What is an unsecured loan and how is it different from a secured loan?
A secured loan is a loan made to a business where the borrower commits an asset to the lender as collateral in the event of default, in addition to committing to repay the funds. The asset used as collateral can take different forms, depending on the business and circumstances of the loan, however it typically falls into 2 categories: asset backed and IP-based.
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Asset-backed loans
Asset-backed loans are secured by a physical asset that the lender could seize in the event of default. Typically this asset will take the form of real estate, accounts receivable (A/R), inventory, or equipment (machines, vehicles, etc.). The basic idea is that the lender could take ownership of the asset and sell it off to recover some or all of the debt owed by the borrower. Additionally, in many cases, when the lender seizes the asset it can have a crippling impact on the business, even if the event of default was not due to the company going bottoms up (for example, failing to maintain a specified financial ratio).
- IP-based loans
IP-backed loans are secured by some form of intellectual property legally held by the borrower. IP is most relevant for businesses with patented software, a valuable domain name with web traffic (www.google.com), or drugs processes (think biotech). In these cases the lender can assign a recoverable value to the IP in the event of default. Alternatively, it’s important for a business owner to recognize that an IP-backed loan means that if your business depends on your web traffic or you’re a developer with a passion for the software you developed, you risk losing all of that work if you trigger a default event on your loan.
The importance of secured vs. unsecured loans
There are two important concepts to keep in mind when choosing between a secure or unsecured loan. First, does your business have assets to which a lender could assign value to support the certainty of repayment, and does securing the loan with that asset adequately reduce the interest rate you would need to repay? In various cases, you may not have an asset that meets the bank’s standard for a secured-loan, and they either won’t accept it as collateral altogether, or assign such little value to it that even after committing it as collateral, your interest payments are oppressively high.
Second, how critical is this asset to the ongoing solvency of your business or personal life? If you commit your company’s manufacturing equipment to secure a loan, you could find yourself in a position where you trigger default by missing a financial covenant, the bank seizes your equipment, and your company is out of business. A potentially worse personal debacle could occur if you instead make a personal guarantee on your company’s loan, and the bank goes after your family’s assets including your home if you trigger an event of default.
How does Lighter Capital think about secured vs. unsecured loans?
We look for companies that have an asset they can commit to secure the RevenueLoan, but we are willing to accept a wider range of collateral to secure the loan than a bank would. For instance, we will look at software IP, domain name ownership, brand names, and even recipes as collateral, in addition to many of the assets accepted by banks.
Additionally, the loan structure of a RevenueLoan provides increased payment flexibility to the business owner which makes it relatively more difficult for a company to default on a RevenueLoan compared to a traditional bank loan. First, the RevenueLoans don’t have fixed monthly payments and instead are repaid as monthly revenue increases or decrease – meaning as long as the company continues to pay the predetermined percent of revenues, it is likely to avoid a default on the loan (and thus maintain control of the secured asset). Second, there are no financial covenants in RevenueLoan terms, which reduces the ongoing financial oversight committed to by the entrepreneur, removing many of the default events typically triggered by bank loans.
In both cases, the RevenueLoan structure offers more flexibility to the small business owner thus reducing the risk of losing the assets committed by the company to secure the RevenueLoan.
