Brad Nakase, Attorney
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After growing up in her grandmother’s kitchen, enjoying the smell of fresh baked bread and pastries, Keira has finally opened up her own French bistro. While her restaurant’s food and service are excellent, the business side of things is harder to manage. Keira did not expect to face so many expenses. In order to prepare quality French cuisine, she has had to purchase top-of-the-line equipment. Because her bistro is located in a chic part of Los Angeles, she must also pay through the nose for rent. Add to that the cute tables, chairs, and décor, and Keira is in a tough spot financially. Ideally, she requires $50,000 in order to afford inventory and contribute to rent while the business seeks profitability. However, when Keira talks to a lender, she is told to provide collateral in order to receive a loan. Keira is worried. She does not know what assets can secure a loan. She is also concerned about not being able to pay back the lender. Will she lose her assets? Keira thinks about what she is willing to lose. She has an Audi SUV worth about $50,000. She decides that the care would be good collateral because she is willing to lose it in the worst-case scenario. Keira offers the Audi as collateral, which the lender approves. Keira receives her loan, and the business prospers.
When the owner of a business takes out any kind of small business loan, he or she is putting the company’s profits, reputation, and credit score on the line. It is a big decision with serious consequences, but the money can also be the reason a business succeeds rather than fails.
When a business enters into a secured loan, it offers up collateral as a way of guaranteeing payment. So, if a business owner asks for a loan worth $50,000, he or she must offer some asset that is valued at a similar amount. If the owner is unable to pay back the loan within the agreed-upon period, he or she will lose the collateral offered.
A business owner has options when it comes to choosing what collateral to risk. In fact, there are several types of business collateral that can be offered to secure a loan. That said, as is the case with any financial decision, there are advantages and disadvantages involved with choosing each type of collateral.
This article will review four different kinds of assets that may be used to secure, or guarantee, a loan. The discussion will also explore how one’s choice of collateral affects the future of a business.
One viable option for an entrepreneur is to use a home as collateral for a small business loan. Business lenders tend to look favorably upon real estate as a way to secure a loan. This is because real estate holds its value well. In fact, entrepreneurs may also benefit because real estate is typically worth a few hundred thousand dollars, which allows business owners to secure larger loan amounts and better loan terms.
That said, while real estate may be an attractive and convenient choice for collateral, it is also risky. For instance, if a business owner puts his or her primary residence as collateral, then defaults on the loan, he or she will lose their home.
An entrepreneur may also choose to offer other real estate, such as that used to run their business. However, this also presents a risk. If the business owner is unable to repay the loan on time, then he or she may lose the property. If the owner relies on this property for income, then this puts their business, as well as their livelihood, at risk.
However, if an entrepreneur owns real estate that is not critical to their life or business, then it may be worth offering to a lender as collateral in return for a sizeable business loan.
A business’ equipment may also be used as collateral to secure a loan. However, its viability depends on a few key factors.
First, a business owner will need to think about the value of the equipment, not only its price. For instance, heavy machinery might be technically valuable due to its expense. However, if it is difficult to find a buyer for the particular machinery, then it is unlikely to be valuable to a lender.
Computers and hardware are poor choices to offer as collateral. This is because this technology quickly becomes obsolete, and its value therefore depreciates over time.
That said, if a business owner is only looking for a small loan, then equipment may be a valid option to use a collateral. A business owner should, however, consider whether the business can function without the equipment. For example, let’s say the owner of a restaurant uses their kitchen’s fancy French stove as collateral. The owner then defaults on the loan, and the bank seizes the stove. The kitchen relies on that equipment, and the business suffers as a result.
In addition, if an entrepreneur takes out an equipment or auto loan, the machinery that he or she purchases using the loan will be used as collateral. If the business owner then fails to pay back the loan, the lender will seize the equipment or machinery.
Inventory is one of the most common forms of collateral that business lenders will accept. When a lender evaluates inventory as collateral, he or she will consider liquidation value and future depreciation. Because of this, the cost and amount of a loan will vary from lender to lender based on how they value the inventory.
When a business owner offers inventory as collateral, they again risks losing it if they default on the loan agreement. This can create a difficult situation if the business already has other debts, such as credit card debt.
If a business owner cannot repay the loan, then the inventory will be seized. As a result, the business owner may struggle to do the following:
Waiting for payments on outstanding invoices presents a common cash flow problem for small business owners. However, an owner can make use of these unpaid invoices by offering them as collateral for a business loan. If a business owner decides to use invoices as collateral, he or she will receive cash from a lender in exchange for the outstanding invoices. This arrangement is also known as invoice financing.
In this arrangement, a business owner will receive cash upfront and will not have to worry about waiting to receive the cash from the invoices. That said, the business owner will still have to pay fees or other expenses to the lender. This means that the business will make less money than it would have if the owner had simply collected the invoices themselves.
In addition, the loan amount will top out below the total value of the invoices. As a result, there is a cap on how much a business owner can borrow using this method.
In general, it is not easy to decide what type of collateral to offer in order to secure a loan. However, the decision is made easier once a business owner assesses what he or she is willing to lose. Whatever personal or business assets an entrepreneur uses as collateral, he or she will need to be content with the possibility of losing those assets. This is true even if the chances of default are fairly low.
After a business owner determines what he or she is willing to lose in the worst-case scenario, they can then narrow down their choices based on what amount the business requires, as well as what terms are most likely based on the collateral. For instance, if a business needs a loan of $100,000, the owner’s mid-tier SUV is not worth enough to serve as collateral for such a large loan. If, however, the owner has a beach house, then this might serve as more suitable collateral.
Once a business owner understands his or her needs and risk tolerance, as well as the limits of different kinds of collateral, it will be easier to decide on what type of collateral is best for the business.
It is also important to remember that a business owner may also apply for an unsecured loan. An unsecured loan does not have to be guaranteed by any collateral to be approved. Rather, a business owner might need to offer a personal guarantee.
However, unsecured loans are often for smaller amounts of money and are difficult to qualify for. This is especially true for individuals with a bad credit score, or whose businesses have a bad credit score. In general, a poor financial history will be disqualifying.
In the end, it is important to think about both secured and unsecured loan options, according to what best suits the business.
Learn more about: Business | Corporate | Employment Law
See all articles: Business | Corporate | Employment
See all articles: Business | Corporate | Employment