Collateral Is King for Business Loans
June 1, 2011
If you're in the market for a loan, understand the role that collateral plays in your chances of successfully getting the funding you need. According to the MultiFunding National Lending Snapshot for the first quarter of 2011, nearly half of all small businesses (47%) are considered "B" borrowers because they don't have assets backing their businesses and won't qualify for traditional loans.
Small business loans today
Loans for small businesses today fall into two categories: collateralized loans (called secured loans) and other forms of lending that do not involve collateral (called unsecured loans). SBA loans require collateral, as do most conventional loans currently available to small businesses.
Without collateral, alternative funding must be pursued. Alternative funding includes accounts receivable funding (e.g., factoring), merchant cash advance loans based on credit card receipts, and personal (unsecured) loans (usually limited to $25,000). Alternative funding options usually are more costly than secured loans.
Collateral is something tangible that's pledged as security for the repayment of a loan. If the loan is not repaid, the lender can obtain the collateral as a replacement for the outstanding debt. Collateral can belong to the company or an owner who owns at least 20% of the business and, therefore, is required to give his or her personal guarantee.
The best collateral sought by small business lenders usually is real property -- an owner's residence, a factory, a strip mall, or other developed property. But the full value of the property isn't the amount viewed as collateral. The lender applies a discount.
Example: An owner's home is worth $1 million and has an outstanding mortgage on it of $200,000. The lender discounts the net value (what the home would sell for now minus any existing mortgages) by 20% or so. Thus, the $1 million property is treated as collateral of $640,000 ($800,000 -- 20% discount).
The 20% discount for residences and other developed property applies for SBA loans; other lenders may apply a 25% discount for such property. In the case of raw land, the discount generally is 50%.
Other collateral may include heavy equipment, machinery, and office furniture and fixtures. In this case, however, the discount generally runs about 50% of the item's auction value (what the item would fetch at auction). Thus, a piece of equipment that originally cost $250,000 and would bring about $100,000 at auction would only be treated as collateral of $50,000. The 50% discount applies to new or practically new items; the discount is as much as 80% for used items.
In the case of stocks and bonds, the discount may run 10% to 50% of the market value. Certificates of deposit and savings accounts are valued at 100%. Mutual funds, however, typically are not treated as collateral. For securities, the lender may take possession until the loan is repaid.
Whether inventory can be collateral depends on what it is or what materials is it made of. If inventory involves perishables, then it won't be treated as collateral.
Also usually not treated as collateral are:
Resource: SBA's What Is Collateral?