How Business Loans Work

While business loans often finance the initial expenses of a startup, they can also be used for relocating and/or growing your business. Similar to a personal loan, business loans can also be secured or unsecured.

Common types of business loans

When choosing a loan, it’s important to check the cost, interest rates, hidden fees, terms of the loan, etc. Interest rates can be fixed rates (the rate will not change throughout the loan term) or variable rates (the rate will change depending on market conditions). Each loan type will also have different tax implications so make sure to speak to a tax advisor.

Secured business loans

Secured business loans are supported by collateral, which can be any property or business asset. pledged or deposited as ‘security’ for the loan. In the event that you fail to pay your loan, the lender can usually apply to seize your collateral as payment for the debt owed. Remember, lending institutions are more likely to let you borrow more if you’ve offered higher collateral.

What are the general forms of security that a borrower can provide?

As mentioned earlier, real estate is one of the most common securities provided by those taking out business loans. This could be commercial property or residential property as guarantor. Cash, future invoices, business inventory, vehicles, and equipment can also be used as security.

Unsecured business loans

With an unsecured loan or low-ranking loan in terms of priority, the risk is greater for the lender so this type of loan generally attracts higher interest rates e.g. mezzanine financing. Since there is no collateral or security on the table (or very low priority if any security), the lender generally relies on the borrower’s credit history, debt payment history, and financial situation.

Guarantors for business loans

If you do not have any assets to provide as security, the lender may ask you to get a guarantor. If a borrower you can’t repay their loan, the guarantor steps into the shoes of the borrower, covering for them and making the repayments (or meeting obligations). In some cases, the guarantor will also be asked to provide security from the assets they own. Generally, banks require the directors of a business to provide a personal guarantee as security for a loan. Depending on which bank, directors may also be required to provide the ‘substantial shareholders’. With a personal guarantee, the guarantors become personally liable for the business’ debt and obligations under the loan.

Line of credit

If you need a certain amount for the purposes of say, a property development project, you can withdraw money any time from the loan facility up to the specific amount approved. You don’t need to use up all the funds, but they’re there in case you want to. A line of credit is often also called a loan facility agreement. It can be helpful in circumstances where you do not need the whole of the facility amount immediately but will through time. Often (and subject to the agreement), this means that you pay a lesser amount of interest as you are only drawing a portion of and not the whole facility.

Overdraft

This is commonly linked to your business account and lets you withdraw approved additional funds when your account balance reaches zero. While some overdrafts may have monthly or annual fees, interest is usually only charged on the overdraft fund you used. Business overdrafts are also available in both secured and unsecured forms.

Invoice finance

Under invoice financing, lenders generally unlock cash through the debtor business’ invoices. The funds you will receive are based on the value of your unpaid invoices. Take note, only 70% to 90% of the funds are generally invoiced and the lender makes the difference as a form of ‘interest’.

Equipment finance

Equipment finance is an ideal loan or lease for businesses that need to secure business equipment. This often includes office equipment, company vehicles, machinery, computer software, medical equipment, coffee machine, printers, etc.

Documents you need to apply for a business loan

Before meeting with a lender or investor, you will need to prepare documentation that provides an overview of your and your business’ financial standing.

Financial statements

With areas like revenue streams and expenses, financial statements best demonstrate your ability to afford the repayment of your loan, including the interest. For example, your financial report shows how much free cash you have left once you’ve paid all your expenses. Generally, lenders prefer seeing two (2) years of financial history through reports, BAS statements, payroll, etc.

Business plan

Lenders often require a business plan, particularly in the case of startups.

Loan agreement

Normally, lending institutions like banks have their standard loan agreement. However, it wouldn’t hurt to get a lawyer to review the document before you sign. This way, you’ll know exactly what terms and conditions you’re signing yourself up for. It’s often necessary when you take out a loan from the bank anyway. Banks often have stricter KYC (know your customer) requirements and require a solicitor to verify the person signing. The solicitor must sign a certificate guaranteeing that they explained the documents to the borrower and the borrower voluntarily signed up for the loan. On the other hand, a company or trustee of a trust is often required to sign a general security agreement.

Guarantee

As mentioned earlier, you may be asked to get a guarantor or guarantee the loan to take out an unsecured business loan. A guarantee is a type of security document that specifically states the conditions wherein the guarantor has to step in and repay the debt.

Get assistance in your business loan applications

Business loans come in all shapes and sizes, each with its own pros and cons. The right one for you will depend on how much money you need, when you need it, and what you need it for. Our experienced lawyers can provide you with full-service legal support for commercial lending, from due diligence and loan documents to payment defaults and dispute resolution. To connect with us, give us a call on 03 9052 3214 or send your enquiry through the contact form below.

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Secured vs Unsecured: How Business Loans Work