Here’s a fundamental truth of any organization: you need cash to help grow your business. Whether you’re a start-up, a sole proprietorship, or a limited liability corporation, getting a small business loan will be one of your top priorities if you’re looking to expand your company’s potential. But before you receive funds from a bank, a lender will scrutinize both you and your business to see if you’re a viable borrower.
A bank will look at your company’s history, business credit, revenues, balance sheet, and your equity contributions. If you pass a credit check and you operate a healthy business, most banks will also require an additional, and tangible, guarantee that their loan will be repaid, i.e., collateral.
Defined by the U.S. Small Business Administration (SBA), collateral is “an additional form of security which can be used to assure a lender that you have a second source of loan repayment.” In other words, collateral ensures a bank that they will either be repaid by you or they can recoup the money in another way, such as liquidating the assets you offer for collateral.
Collateral assets are owned by your business or by you personally. Most commonly, collateral is real property (e.g., an owner-occupied home), but it can also be represented by your business’s inventory, cash savings or deposits, and equipment. In order to structure a loan that benefits both you and your business, you’ll need to make the right decision about what you offer to the bank as collateral. It’s also important to be realistic when considering the risks of defaulting on a loan, which could have harsh consequences for not only your business, but for your personal life, too.
While asset-based lending can be a great way to get a fast influx of cash to your business there are precautions to take to protect yourself and your business. Below are a few tips on how you can use your assets as collateral, and how you can mitigate the risks associated with defaulting on a loan.
1. Keep Detailed Records of your Asset’s Worth
Banks are notoriously conservative about valuing a borrower’s assets for collateral. After all, if the borrower does default, the lender must expend resources to take the asset, find a buyer, and sell it.
Jeff Allen, the director of operations for Trendant, a small business consulting firm based in Salt Lake City, says that one of the most common mistakes business owners make about collateral is they think it’s worth a lot more than it actually is. “They’re considering what they paid for it, and the banks only consider the fair market value of today,” he says.
If you’re not sure what your assets are worth, it could be worthwhile to find an independent appraiser to give you an idea of how the bank will value your property.
It is also critical to keep detailed records of your assets on your balance sheet. When a bank is reviewing your business documents, they’ll want to see that you’re paying careful attention to all of the relevant factors. This is usually simpler than you think. “In keeping records, businesses tend to overcomplicate,” says Allen. “They think there’s some magical solution that the big boys use. The bottom line is that an Excel spreadsheet with a couple of line items is all you need.”
2. Know What You Can Use as Collateral
Essentially, there are two types of collateral: assets that you own and assets that you still have a loan against. If you still have a loan on an asset (e.g., a mortgage for a house), the bank will be able to recoup the loan by refinancing with the lending institution and claiming the title.
A viable asset to use as collateral will have a title of ownership, and banks will only lend if they can get a title back, says Allen. Homes and cars are the most common forms of collateral, but you can also use watercraft, motorcycles, as well as pieces of equipment that have a title of ownership.
Below are some relevant issues associated with each type of collateral to consider before approaching a bank for a loan:
Real Property: Since the housing bubble burst, using real property as collateral financing took a huge hit. Denise Beeson, a commercial loan officer based in San Francisco, says that this has been a significant roadblock for small businesses seeking small business loans. “It’s devastating small business right now,” she says. “In the past, they’ve used the equity in their home, and they don’t have any of that equity anymore.” Additionally, banks will not consider vacant land, or “dirt” as it’s referred to in banking, as viable collateral.
Business Inventory: If you need the loan to purchase inventory, that inventory can act as the collateral for that loan, according to Fundera, a financial solutions company. The challenge with this approach, the company cautions, is that lenders may be more hesitant to take it on because if you can’t sell your inventory, chances are they won’t be able to either and may not recoup the money from the loan.
Accounts Receivable: If your firm gets a big purchase order, you may not have the resources to meet the needs of the client without bringing on additional staff, equipment, or raw materials. In some cases, a bank will allow a company to use that purchase order as collateral. “It’s a little trickier to get,” explains Jeff Allen. “It might be more difficult because it’s harder to authenticate…but a bank will usually lend against that.”
