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As you likely know from your research on small business loans, pledging collateral is critically important when attempting to secure financing for your company. But why is that? And, further, what is collateral in business?
On that first point, collateral is just one form of security for lenders. Obviously, lenders are putting a lot at stake when they offer up capital to a small business. And as well-intentioned as a small business owner is when they accept a loan, there’s always the risk that things can go south and they’ll be unable to repay what they owe. That’s the function collateral—if a borrower defaults on their loan, the lender has the right to seize whatever assets the borrower pledged to make up for the lost capital.
Other than collateral’s very real function, on a symbolic level lenders like to see that a borrower has skin in the game—and that they, too, have a lot to lose if they fall through on their loan payments. So, what can be used as collateral to secure a loan? That’s what we’re here to show you.
Here’s something that most new entrepreneurs learn very early: Even the best business idea can’t fully blossom if there isn’t enough capital to support it. A healthy business needs growth—and growth takes money.
This leads to an age-old conundrum for small business owners: How do you raise enough capital to let your business flourish? In many cases, small business owners opt for a loan.
But for both the lender and the borrower, there are risks involved with taking on debt—namely, that a borrower fails to repay their loan. If the borrower defaults, that means the loan’s capital boost didn’t fulfill its intention of improving the business’s financial standing. Also if the borrower defaults, then the lender loses all that capital. Right?
Well, mostly. Clearly, lenders need to protect their interests in a loan agreement. During the underwriting process, they’ll rigorously vet the viability of any borrower to minimize the odds of a loan default. (That’s why we harp on the significance of a business’s profitability, average revenue, and personal and business creditworthiness in loan agreements.)
But that vetting process doesn’t provide quite enough security for lenders. Typically, lenders will also ask for some form of collateral from the borrower to help secure the loan. In reality, “secure” means “sell or liquidate to recoup what the lender lost when the borrower defaulted on the loan.”
It figures, then, that collateral is any asset that the business owns, either tangible or intangible, which is equal to the value of the loan and can be easily and quickly liquidated.
With that in mind, let’s review five different types of collateral that business lenders might want to see when processing a small business loan.
As we mentioned, your lender might be open to considering any valuable asset as collateral—and there’ve been some pretty surprising items used as collateral in the past.
Of course, not every lender is willing to lock in a loan with Parmigiano-Reggiano (true story), so instead, look toward these five—more commonly held—types of collateral that business lenders might want to see to secure your loan.
Using real estate assets or home equity as collateral when applying for a small business loan is a common approach. That commonality, and desirability for lenders, comes down to a few factors: Real estate is valuable; it retains its value over time, even after liquidation; and it’s widely available.
On that last point: Many business owners have access to home equity, which makes real property a natural and easy first choice for securing a small business loan. That’s especially the case since the US housing market recovering from the post-bubble collapse.
There are some important caveats, though. Using real property as collateral can have serious effects on your overall finances or net worth if the loan defaults, and a lender seizing your family home can be especially devastating. Before you offer up any real property to secure your small business loan—or any of your business or personal assets, for that matter—it’s important to understand all risks involved.
Don’t forget that “real property” extends beyond real estate. You can use equipment, cars, boats, motorcycles, planes, and so on as collateral; they all fall under the “real property” umbrella.
Another type of loan security is inventory. Of course, this type of collateral is only viable if you’re a product-based (rather than service-based) business.
However, inventory doesn’t always tick all the boxes that make for a useful collateral source—more specifically, your lender won’t always deem your inventory equal to the value of your loan, especially when taking depreciation into account. To vet your inventory’s current and projected worth, a lender might send out a third-party auditor to value your inventory in person.
One approach to using inventory as collateral is inventory financing. In this scenario, a business owner requests a loan to purchase items that’ll later be put up for sale (aka, their inventory!). This inventory acts as built-in collateral in case you’re not able to sell your products and, eventually, default.
