when you start missing payments. By staying transparent, most lenders will work with you in some way. In terms of other resources, the National Foundation for Credit Counseling provides small business owners and individuals with free legal counseling and resources. It can be a great start if you're looking for more guidance on a loan dispute.
Another important thing to consider is the type of lender you're dealing with. Rodney Ramcharan, an associate professor of finance and business economics at the USC Marshall School of Business, echoed what Goldenberg said about traditional banks.
"If you're borrowing from a bank that's strictly arm's length, so it only uses data to score and evaluate these loans, then your ability to get some kind of dispensation from the bank could be much more constrained than if you are lending from a relationship-based lender who, again, might be more inclined to use soft information to not foreclose upon this loan," Ramcharan said.
Working with traditional or local banks means there will be a greater chance that you'll be able to work through issues as they arise. Goldenberg said arm's-length lenders, such as MCAs, have different funding practices and may be in a position where they need to get their money back.
"When you have a bank, they sort of understand this business on a much larger scale … There's always going to be some underperforming accounts," he said. "With MCAs, you might have an individual person that funded that loan or maybe a small group of private investors that put down 100, 200 toward funding a particular company and when that company defaults, these people – they're not a large corporation."
This means the stakes for working with arm's-length lenders are different from traditional or local banks, and it's important to understand this distinction as a borrower.
The best strategy for maintaining a healthy, financially stable business is to have good cash flow and accounting practices implemented from the get-go. DesMarteau said keeping business and personal finances mutually exclusive is an important first step.
"Muddling finances can cause SBOs to miss any warning signs that their business finances aren't on track or make it easier to 'borrow' money from the business to pay personal needs, which can cause them to slip up on a payment or overdraft accounts," he said.
Sometimes default is unavoidable. Try and work with your lender and use the resources you have at your disposal.
"Most lenders would appreciate a forthcoming debtor and might actually reciprocate with courtesy to a debtor who is acting genuinely, sincerely, and proactively to try to come to reasonable terms," Goldenberg said.