When you apply for a personal loan, the bank looks at your credit history and other factors to determine if you are likely to repay your debt fully and on time. Since the banks and other entities who lend to businesses are equally concerned about your risk as a borrower, they frequently ask for collateral. That is why it is important to learn what it is and what you can use as collateral on a loan.
What Is Collateral?
Collateral has long been one of the so-called “five Cs” that lenders look for in a potential borrower. These include the following:
- Character, including your management experience, your history as an owner and your reputation within your industry;
- Credit score. For bank loans, this should be above 680 while nontraditional lenders and the Small Business Administration (SBA) will often accept one that is slightly lower;
- Capacity. In other words, do you bring in enough cash to repay this loan?
- Capital. It helps to show lenders that you have invested some of your own funds in the business, especially if you can scrape together more than the loan amount. This demonstrates your long-term commitment to your business endeavor;
- Collateral. This consists of valuable assets that you pledge to turn over to the lender in the event that you default.
Particularly for startups and new entrepreneurs with sparse credit histories and no reputation in the industry yet, your willingness and ability to provide collateral may turn out to be the difference between being refused for a small business loan and receiving one.
What Can Be Used As Collateral?
Different lenders define collateral in various ways. Traditional banks, for instance, will only accept so-called secure assets such as equipment and real estate whose value can be recouped by selling them for loan repayment purposes. The SBA generally also requires collateral as a way to secure most of their loan types. However, there is a caveat: If you have inadequate collateral but everything else in your loan application looks good, the SBA will not reject your application out of hand.
Many lenders go along with the SBA’s definition of what can be used as collateral:
- Assets such as buildings, equipment, accounts receivable and inventory that can be resold;
- Personal assets outside of the business;
- All assets financed with borrowed funds
If the lender accepts your proposed collateral, they will then determine the loan-to-value ratio of that collateral. In other words, you may only need to borrow a percentage of the value of your collateral based on the nature of the asset involved.
General Lien On Business Assets As Alternative Collateral
If you are seeking a loan from a nontraditional source, you often have more leeway in how you can become qualified to get a business loan. In other words, many of these entities are willing to look more at factors such as your personal and business credit profile, the health of your company and the amount and consistency of your cash flow than the loan-to-ratio of specific assets. As a result, some lenders are willing to fund your company by requiring a general lien on your business assets combined with your personal guarantee that the loan is secure. Often, this extra flexibility makes it possible for entrepreneurs to get the monies they need faster and with less difficulty. Keep in mind, however, that you become inextricably linked to the fortunes of your company; if your company’s funds run out, the lender will immediately come after your personal resources.
Getting a financial shot in the arm from a bank, credit union or nontraditional lender is commonplace in the business world. Unless you are independently wealthy, it is unlikely that you have the funds on hand that you will need either to start a new endeavor, make it over some sort of challenge or hurdle or expand your company. Collateral is one of the factors that both you and your prospective lenders should consider as you move forward. Now that you understand the basics of how collateral is defined, you can take the next step on your entrepreneurial journey.