When you are in business, whether that be a property developer, a manufacturing business making widgets, a service business supporting your clients, you will have decided on what type of legal entity you are.
The choices are:
- Sole trader
- Limited company
- Limited Liability Partnership
Each legal structure will have its own advantages and disadvantages. In this article we take a look at the different types of security used and how it impacts these legal entities, if at all.
What is security?
OK, so let’s get this out there early There is no such thing as unsecured borrowing in business. Where a lender or other profession is promoting unsecured borrowing, they are referring to not needing ‘tangible security’. A lender will always want and need a way to recover their money in the event of default, whether that be personal guarantees, debentures or any other security instrument specific to the facility type.
Security is something that is offered to a lender so they can call upon it in the unfortunate event that a facility cannot be repaid. Security is always the secondary form of repayment. The primary form of repayment is to pay the facility back as agreed. This is why lenders have a detailed application process; to assess the likelihood of the facility being successfully repaid.
What are the different types of security?
Security can be broken down in to two broad categories:
Tangible Security – is where you offer the lender a physical item as security. Most commonly this is property or a large asset, but it can be anything.
Intangible Security – is where there is no specific asset provided. The worth or value placed on intangible security depends on the underlying worth of what or who is offering the guarantee.
Tangible Security Types
This is appropriate for all legal entities that own the asset
Property 1st Charge – You provide a lender the first claim on a specific asset. In the event of default and the asset being sold, the lender will be the first liability to be repaid.
Property 2nd Charge – You provide the lender with a second claim on an asset. This is usually because there is already a lender that holds the 1st charge. In the event of default and the asset needing to be sold, the 1st charge holder gets repaid first and any money left over, the residual balance, goes towards repaying the second charge holder. It is a lender’s preference to be first charge, for obvious reasons, and this is often reflected in the cost of the loan as its deemed as lower risk. Lender’s will look lend on second charges, however the overall borrowing limit will need to be within a specific Loan to Value (link to LTV blog). For Limited Companies, Limited Liability Companies
Third Party Security – Not to be confused with a third party guarantee. This is still a charge over a specific asset and can be either 1st or 2nd charge. Where the company doesn’t own the asset but the Directors or Partners own a property they are prepared to offer as security, this is known as third party security. The asset will have a direct charge over it which would be called upon in the event of default.
Intangible Security – This is specifically for Limited Companies and Limited Liability Partnerships. Any security of this nature t a sole trader or partnership automatically has a personal liability There are many forms of intangible security, some are specific to the type of borrowing, however we have covered the main one’s below:
Personal Guarantee – Directors or partners offer a personal pledge to repay any facility the company is borrowing in the event of default.
Joint and Several Guarantee – The same as a Personal Guarantee, however the liability is not shared equally across multiple directors/partners. This type of guarantee allows the lender to as pursue directors to differing degrees i.e. if there are two directors and one director is has the means to repay whilst the other doesn’t the lender can ask the director with the means to repay all of the liability.
Cross company guarantee – Often used in group company structures or when the affordability assessment has taken more than one business in to account. There are some rules around this, you cannot use one unrelated limited company to guarantee another. There has the be a ‘commercial benefit’. For example, if have a group of businesses in a restaurant chain and have open each restaurant in its own limited company, as part of the affordability assessment the lender would look at the overall performance of the chain to make a decision on lending. As a result they would want to make sure they have guarantees over all companies to secure their position.
Debenture – In very simple terms a debenture is an agreement between a lender and a borrower which is registered at Companies House and lodged against your company’s assets. The debenture can sometimes be referred to as a ‘floating charge debenture’ and includes all company assets. The charge is deemed to be ‘floating’ as some of the assets may be changing on a daily basis, such as stock for example. The debenture secures the assets for the lender should the company fail and in liquidation, the charge becomes ‘fixed’ on the asset’s value at that point in time.
The value placed of any of these security types depends on the underlying value of the guarantor. If the company is providing a debenture, the company’s balance sheet becomes the point of interest whereas if you are providing personal guarantees, the net worth of the guarantor is reviewed.
There is no rule on which one is more acceptable and lenders will have their own criteria when assessing lending applications. It’s also worth noting that a lender may want multiple forms of security to support a facility