Financing Using Collateral
Financing is easier to come by when the business has collateral with which to back the loan. This is one guarantee that the business gives as assurance that they can indeed cover the loan – through materials, receivables and other assets that hold value. This helps keep associated costs and interest as low as possible. Collateral is the key that unlocks the finance door for many savvy small businesses.
Smaller businesses generally have two options – an unsecured loan or a secured loan. For the business with no big brand or name, this means either outright refusal or punishing loan conditions of extremely high interest and inflexible terms.
How Using Collateral Works
Loans that use collateral to gain finance are relatively simple in their construction.
The business uses collateral – for example, accounts receivable, equipment or a property, and then makes scheduled payments of the principal – the amount borrowed, and interest.
The business and the lender agree the time frame of the payments beforehand and determine this by the life span of the collateral borrowed against. For example, a loan taken against equipment or receivables will have a shorter repayment schedule than property. This is because property will retain its value for much longer than equipment or accounts receivable, which will definitively become less valuable over time.
- A business uses collateral assets – property, receivables, equipment – and uses them to unlock finance
- The repayment period is determined by the value of collateral over time – a building will allow for a longer repayment schedule, equipment a shorter one
- For small businesses, borrowing against collateral makes sense to fund anticipated growth or if they do not have extensive credit and business history
Who Benefits from Borrowing Against Collateral?
Aside from the lenders themselves, small businesses can benefit in a number of ways from collateral-based borrowing. If done properly and with the right lenders, it can turn static assets like equipment and overdue receivables into an asset that works for the business without having to commit to the financial burden resulting from those conditions of unsecured loans.
Every business – from Apple to Nike and beyond, was once just a dream. Turning that dream from a small, perhaps one person, operation into something bigger takes time but, more importantly, it takes money.
The expenses facing a new business are often dizzying; computing hardware, manufacturing equipment, insurance, staff wages, and property overheads and so forth, often it can seem almost impossible to ever get a new concern off the ground.
This is because most start-ups have little or no credit or business history. Any loans manager will look at this and immediately ask, ‘But what collateral do you have?’
This could take the form of personal property, already purchased equipment or already attained receivables.
Borrowing against collateral is beneficial for a start-up because it allows for more negotiating power. The business can argue for the value of their collateral, thus borrowing more money at better terms than an unsecured loan. Simply put, collateral reduces risk, which reduces the balance to be repaid.
Many might think that a rapidly growing business, with good products or services and an expanding customer base, would have money thrown at them by eager lenders. However, the opposite is often the case.
A fast-growing business, even with much evidence to point to expected future success, still lacks what most lenders want to see – a long, detailed credit and business history. This is where borrowing against collateral can help.
The growing business needs finance to buy more equipment, hire more staff and buy better hardware – in short, to fund their expansion. Borrowing against the collateral they have accrued – which could be a fat stack of accounts receivable or their headquarters, lets them get this done.
Lenders are keen to lend to such businesses for a number of reasons. For one, they know that a growing business will likely be able to repay their loans in good time and, secondly, will likely prove good customers in the future. In this relationship, both sides win.
Companies with Debt
Such is the way of business that there are very few companies in the world who do not carry some form of debt. Some businesses, however, have more than others.
Some might assume that a business in debt would struggle to access any kind of finance, but this is not always true. Indeed, the debt of others can often become an asset.
A company with intermittent cash flow or seasonal highs and lows can use the debts owed to them – the accounts receivable for services or products they have rendered to customers, as collateral to access finance. This makes lenders much happier about the company’s own debt, as the lender can see the amount of money that borrower is owed, but does not yet have.
In a factoring agreement, for example, the factor will take these receivables and collect them, unlocking the unrealised finance beforehand for the business to use as they need.
For smaller concerns, raising finance is one of the biggest hurdles to growth. For many, it is a catch-22 situation – the business cannot grow with an injection of finance, but many lenders are very reticent to lend to smaller businesses. Without a storied and spotless history, many mainstream lenders – banks, for example, are still standoffish about offering finance in these still-shaky, post-recession days. They need to see something that will give them confidence to lay out that precious finance.