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. There are risks involved with taking on debt, but those risks are definitely acceptable if you need capital to unlock the full potential of your business.
Lenders, though, need to attend to their own interests, so they’ll rigorously vet the viability of any borrower to minimize the odds of a loan default. They’ll also typically ask for some form of collateral from the borrower to help secure the loan. Though small business lenders have eased their requirements slightly following the 2008 recession, personal collateral is still critically important when attempting to secure financing.
With that in mind, let’s review 5 different types of collateral that business lenders might want to see when processing a small business loan.
Using real estate assets or home equity as collateral when applying for a small business loan is one of the most common approaches used by borrowers—and that’s because of availability. Many business owners have access to home equity, making it a natural and easy first choice, especially with U.S. home prices continuing to recover from their post-bubble collapse.
There are some important caveats, though: using real property as a collateral source can have devastating effects on your overall finances or net worth if the loan defaults. It’s important to understand all risks involved!
Don’t forget that equipment, cars, boats, motorcycles, planes, and so on can all also be used as collateral.
Another popular approach to collateral is inventory financing. Under this scenario, a business owner requests a loan to purchase items that’ll later be put up for sale. This inventory acts as collateral for the loan in case you’re not able to sell your products and, eventually, default.
Take note, though, that 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 more difficult to secure with some lenders.
Savings Secured Loan
Using cash in the way of a savings account as collateral is another move favored by lenders. Generally, you would apply for a savings secured loan (otherwise known as a “cash secured loan” or “passbook loan”) from the same bank where your account is, so it’s fairly easy to qualify. 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 riskier because you could lose your entire savings. And if you’re looking to build your credit score, be sure to ask your bank to report your payments to the credit bureaus, since smaller institutions don’t usually report cash secured loans.
When you’ve invoiced your customers but they’re slow to pay, this can cause some difficulty in running your operation—liking buying inventory or paying your employees. Many lenders will agree to accept collateral based on these outstanding business invoices—a process sometimes called accounts receivable financing. This is a good option for businesses that don’t have a strong credit score, because you don’t need perfect credit to get this type of loan.
While 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.
A lien is a legal claim that’s attached to a business loan allowing the lender to sell the assets of a business in the event of a default. 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.
While blanket liens provide plenty of protection for lenders, they can be onerous for borrowers. Not only do they expose you to the possibility of losing everything, they can also make securing a new loan in order to satisfy existing debts more difficult. Lenders prefer to be in the “first lien position,” so the presence of a blanket lien in that spot could make subsequent loans from new creditors extremely expensive—or impossible to get.
While growth is the key to fulfilling the long-range potential of any business, you can’t prompt that growth without capital. At some point, the opportunity cost that comes with being undercapitalized becomes so large that it compromises the future prospects of a business.
Small business lenders help bridge this gap by providing the resources a company needs to fill its potential. It’s important, though, that you carefully consider the ramifications of offering collateral to lenders. It’s important to fully explore the risks involved with placing assets up for collateral and the consequences that would follow in the event of a default.
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from Fundera Ledger https://www.fundera.com/blog/2016/02/18/5-types-of-collateral/