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Understanding and Using Collateral for Secured Business Loans

By Kristina Russo

When small businesses apply for debt financing they often must pursue a secured business loan, which makes collateral a critically important part of the discussion.

In fact, a 2016 Federal Reserve study found that, among firms with less than $1 million in revenue, unproven firms, and businesses/business owners with poor credit history, 67 percent of small business loan terms include collateral.1 And 45 percent of all U.S. small businesses do pursue business loans, whether to fund expansion, meet working capital requirements or even refinance other debts, according to the Fed study. Further, the Fed noted that 49 percent of small business loans are secured by business assets while another 38 percent are secured by owners’ personal assets.

 

This article explores the different types of collateral used to secure business loans and significant aspects of collateralization small business operators may need to know in order to meet business loan requirements.

 

What is Collateral?

 

Collateral is any asset owned by a borrower that is pledged to secure a loan. The process of doing so is called collateralization, and it helps safeguard a lender against the loan’s risk. If a borrower defaults, the lender has the right to seize and liquidate the collateral to recoup the loan’s balance. Securing a business loan with collateral may enable a small business to borrow a higher amount; get a loan that would otherwise be rejected; or enjoy a reduced interest rate. Of course, lenders always prefer loans be repaid in cash according to the loan terms, so seizing collateral is always a secondary method of repayment.2

 

Types of Collateral for Secured Business Loans

 

Broadly speaking, secured business loan requirements call for collateral that comes in two categories: assets usable in the small business (inside collateral) or personal assets of the owners (outside collateral). It can take many forms, including real estate, machinery, investments, bank accounts, insurance policies, customer contracts, accounts receivable, and inventory.3 For example, specialized “invoice financing” loans are available to small businesses that wish to leverage their accounts receivable. The asset can be owned outright or, if partially owned, the owned portion of equity value can be used as collateral.

 

From the lender’s viewpoint, assets that have an easily identifiable value and are more liquid, like cash accounts, are more desirable as collateral.

 

For the borrower, deciding which assets to use as collateral to secure a business loan is more complex. Using personal assets, such as homes, valuables or vehicles, can have significant lifestyle consequences if the business defaults on the loan. Similarly, potential loss of a key business asset, such as manufacturing equipment, could close the business.

 

Collateral Valuation: Part Art, Part Science

 

Valuing collateral for a secured business loan is part science and part art. The valuation process typically begins with independent, expert appraisers determining an asset’s fair market value in accordance with industry regulations, if any.4 Appraisers choose from several methods to determine a fair market value, including what the asset has recently sold for in similar transactions, what it would cost to replace it, and the asset’s income potential.5

 

The fair market value is then discounted, or “haircut,” to reflect potential volatility in the fair market value. Haircuts are generally expressed as a percentage of the asset’s fair market value.6 Volatility can result from many sources, including disparities among the various appraisal methodologies, the time and cost to liquidate the asset, and possible lost value if that asset must be liquidated quickly.7 Forced liquidations can result in discounts up to 50 percent.8

 

The Loan-to-Value Equation

 

Even after a haircut, lenders generally don’t even offer secured business loans of 100 percent of the collateral’s discounted value. Instead, lenders determine the amount as a percentage of the collateral’s haircut value, with more desirable collateral garnering a higher loan-to-value ratio. Each lender utilizes its own calculation of loan-to-value, which can range from 50 percent to as much as 98 percent.9

 

In cases where lenders plan to bundle multiple secured business loans into sellable securities, they may require “overcollateralization” – i.e., their small business loan terms require pledging more collateral than the loan amount. Overcollateralization can enhance the credit rating of resulting securities because it lowers investors’ exposure to default risk.10

 

All these complex factors – conservative collateral valuations, overcollateralization requirements, and loan-to-value ratios – contribute to why small businesses sometimes find it difficult to borrow what they need. In fact, according to the Fed study, 31 percent of small businesses that had a shortfall in financing requirements were denied funds due to insufficient collateral.11

 

When a Secured Business Loan Defaults

 

When a business fails to meet agreed-upon repayment terms, the loan can go into default. How quickly a loan goes from delinquent to default depends on the lender’s policy. These policies are based on what the lender considers acceptable limits for collection effort and cost to remedy delinquent payments. Default classification generally means the lender believes a delinquency is permanent.12

 

One recent study by Nerd Wallet asserts that 17.4 percent of the 1 million secured business loans backed by the Small Business Administration between 2006 and 2015 defaulted.13 Most often, those loans defaulted after 4.7 years.

 

Default can also be triggered if the collateral is sold, stolen, or if its value is impaired somehow. In these cases, the lender may require additional assets be pledged to restore the loan-to-value ratio.

 

Collateral is seized when a loan goes into default. The collateralized assets have a lien on them, enabling the lender to sue for the asset in court. Once the assets are liquidated, the borrower may still be responsible for any remaining loan balance.

 

The

Takeaway:

Most small businesses will require debt financing at some point in their growth trajectory. Securing a business loan with collateral can be a critical determining factor that helps a small business attain the amount they need – and at attractive terms. However, pledging collateral comes with risks to the small business, especially in the event of a default.

Kristina Russo

The Author

Kristina Russo

Kristina Russo is a CPA and MBA with over 20 years of business experience in firms of all sizes and across several industries, including media and publishing, entertainment, retail and manufacturing.

Sources

1. Small Business Credit Survey Report on Employer Firms, Federal Reserve Bank of New York; https://www.newyorkfed.org/medialibrary/media/smallbusiness/2016/SBCS-Report-EmployerFirms-2016.pdf
2. “What is Collateral and How Does it Work,” The Balance; https://www.thebalance.com/collateral-loans-315195
3. Ibid.
4. “Collateral and Credit,” U.S. Small Business Administration; https://www.sba.gov/offices/district/nd/fargo/resources/collateral-and-credit
5. “Collateral Evaluation Methods. What is a borrower’s collateral worth?,” Smith & Howard; http://www.smith-howard.com/resources/articles/collateral-valuation-methods-what-borrower’s-collateral-worth
6. “How Much Collateral Do You Need for a Business Loan?,” Value Penguin; https://www.valuepenguin.com/small-business/how-much-collateral-business-loans
7. “What is a Haircut?,” International Capital Markets Association; https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/repo-and-collateral-markets/icma-ercc-publications/frequently-asked-questions-on-repo/21-what-is-a-haircut/
8. “Collateral Evaluation Methods. What is a borrower’s collateral worth?,” Smith & Howard; http://www.smith-howard.com/resources/articles/collateral-valuation-methods-what-borrower’s-collateral-worth
9. “How Much Collateral Do You Need for a Business Loan?,” Value Penguin; https://www.valuepenguin.com/small-business/how-much-collateral-business-loans
10. “Overcollateralization- OC,” Investopedia; https://www.investopedia.com/terms/o/overcollateralization.asp
11. Small Business Credit Survey Report on Employer Firms, Federal Reserve Bank of New York; https://www.newyorkfed.org/medialibrary/media/smallbusiness/2016/SBCS-Report-EmployerFirms-2016.pdf
12. “How to Avoid Defaulting on a Business Loan,” Merchant Maverick; https://www.merchantmaverick.com/avoid-defaulting-business-loan/
13. “1 in 6 Small Business Administration Loans Fail, Study Finds,” NerdWallet; https://www.nerdwallet.com/blog/small-business/study-1-in-6-sba-small-business-administration-loans-fail/