5 Tips for Using Collateral to Secure a Small Business Loan
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: collateral.
Collateral assets come in many forms. Defined by the Small Business Administration, collateral is "an additional form of security which can be used to assure a lender that you have a second source of loan repayment." Most commonly, collateral is real property (i.e. 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 up as collateral to the bank. 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.
Below are a few tips on how you can use your assets as collateral, and how you can mitigate the risks associated of defaulting on a loan.
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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 of what your assets might be worth, it could be worthwhile to find an independent appraiser to give you an idea of how the bank will value your property.
Besides for simply knowing your asset's worth, it's 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."
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2. Know What You Can Use as Collateral
Essentially, there are two different types of collateral: assets that you own, and assets that you still have a loan against. If you still have a loan on the asset, (e.g. a mortgage for a house) the bank will be able to recoup the loan by refinancing your loan from the institution you have the loan against, and claim 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 that you should 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 its referred to in banking, as viable collateral.
Business Inventory and Accounts Receivable: Asset-based lending can be a great way to get a fast influx of cash to your business. For example, 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."
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 possession of your savings.
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3. Understanding the Risks
Taking a loan using personal assets as collateral presents the risks of losing the assets in the event that 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.
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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, a business can always reject a lender's offer and seek a loan from a different lending institution.
Since banks tend to be exceptionally conservative when it comes to valuing your assets, it could be worthwhile to request an appraisal review, which is a report that comments on the accuracy of an appraisal. Similarly, a bank that does not require any collateral requirement will often charge extremely high interest rates. Be wary of predatory lending practices that could end up being expensive and harmful to your business.
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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. Peer-to-peer lending is becoming an effective way for small businesses to drum up cash in the short run. "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
While loans typically amount to less than $25,000, there's often less red tape involved in obtaining a peer loan. Prosper.com, for example, allows borrowers to choose a loan amount, a purpose and then post a loan listing. Then, investors choose which loans they prefer to invest in based upon a series of criteria. Borrowers make fixed monthly payments to their investors, who receive the funds directly in their Prosper account.
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