Even unpaid invoices potentially may be used as collateral. According to Fundera, if you have customers who are late in paying their bills, invoice financing companies will lend you 85% of the value of the outstanding invoice. They will charge fees against the 15% they hold in reserve up to the time when the customer pays the invoice (then you get what remains of the reserve back). The benefit is that it is up to the lender to pursue payment from the customer and if the customer doesn’t pay you are only responsible for repayment of the initial invoice amount and are not at risk of losing any assets.
Cash Savings or Deposits: “Cash is always king,” says Allen. Using personal savings will almost definitely be allowed as collateral since it’s a low-risk loan for a bank. This also applies to CDs and other financial accounts. The advantage in using these accounts as collateral is that you’re guaranteed a low interest rate because it’s a secured loan. The disadvantage, clearly, is that if you default, the bank will take your savings.
3. Understanding the Risks
Loss of Assets: Taking a loan using assets as collateral presents the risks of losing the assets if you default on the loan. Therefore, it’s important to discuss the risks of using certain assets as collateral with a financial advisor, as well as people that could be affected by the loss of that asset.
“Some business owners are highly risk averse, and I wouldn’t recommend putting some stuff up for collateral,” says Jeff Allen. “Because if you can’t pay it, they’re taking your car or home.”
Be realistic about your company’s needs, and how the company will be using the funds. A financial advisor will help you assess the risks involved, as well as the odds of the loan being successful. “It comes down to being honest with yourself, knowing your situation, and knowing what the funds will be used for,” says Allen. “If you really need the money, you might to find alternatives, because you might lose what you’ve leveraged.”
Often, a limited liability company is formed to shield the business owner from these risks, but a default will inevitably still affect the owner, especially if he or she is the only shareholder.
Unsecured Loans: If you choose not to use collateral to secure a business loan, there are also risks in that decision. Lenders can charge extremely high interest rates for unsecured loans. You need to assess what your company can afford.
Predatory Lending Practices: Read all of the terms of your agreement and be willing to reject a loan offer if anything seems potentially harmful to your business. The SBA cautions, “Some lenders impose unfair and abusive terms on borrowers through deception and coercion. Watch out for interest rates that are significantly higher than competitors’ rates, or fees that are more than five percent of the loan value. Make sure the lender discloses the annual percentage rate and full payment schedule. A lender should never ask you to lie on paperwork or leave signature boxes blank.”
4. Negotiate When, and If, You Can
If you’re a qualified borrower with a demonstrable history of good business credit, you should be able to secure a loan with commitments you are comfortable with. Remember, you can gather loan offers from multiple lenders to compare your options.
When reviewing your offers, one thing to consider is the loan-to-value ratio of each. This is the percentage of the asset’s value against which the lender is willing to advance funds. According to ValuePenguin, a personal finance site, loan-to-value ratios generally range from 50 to 98 percent. The higher the percentage the less collateral you’ll need to put up to cover the value of the loan. For example, if you need a loan for $80,000 and you have an asset valued at $100,000, you’d prefer a loan-to-value ratio of 80% over one of 50% as the latter will require you put up additional collateral to cover the full loan value.
5. Consider Peer-to-Peer Lending
If an asset-based loan isn’t ideal for your business, Denise Beeson recommends alternative methods of securing cash. “Because it is extremely difficult to get a loan based on existing collateral, a lot of borrowers are going to peer-to-peer sites to see if they can get some money from that mechanism,” she says.
Peer-to-peer (P2P) lending enables you to get a loan from individuals rather than a bank. P2P has been around for more than a decade and has been growing. The Balance, a personal finance website, explains that generally the services are web-based, which cuts down on overhead costs allowing rates to be competitive. P2P lending started with personal loans that were not secured with collateral. Today, while personal loans are still the most common, according to The Balance, P2P platforms also offer options for loans for specific purposes, e.g., business loans, and collateral-secured loans.
While loan amounts may be less than what might be available through a bank, there’s often less red tape involved in obtaining a peer loan. Prosper.com, for example, allows borrowers to choose a loan amount of up to $40,000, answer a few questions and instantly view lowest eligible rates. The applicant selects the terms and they are then listed as an option for investors. Then, investors choose which loans to invest in based upon a series of criteria, including FICO score. Loan funds go directly into the borrower’s bank account and borrowers make fixed monthly payments to their investors, who receive the funds directly in their Prosper account.
There are many P2P platforms to choose from. Since loan applications will require you to share personal information, The Balance suggests researching potential lenders and reading reviews from reputable sources to be sure you’re dealing with a legitimate service.