Using Collateral to Back Small Business Loans

Every business needs financial resources to launch and sustain commercial operations. From the money spent building-out facilities, to staffing expenses and outsourcing costs; business spending typically starts before the first sale is made. Without access to cash, a business may not be able to hold on long enough to achieve profitability. Fortunately for startups and established businesses, various capital resources are available, addressing diverse commercial spending concerns.

In much the same way mortgage loans are secured by real property, banks often call for collateral when extending commercial finance offers.

How Does Collateral Help Me Get a Business Loan?

Whenever you apply for commercial funding, lenders assess your creditworthiness. The review includes thorough vetting of your business finances as well as a close look at your personal credit history. In addition to your business balance sheet and commercial credit rating, lenders also consider revenue and equity contributions, before approving commercial loans. Depending upon conditions reviewed, collateral may be required.

Loans backed by real property and other assets are “secured,” whereas commercial financing that is not guaranteed by collateral is considered “unsecured.” Collateral effectively serves as a secondary payment method for making good on the loan. Though creditors would prefer not to take ownership of assets as a repayment substitute, property provides a fallback recovery option against loan default. Whether you are a sole proprietor, limited liability company, or corporation, you can use collateral to back business loans.

When you agree to terms for commercial financing, you should expect everything you buy with the loan proceeds to serve as collateral. Examples of commercial collateral include:

• Real Estate
• Equipment
• Inventory
• Accounts Receivable
• Cash
• Deposits

Personal assets can also be presented as collateral. For instance, small business founders and sole proprietors may choose to take second mortgages on their homes, in order to finance entrepreneurial endeavors. Putting assets at risk is one way to secure financing, but commercial funding alternatives are also offered without collateral requirements. 

Securing Loans and Mitigating Risk

A recent Inc. article explored the ins and outs of commercial funding, including ways to use assets to secure loans. According to the author, asset-backed funding provides fast access to commercial capital, but care should be taken when utilizing this type of financing. As a secondary means of repaying your loan, it is important to be realistic about the potential for default – you will forfeit your property if you don’t meet repayment obligations.

Before putting assets at risk, you may wish to consult a financial advisor familiar with credit contingencies. It is also important to discuss the prospect with partners, family members, and other people who might be affected by the credit outcome. Your spouse, for instance, has a stake in the game, when a house or other jointly owned asset is considered for collateral.

Establishing exactly how you’ll spend the money, as well as identifying desired returns from the investment, can help increase the likelihood of a successful lending outcome. Forming a limited liability company (LLC) is one protective strategy adopted by small business entrepreneurs, insulating them from potentially negative credit impacts. Though the move is prudent in many cases, defaulting on a loan for your LLC may still have personal financial repercussions.

Accurate Valuation

Banks and business owners assess property values from different vantage points. Small business operators tend to overvalue assets, while creditors may assign substantially lower values to business collateral. When they are crunching numbers for commercial loans, business owners commonly consider the original cost of an asset. Banks, on the other hand, start with the present day value of an asset, depreciated to reflect an item’s prevailing fair market value in today’s dollars. Since they must also spend money to recover assets in the event of default, banks shoot low with valuations, accounting for the cost of marketing and selling recovered items used as collateral.

Keeping detailed records about the value of assets is recommended, showing creditors your balance sheet accurately reflects financial conditions impacting your organization. If you’re unsure of the value of an asset prior to seeking a loan, conducting an independent appraisal may be worthwhile, giving you an accurate idea of how banks might value the property.

Utilizing Assets

Various assets can be used as lending collateral; items typically fall in to two categories: assets you own and assets already leveraged by financing. If you put your house up as collateral with a mortgage attached, your mortgage lender gets paid-off by refinancing with your new lending partner and claiming title to the property.

A title of ownership is an important consideration for lenders evaluating collateral, because the document creates a clear designation and allows lenders to take the title back. As a result, common collateral includes cars, homes, motorcycles, boats, and business equipment identified by a title of ownership.

• Real Property – Equity in your home can serve as collateral. Among the most common assets put up by business borrowers, homes don’t necessarily provide the same access to commercial capital as they did before the financial crisis. When the housing bubble burst, many owners experienced equity losses, limiting the collateral function of real property. Though your primary home or vacation property may qualify as collateral, most lenders do not consider vacant, undeveloped, land a suitable form of collateral.
• Savings – Personal savings serve as a good source of collateral, because deposits represent low risk for lenders. The upside of using savings, CDs, and other cash equivalents for business funding collateral includes low interest rates on loans secured by cash. The downside, of course, is that you’ll lose your nest egg should the lender be forced to pursue recovery, following default.
• Inventory – When you use a commercial loan to buy inventory, the goods can sometimes be used as collateral. The strategy is somewhat limited, because banks are not in the business of selling whatever it is that you sell. If you’re unable to generate enough sales to pay back your business loan, lenders may also have trouble unloading the goods to recover money, following default. Under some conditions, inventory is used in conjunction with other types of collateral, jointly backing the loan.
• Receivables – In the course of doing business, your company may land purchase orders that require additional resources to fill. When you need to hire staff or invest in raw materials to accommodate an order, banks may be willing to consider receivables a viable form of collateral. In additional to lending against a large purchase order, some creditors may also allow you to borrow money based upon unpaid invoices. The arrangement is more complex than some other collateral loans, but the money you have coming from customers may be enough to secure commercial funding.

Loans secured by collateral provide adaptable financial resources for business borrowers. When you need money to launch a business or working capital to facilitate growth, consider collateral loans for flexible access to commercial funding.