There are few steadfast rules when it comes to growing a small business. However, one of them is this: You need cash to grow. There’s no way around it—no matter your industry or what type of business entity you own, reliable access to cash is a must to get your operation off the ground.
Thankfully, affordable business loans provide an easy option for accessing working capital during the early stages of your business’s growth. However, banks can be picky when it comes to issuing loans.
This is where the importance of business collateral comes into play. If your business meets the criteria for a bank loan, chances are you will have to secure the loan with collateral. Sound intimidating? It shouldn’t be. In this article, we’ll walk you through the ins and outs of putting up business collateral so you can get the working capital your company needs to grow.
What Is Business Collateral?
Lenders assume considerable risk whenever they hand money over to a business looking to grow or scale. For creditors to mitigate the risk of lending, they require business collateral to “secure” the loan against the risk of default. Collateral is an asset that a borrower provides to a lender as a means to secure a loan.
Even though lenders take every precaution possible to vet applicants to allow only the most creditworthy borrowers, most banks will still insist that business owners offer collateral to hedge the inherent risk of lending.
In other words, an impressive credit history, positive cash flows, and other attractive attributes aren’t enough to bypass a bank’s collateral requirement. No matter your small business’s history, chances are you’ll need to set aside a lump sum of cash (or other assets) to get approved for a business loan.
What’s Used as Collateral?
There are several types of collateral for loans that range across several asset classes. Whenever we’re asked, “what can be used as collateral for a business loan” we’re tempted to say “whatever can be liquidated fast,” because banks and lenders need collateral that can be quickly converted into cash. That’s why cash itself is preferred over most other forms of collateral.
Securities are another form of collateral in high demand among banks and other lenders. Forms of negotiable securities, such as those listed below, are acceptable forms of business collateral because they can be quickly bought and sold on capital markets:
- Treasury debt
- Certificates of Deposit (CDs)
- Corporate bonds
- Future earnings (invoices, accounts receivable)
Property and physical real estate is another form of collateral that is widely accepted by creditors and lenders. Although these “hard assets” are more difficult to convert into cash—not to mention their uncertain value—buildings, equipment, inventory, vehicles, and homes can all be used as forms of collateral after being appraised by an independent party.
SBA Loan Collateral
Do SBA loans require collateral? The answer, usually, is yes. Loans secured by the US Small Business Administration are secured by a government agency, and often require collateral to minimize the associated risk. SBA loan collateral is unique in that personal assets, like cars and salaried income, can be used as SBA collateral.
The Loan-To-Value Ratio
Your business loan’s loan-to-value (LTV) ratio provides lenders with a convenient, bite-sized assessment of the risk of approving a loan. The higher the LTV ratio, the riskier the loan is for the lender. Typically, an LTV ratio of 75 percent or lower results in an approved loan, although collateral for business loan approvals may be necessary.
Top Assets Used for Business Loan Collateral
Although some business loans have been secured with rather eccentric assets (such as parmesan cheese), most banks rely on these five common types of collateral for small business loans. If you’re in the market for a business loan, have at least one of these assets set aside to secure it.
When it comes to lending, cash is king. Although it may seem like a paradox to secure a cash loan with cash, a cash-secured loan is common. This is because cash-secured loans give lenders the ability to instantly recoup their losses in case you default.
Typically, a cash savings account held by the owner of the business (at the same bank) will be used to secure the loan. As a result, the creditor can quickly liquidate the cash in the applicant’s savings account immediately after they default on the loan. Consequently, cash-secured loans present a very low-risk solution for lenders.
On the other hand, allowing a lender to reclaim your life’s savings presents a high-risk opportunity. If you are forced to default due to outside circumstances, then your personal financial security can be jeopardized.
One of the unsung forms of collateral business owners can use is their company’s inventory. Of course, conditions apply when it comes to using inventory as small business loan collateral. For instance, the value of inventory usually depreciates—and some very quickly—which implies that the assets may have to be appraised by an independent third-party auditor.
Inventory financing is one of the most effective ways to use your business’s inventory as collateral. This financing option involves the business owner taking out a loan for purchasing inventory items that will later be available for sale. However, since the value of the inventory is uncertain and subject to volatility, some lenders are averse to offering inventory-secured loans.
When discussing what can be used as collateral for a loan, invoices are rarely mentioned. However, invoices are fast becoming one of the most popular ways to secure a loan for small business owners that don’t have enough cash on hand to back the loan.
Invoice financing occurs when lenders accept outstanding invoices as a form of collateral. For business owners whose credit score isn’t high enough to get approved for a loan, invoice financing provides a reliable option for locking down borrowed capital.
For those that need working capital as fast as possible to keep their businesses running efficiently, invoice financing provides a reliable option.
It can be hard to discern how much collateral for a business loan is necessary when discussing real property. However, home equity and real estate are some of the most common forms of collateral when applying for a business loan.
Be warned that, if you default on the loan, you may lose your home if you secure it with your existing home equity. Therefore, there is considerable risk involved whenever you back your business loans with real property. If putting up your real estate as collateral sounds too risky to you, you can lean on your vehicles and equipment as collateral too.
When most people ask themselves, what is collateral in business, they don’t think of a lien. A blanket lien is, in short, a legal right granted by the owner of a property to a second party to seize it in the event of default.
Technically, a blanket lien is a contract that affords the lender the right to reclaim the borrowed assets if the terms of the contract aren’t met. For this reason, blanket liens protect lenders but offer no protection to borrowers.
Borrowers considering taking out a loan backed by a blanket lien should be aware that most banks will refuse this option unless they are in a “first lien position.” In other words, creditors want to be the first lender to file a blanket lien on your assets. Otherwise, they will have the second or third claim on your assets if you default, which means they may end up empty-handed.
Finding Your Best Option for Collateral
No borrower should assume that a secured business loan is automatically the best option for them. While it can be convenient, it can also present a great deal of risk if you default on the loan. However, those with poor business credit might have no choice but to agree to secure their loan.
Knowing how much collateral is needed for a business loan is mostly a matter of negotiating with your creditor. Usually, business collateral should be roughly equal to the value of the loan in question. From the list of five collateral sources above, prospective borrowers should consider using whatever they have on hand and can afford to lose more than any other.
To minimize the risk associated with putting up collateral, never offer collateral that you cannot afford to lose. If you secure your business loan with your personal real estate, not only does this put your business at risk, but your personal life as well. Therefore, prospective borrowers should always exercise discretion before using business collateral to secure their loan.