Almost all banks require a small business to offer collateral for a loan. Here are a few tips on how to use your assets to secure financing for your company.
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 payday loans in Youngstown OH, 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 homes, 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.