Take note, though, that the value of your inventory is key to inventory financing, just as it is in any other form of small business loan that considers inventory as collateral. So some lenders might not view inventory financing as fully secured lending. If the borrower can’t sell their inventory, the lender might have trouble doing so as well, forcing them to sell at a loss. For this reason, inventory financing could be difficult to secure with some lenders.
Lenders also favor cash, in the way of a business savings account, as collateral. And you can probably understand why—a bundle of cash ensures that the lender will quickly and easily regain their losses if you default on your loan. They won’t need to go through the hassle of selling an asset.
Generally, you would apply for a savings secured loan (otherwise known as a “cash-secured loan”) from the same bank that holds your account. And because the bank can liquidate your account the moment you default on your loan, it’s very low risk from the lender’s perspective, which should ensure that the borrower gets an optimal interest rate.
From the borrower’s perspective, however, putting up your savings account is obviously high-risk, because you could lose your entire savings.
If you’ve invoiced your customers but they’re slow to pay, you’ll more than likely experience some difficulties in running your daily operations—you might need the cash tied up in those invoices to replenish inventory, for instance, or pay your employees.
As a fix, some lenders will agree to accept collateral based on these outstanding business invoices—a process called invoice financing. This is a good option for business owners that don’t have a strong credit score, because lenders determine a borrower’s viability mainly through the worth of those outstanding invoices.
Although the borrower might give up a bit of the total cash value of the invoices, she receives the flexibility and security that comes with an immediate cash infusion. With this new capital in hand, you can focus on building inventory, filling orders, paying staff and vendors, and generating new business.
The final type of collateral we’ll cover here isn’t a tangible asset, like the previous four types of collateral are. A “lien” is actually a legal claim that’s attached to a business loan, and it allows the lender to sue the business and collect their assets in the event of a default. The assets can be specified, or not.
As you can probably guess, a “blanket” lien is the most comprehensive of its kind—and the most favorable for the lender. Blanket liens give a lender carte blanche to seize every asset and form of collateral a business owns in order to satisfy its debts.
Although blanket liens provide plenty of protection for lenders, they can be onerous for borrowers. The clearest risk here is that blanket liens expose you to the possibility of losing everything you own.
Also, liens can make securing a new loan in order to satisfy other debts more difficult. Lenders want to be in the “first lien position,” which means that they’re paid off first in case they need to liquidate your assets. If an existing lender has filed a lien on your assets, any additional lenders you work with are bumped down a spot, and they’ll only be paid after the first lender.
Of course, the likelihood that a lender in the second or third lien position would be fully repaid in case of default is much lower—and the overall risk involved for the lender a lot higher. So, the presence of a blanket lien could make subsequent loans from new creditors extremely expensive—or impossible to get.
To fulfill your business’s true potential, you need to kickstart your growth—but you can’t prompt that growth without capital. Luckily, small business lenders help bridge that gap by providing the resources a company needs.
As you know, though, small business loans don’t come for free. In addition to a strict vetting process, many lenders require that the borrower offers up their assets to secure their loan. That collateral lowers the risk to the lender, ensuring that they’ll receive everything they’re owed even in the worst-case scenario of loan default.
As a refresher, five of the most common types of collateral include:
Some of these types of collateral are more desirable for lenders than others—namely, the collateral that’s the most valuable, and which lenders can quickly liquidate to recoup for cash. And some of these types of collateral, like inventory or invoices, aren’t realistic options for the businesses that simply don’t have these assets to hand.
Ultimately, what can be used for collateral to secure a loan is contingent upon the type of loan you’re applying for, your business’s valuable assets, and what your lender considers, and accepts, as a valuable asset.
As a borrower, it’s important that you carefully consider the ramifications of offering collateral to lenders. Fully explore the risks involved with placing assets up for collateral, and the consequences that would follow in the event of a default.
Better yet, only sign on for the loan that you’re certain you can repay, so you don’t need to worry about risking your assets at all. If you’re not quite sure what that loan entails—collateral included—work with a loan specialist to help you out.
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