Securing Promises to Pay

A promise to pay money can arise in many contexts.  If you buy a car on credit, you promise to make the monthly payments plus interest in a promissory note.  If you sell your business, the buyer may promise to pay a portion of the purchase price over time.  If you are a seller of goods or services, you may extend trade credit where the customer promises to pay in the future based on agreed terms.  Promises to pay money in the future are very common in our credit based economy.

A promise to pay money in the future is just that – a promise — and nothing more.  Promises to pay money can be oral or they can be written.  These are nothing more than basic contracts giving the payee the right to receive payment and placing upon the obligor the duty to make payments as agreed.  If the obligor breaches his or her promise to pay the payee is left with a lawsuit, which can be drawn out and expensive.  Suppose you sell me your business and I promise to pay you a portion of the purchase price over the next 5 years along with 6% annual interest.  Immediately after the sale, I own your business, and you own the right to be paid as agreed, usually represented by a promissory note.  If I default, you have the right to sue me in court.  That is not much solace since you no longer own the business which you probably worked very hard to build.

There are, however, ways to secure a promise to pay money which substantially increase the likelihood of full payment.  Consider the following:

Pledge of Stock.  In the context of a sale of a business, if the business is a corporation or other entity, the buyer of the business can be required to pledge his ownership in the business back to the seller as security for the obligation to pay the balance of the purchase price.  This can take the form of a pledge of the shares of stock of the company, or a pledge of its physical assets.  If the buyer defaults in payment, the seller would have the right to take back the business to satisfy the debt.

UCC-1 Filings.  If you are a seller of goods on credit, you can take a security interest in the goods you are selling.  Buyers are often required to grant the seller a security interest in the goods being sold.  Sometimes the seller receives a blanket lien on the buyer’s inventory.  In the event of default, the seller can reclaim the inventory in the hands of the buyer.  Credit sales of equipment usually are secured by a UCC lien.

Mortgages.  Perhaps the most familiar form of security for payment is the mortgage on real estate.  Mortgages recorded against real estate usually secure loans obtained to purchase the real estate.  The promise to pay the loan is secured by a lien on the property, which can be foreclosed if there is a default in payment.  However, mortgages on real estate can also be used to secure other promises.  If I buy your business and promise to pay you part of the purchase price in the future, that promise can also be secured by a mortgage on real estate.  It is not uncommon for buyers of businesses to pledge their personal homes as partial security for seller financing.

Personal Guarantees.  Promises to pay money in the future are often made by corporations or other limited liability entities which are notoriously undercapitalized.  If I sell equipment to your corporation, your corporation’s promise to pay for the equipment may be worthless from an economic standpoint.  It is common to require the owners of a corporation to personally guarantee the payment and performance by the corporation of its monetary obligations.   Banks usually will not loan money to small corporations without receiving a personal guarantee from the owners of the corporation.  Small businesses can likewise require personal guarantees from the owners of a customer’s business, which is something we strongly recommend.

Smart lenders and sellers do not extend credit without proper security.  Before extending trade credit you should consider obtaining a personal guarantee and other security from your buyer.  If you are selling your business you should always take back a security interest in the business if you extend financing to your buyer.  Even personal loans to “friends” should have proper security in case your friend should become unfriendly in the future.  This is one area that we strongly recommend “belt and suspenders”.

– Kevin Palmer


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