Financing your small business is no small feat – it can be a long and tricky process to navigate. But financing is also a necessary part of American enterprise, since small businesses depend on borrowing money to grow.
This dependence on financing also opens up the potential for small businesses to fall into financial hardship and default on their loans.
As payments are missed and the possibility of default looms, the type of lender, loan and business factor heavily into what the default process looks like. Regardless of your agreement with the lender, 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 distribution for TD Bank.
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Loan default processes vary by state; the ones outlined below are standard in New York. Even some alternative lenders that are not based in New York still 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, they may decrease your 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 to prepare you for what a lender will require. The most important takeaway is that the type of lender you 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 on a business loan?
If you work with a larger bank, the default process can take several months or even a couple of years. With some smaller loan companies and alternative lenders, your assets can be frozen after just a few days of missed payments. Simon Goldenberg, an attorney based in New York and New Jersey who specializes in debt relief for small businesses and individuals, 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 bargaining period 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 that, 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 various other 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 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.
- The lender will cut its losses and settle with you for a defined amount.
Keep in mind that it's always in the lender's interest for you to make payments – it's a company that needs its investment back and will be willing to acquire it in the best way possible.
"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 litigates to seize and liquidate your assets depends largely on the relationship and terms it has with you. If 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, and they usually require a personal guarantee from the business owner.
What is a personal guarantee?
In many instances of an unsecured loan, business owners are 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."
What happens if you default on a personal guarantee?
Defaulting on a loan when you've signed a personal guarantee will likely impact your credit score for up to 10 years. If you default and you haven't signed a personal guarantee, your business's credit score will be impacted. If you put up collateral, you will lose whatever asset you put up.
Can you get a business loan without a personal guarantee?
Most business loans require a personal guarantee, which can serve a great purpose for some loan situations – it's an easy way for a business to get funding when it may not qualify for a loan from a traditional bank. There are some business loans and lines of credit that you can get without a personal guarantee, though they generally have higher interest rates.
Will filing for business bankruptcy get rid of a personal guarantee?
It is possible to get rid of a personal guarantee by filing for bankruptcy, and most personal guarantees do qualify for discharge. However, if it is a nondischargeable debt, you cannot use bankruptcy to remove your personal guarantee.
Furthermore, filing bankruptcy on behalf of the business will shift the responsibility for paying back the loan from your business to you personally, and the lender will look to you and your personal assets for the money.
How are personal guarantees enforced?
When a contract with a personal guarantee is breached, such as when you default on a loan, the lender can go directly to the guarantors and are not required to exhaust other options against your business before doing so. As such, it is vital 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," Goldenberg said. "To borrow from an MCA that's going to file a confession of judgment 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
Small Business Administration loans are from banks backed by the government. This is a program for businesses that may not otherwise 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 to cover 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 … the SBA requires the business owner to pledge all available collateral, often including a person's residence. If the business owner defaults, the government organization might force a liquidation of all collateral to repay the debt."
The SBA itself is not a lender; it only guarantees up to 85% of the loan amount to lenders who give SBA loans. If you default on an SBA loan, you will deal directly with your lender, not the SBA. The lender will call in the SBA guarantee only when its efforts to collect payment from you fails.
Lenders' efforts generally include contacting borrowers after a 10-day grace period and possibly charging a late fee, but different lenders have varying policies on how they treat late payments. A lender might allow a borrower to restructure the loan or deliver interest-only payments for a certain period of time.
If a lender calls on the SBA for the guarantee and the federal government takes a loss on the loan, it may take additional measures to repay the loss, such as garnishing the borrower's wages or freezing their bank account.
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. If you're transparent with them, most lenders will work with you in some way.
As for 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 place to 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 gives you 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 their primary concern is just getting their money back.
"When you have a bank, they sort of understand this business on a much larger scale … [knowing that] 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 money toward funding a particular company … 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.
You may also consider an offer in compromise, which allows you to settle your tax debt for less than the full amount you owe. This is an option for borrowers who cannot pay their full tax liability, or if doing so would create undue financial hardship for them. If you take this option, it might be helpful to contact an attorney who specializes in business debt settlement to help you navigate the process.
Bottom line
The best strategy for maintaining a healthy, financially stable business is to have good cash flow and accounting practices from the get-go. DesMarteau said keeping business and personal finances mutually exclusive is an important first step.
"Muddling finances can cause SBOs [small business owners] 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 to work with your lender and use any resources 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.
Matt D'Angelo contributed to the reporting and writing in this article. Some source interviews were conducted for a previous version of this article.