Surviving the first few years as a small business requires reliable access to funding from a loan or other financing option. You can use loans to buy inventory, fulfill payroll for employees, or complete necessary functions for daily business operations.
Business loans help you get your business off the ground, but getting loan approval from a bank or lender without adequate collateral can be challenging. As a borrower, you must prove to lenders that taking a risk on your business will always have a favorable outcome.
Personal and business assets can back you up as collateral when applying for a small business loan, but putting up collateral for business loans can always be risky for budding entrepreneurs.
What Is Collateral?
Put simply, collateral is an asset that has value. Collateral can include the assets of a business or the owner, but not every asset can function as collateral when applying for business financing or loans.
In fact, not all loans require you to offer assets as collateral. Collateral can be valuable when securing loans because it acts as a guarantee to lenders, but it can also be a considerable risk to you as a borrower.
Does Collateral Impact Eligibility for a Business Loan?
Small business lending is a volatile industry, so lenders always look for ways to reduce the related financial threats of providing a loan. Although you don't need collateral to apply for all small business loans, securing the loan you want with the best terms can be helpful.
Lenders primarily require collateral for small business loans to protect themselves from potential risks. Small business loan collateral guarantees your lender that they won't lose any money if a borrower fails to repay the loan.
However, not all small business loans are created equal. Each loan or financing product in the marketplace will likely have individual requirements and credit standards. Some small business loans require collateral, while others do not.
A secured loan is a business financing option that requires collateral before approval. Alternatively, unsecured loans are also available, which do not call for any kind of collateral. With unsecured business loans, lenders will likely base loan amounts on the borrower's creditworthiness. Banks and online lenders typically consider the following factors:
- Personal credit score
- Business credit score
- Time in business
- The overall financial health of the business
- Cash reserves
If you have a less-than-stellar credit score, spotty credit history, or haven't been in operation for long, qualifying for certain small business loans can be challenging. Using collateral to prove your personal and business creditworthiness can increase your chances of obtaining some advantageous small business loans.
Do You Need Collateral For A Small Business Loan And How Much Do You Need?
The amount of collateral required will ultimately depend on the kind of small business loan you seek and the loan-to-value ratio, or LTV. The LTV is the loan amount you receive based on your collateral's value.
For example, if you offer your lender collateral real estate worth $100,000, and they give you $80,000 in return, the LTV is 80%. So, the more collateral you can bring to the table, the better your chances are of receiving significant money from your small business lender.
"The Five C's" of Financial Health
When applying for a loan for your small business, banks and other lenders will first look at a few common financial health indicators, regardless of the collateral you can offer. These financial health indicators are often called "The Five C's."
Knowing where you stand financially is essential before attempting to secure a business loan from a bank, credit union, or online lender. "The Five C's" that banks and lenders will consider before approval include:
- Credit history
- Capacity for Repayment
- Conditions (interest rates, terms, loan amounts, etc.)
Depending on your financial standing and the lending product you're seeking, you may need to supply more assets as collateral compared to other small business loans. We'll dive deeper into that subject below, but first, we must learn about the acceptable assets business owners can use as collateral for a business loan.
Kinds of Collateral Commonly Used for a Small Business Loan
Collateral is assets with value, but like business loans, not all kinds of collateral are created equal Lenders value some assets more than others, and certain assets cannot be used as collateral to secure business loans or financing.
From a lending standpoint, the best kinds of collateral are those things that can be quickly liquidated or converted into cash. The majority of lenders look for the following forms of loan collateral:
Cash and Securities
The best collateral you can provide for a business loan is cash or assets that quickly convert into real money, called liquid assets or cash equivalents. Cash collateral for loans is all cash and equivalents your creditor collects if you or your business ultimately file for bankruptcy.
Some examples of cash equivalents or business securities include:
- Treasury bonds
- Corporate bonds
- Certificates of deposit (CDs)
- Accounts receivable collections
- Cash from the sale of:
Another popular form of collateral many small businesses put up is physical properties. This can include anything from real estate and land to vehicles or equipment. Using property as collateral is prevalent in many industries, enabling small businesses to successfully obtain term loans, equipment financing, or other business funding options.
When providing property as collateral, lenders will evaluate what your assets are worth. Their loan amount is typically a percentage of the total property value. Since you likely want to get the largest loan sum possible, scheduling an appraisal is essential.
An appraisal is a professional estimate of the value of your assets. Real estate appraisers help ensure your personal and business assets are appropriately valued before providing collateral to a lender.
Another option business owners can consider is using future earnings as collateral. Unpaid invoices, otherwise known as your accounts receivable, can act as collateral for certain secured small business loans.
Some loan options will require business owners to provide personal assets as collateral. These pledged assets can include your home or a vehicle. Loans obtained through the Small Business Administration (SBA) most often require personal collateral when a company can't meet the current business asset requirements.
Breaking Down Collateral Requirements by Small Business Loan Product
As mentioned above, all small business loan products will have individual collateral requirements on top of separate paperwork and credit standards. Different financing and loan options can come in handy depending on your business's needs. