When borrowing money, we are usually required to pledge funds or assets to support the lender’s risk. Sometimes, this includes providing a guarantee for another person or on behalf of a business. When is it worthwhile?
Security and Serviceability
Security or Collateral are the assets that an individual or entity borrower provides to a lender to secure a loan. For the credit provider, this protects against potential loss of capital.
Often, the borrower does not entirely understand what they provide and the potential implications. Broadly, security is either:
- TANGIBLE SECURITY
Tangible Security usually takes the form of acceptable property security or cash and is the most common form of lending, especially in the small to medium business market (SME). A registered first mortgage is taken over the property and is commonly supported by personal and directors’ guarantees. The lender will request a General Security Agreement (GSA) over the borrowing entity and other entities in the group that directly or indirectly provide serviceability support for a loan.
- INTANGIBLE SECURITY
Intangible Security is sometimes called “Cash Flow Lending” and is more difficult to obtain in the small business market. Only businesses demonstrating strong balance sheets and future cash flows may receive lending facilities without providing property or cash security.
Common Types of Security
1. PROPERTY SECURITY
Most people are familiar with a registered real property/mortgage. In Australia, this is usually a Torrens title mortgage, which operates as a statutory charge on the relevant lot or interest in the land for the amount of debt or liability secured. It may also be over a lease.
2. GUARANTEES & INDEMNITIES
In most cases, an individual guarantee and indemnity will be required from the natural person(s) that support the borrowing entity.
For example, Jane Smith provides a “guarantee and indemnity” with respect to the obligations/conduct of the borrowing entities, Smith Group Pty Ltd & Smith Holdings Pty Ltd. This potentially means the personal assets of the borrower, Jane Smith are at risk. A certificate of independent legal advice is generally required for each individual guarantor.
3. GENERAL SECURITY AGREEMENTS & ”PPSR”
The Personal Property Securities Act 2009 (PPSA) is a law regarding security interests in personal property. The Personal Property Securities Registry (PPSR) is a register of security interests in personal property.
- A General Security Agreement (GSA) over the general assets of a guarantor, including tangible movable property and other property such as intangible property.
- A specific security agreement over specified goods.
For example, Smith Group Pty Ltd & Smith Holdings Pty Ltd provides a “General Security Agreement” over all present and after-acquired property.
Key Considerations When Providing Security
When the borrower provides security
In this situation, the borrower must understand exactly:
- What is being asked of them by the lender and
- Is it reasonable in the circumstances?
If the debt obligations are met as planned, the security is released at the conclusion of the agreed obligations. Remember that the quantum and quality of the collateral/security will usually drive the terms for the debt. Ultimately, security is a “second way out” for the lender if the borrower cannot repay the debt in the agreed timeframe.
If you are the borrower, you should understand the risk involved and plan for contingencies. This is not the lender’s responsibility. You may require business planning or legal and financial advice before making long-term debt commitments.
When security is provided to support lending to third parties
This scenario is where a lot of issues can arise. A guarantee may include:
- When a business has multiple owners, and you only have partial influence
- Supporting a person in a situation where you have limited or no control
1. EXPERIENCE
A key determinant is the applicants’ experience. A guarantor should evaluate this in detail to ensure the necessary business expertise is present to support future goals and objectives.
2. FINANCIAL POSITION OF BORROWERS / GUARANTORS
The capital base accumulated by the individual borrower should indirectly reflect their business life. A lender will seek connect the dots and so should the guarantor.
Lenders will request a completed Asset & Liability Statement for all borrowers and/or guarantors. The guarantor will be assessed for their ability to meet obligations in the event the obligor cannot.
3. RETIREMENT OF DEBT
When borrowing money or guaranteeing a loan, start with the end in mind. The financier needs to see a demonstration of the way the debt will be retired. It is an excellent test to apply to understand the risks better. Typical strategies include:
- Full payment over the term of the loan out of the current cash flow
- A forecasted increase in earnings, demonstrating a capacity to retire debt in the future
- The acquisition of new contracts or revenue streams that are recurring in nature
- The divestment of non-core assets
In most instances, the sale of the primary security is not a sufficient debt strategy. The financiers should seek a “first way out” where debt can be repaid without selling the core asset.
Plan for the Worst
‘Hope for the best, but plan for the worst’ is a very apt attitude when borrowing money. The worst outcome is when a guarantor is left with a remaining obligation should the primary security be insufficient to retire the debt and its associated costs.
The old legal saying, “If you don’t pay, they take it away”, explains the risks in simple terms. Always seek professional advice to ensure the obligations are clear, including what will happen if the lending terms are unmet.
The Final Decision
Once you have done the due diligence and weighed the risks and benefits of providing security or guarantees for debt, you can decide if it is the right move for you. Our blog contains many more articles about lending, business management and financial forecasting to assist with your learning. Please explore and reach out if you have further questions.
More Information?
Contact MCP:
E - enquiry@mcpgroup.com.au