Using Business Assets as Collateral for Debt
Many small business owners use assets from their business as collateral when taking out loans or lines of credit. This allows them to leverage the value of equipment, inventory, accounts receivable, real estate, or other business resources to secure the financing they need to operate and grow their company.
How Using Assets as Collateral Works
The basic mechanism is simple:
- The business pledges an asset it owns as collateral for the loan
- If the loan payments are made on time, the lender has no claim on the collateral
- If the borrower defaults, the lender can seize and sell the collateral to recover their money
Lenders prefer lending against assets because it reduces their risk – if the borrower cannot repay, the lender has a “backup plan” to get their money back. Common types of business collateral include:
Equipment and Machinery
- Manufacturing equipment
- Tools, furniture
- Vehicles and fleet
Inventory and Accounts Receivable
- Raw materials
- Work-in-progress goods
- Finished goods inventory
- Outstanding invoices and accounts receivable
Commercial Real Estate
- Land
- Office buildings
- Retail stores
- Warehouses and factories
Intellectual Property
- Patents
- Trademarks
- Copyrights
Benefits of Using Business Assets for Collateral
Using assets as collateral to secure financing has several potential benefits:
More Available Funding
Pledging assets often allows a business to qualify for more lending or get better terms because the risk to the lender is lower. This “borrowing power” can be used to:
- Meet payroll and operating expenses
- Take on more inventory
- Expand facilities
Lower Interest Rates
Putting up collateral, especially tangible assets like equipment or real estate, may allow a business to get a loan with a lower interest rate – saving significantly on financing costs over the life of the loan.
Access to Capital
Some lenders may not provide financing at all without collateral – so pledging assets opens doors to capital that might otherwise be closed. This access to money can fuel growth.
Tax Benefits
The interest paid on loans secured by some types of business collateral may be tax deductible – providing a way to effectively reduce borrowing costs.
Risks of Using Business Assets as Collateral
While using assets as collateral has benefits, business owners need to carefully consider the risks:
Loss of Assets
If the business defaults on secured loans, the lender will seize and sell pledged assets. Losing essential equipment, property, or other resources could cripple operations.
Burdensome Terms
To secure loans against specialty assets like intellectual property or accounts receivable, lenders may impose strict requirements around paying down balances or collecting on invoices. This financial strain could hurt cash flow.
Cross-Collateralization Risks
If multiple loans are secured against the same collateral, defaulting on one debt could allow lenders to take assets pledged for other (performing) loans. This cross-collateralization can rapidly snowball out of control.
Opportunity Cost
Using assets as collateral ties up equity that might be invested elsewhere if it remained unencumbered. There is always an opportunity cost when pledging collateral.
Key Considerations Around Collateral
Business owners should keep several important factors and questions around collateral in mind:
Loan-to-Value (LTV) Ratio
- What is the amount of the loan relative to the appraised value of the asset? Lenders limit LTV ratios to control their risk.
Essential vs Excess Assets
- Which assets are mission-critical to daily operations? And which are unused extras? Only pledge excess collateral.
Security Agreements
- What specific rights does the lender have to take, sell, or dispose of collateral assets in a default scenario? Know the fine print.
Insurance Requirements
- What kinds of property, casualty, or liability insurance must be kept in place to protect pledged assets? Collateral must be insured.
Recovery Value
- If seized in default, how much could the asset realistically be sold for? Recovery values on used equipment or niche IP may be low.
Depreciation
- How quickly does the market value of the pledged asset decline over time? Depreciation reduces collateral value.
Getting Started with Asset-Based Lending
If you think leveraging your business assets as collateral is a good funding option, here are practical first steps:
1. Catalog and Value Assets
Make a detailed list of equipment, property, IP rights, and other assets. Estimate realistic current market values including depreciation.
2. Identify “Extra” Assets
Determine which assets could be pledged as collateral without hampering daily business operations if seized. Target non-essential assets.
3. Research Lending Options
Reach out to lenders like banks, credit unions, asset-based lenders, or alternative lenders to discuss financing against your assets.
4. Compare Loan Terms
Weigh factors like loan amounts, interest rates, repayment terms, collateralization rules, and default provisions to select the best loan.
5. Close Financing and Reporting
Finalize paperwork, secure necessary insurance coverage, collect funds, and put reporting procedures in place to satisfy lender requirements.
Using business assets as collateral carries risk but can be an effective way to fund growth. Being informed on the pros and cons allows owners to make smart financing decisions for their unique situation. With careful planning, pledging collateral can provide the capital and cash flow needed to build a company.
Resources
Additional Reading
- Secured vs Unsecured Business Loans
- Should You Use Business Assets as Collateral?
- Risks of Using Accounts Receivable as Collateral
Videos