If you're starting a business, chances are you need a loan for your new venture. When a business doesn't have a performance record for its product or service, a lender will want to carefully review a request for a loan so that they don't make a bad financial investment. One way for the lender to feel more secure about lending to your business is through a security agreement.
Security Agreement Definition
A security agreement is a contract that allows a lender to collect collateral that a borrower puts up, or guarantees, for the loan. Guaranteeing collateral allows the lender to feel more assured about lending money. Collateral can include business-related items such as inventory, business furniture, accounts receivable, or some business savings accounts.
If a borrower defaults, the security agreement allows the lender to collect the borrower's collateral and either sell it or hold onto it until the loan is repaid. Some security agreements allow the lender to sell the collateral immediately.
A security agreement often goes hand-in-hand with a promissory note, which is a form the borrower signs agreeing to repay the loan. As an additional document indicating there is a promissory note to repay the lender, the security agreement spells out what happens to the collateral if the borrower defaults.
Creating a Security Agreement
- Describing the collateral as accurately and as detailed as possible so both the borrower and the lender agree upon the secured property.
- How to determine whether and when the borrower is in default under the loan.
- If a borrower is in default, how and when the lender can take the collateral and either use it or sell it. Some security agreements allow the lender to hold onto the collateral until the loan is repaid. In that case, the lender already has the collateral and can sell it pursuant to the terms of the security agreement.
- A statement that the borrower agrees to protect the collateral so that if the borrower is using it, the collateral will be of the same or similar value as when you created the security agreement.
- Restating the borrower's obligation to repay the loan, and when and how to do so.
- Provisions about allowing or not allowing the borrower to accelerate payment of the loan.
- Covenants, which are conditions placed on the borrower's ability to borrow additional money from a third party or prohibiting the borrower from putting themselves in a position where they could default on the loan. The covenants can include such clauses as prohibiting the borrower from opening another office, getting more expensive property, or moving locations, among others.
Enforcing the Security Agreement
If you're the lender, you can collect the collateral under the terms of the security agreement if the borrower is in default. A carefully drafted security agreement allows the lender to take the collateral upon default and either sell it, use it, or hold it. If, as the lender, you are holding the collateral, such as some of the inventory, you can follow the security agreement and sell the collateral immediately if the agreement allows. You can also file a Unified Commercial Code-1 (UCC-1) statement with your state, which acts as a lien on the property. Check with your state's Secretary of State, or government agency that regulates businesses, to get a UCC-1 form, as each state has its own unique document.
If, as the lender, the borrower defaults and you don't have either the collateral in-hand and a lien, you must get the collateral from the borrower, which is why getting a lien is so important. If the borrower refuses to turn over the collateral, you may need a sheriff to retrieve it or you may have to get a court order. A properly drafted security agreement can prevent you from having to go to court. Holding the collateral and obtaining a lien are good ways to prevent that.
Security agreements can be tricky to create because it's easy to omit covenants and other important information. To ensure your document is properly prepared, you can have an attorney or use an online template, whether you're the lender or the borrower.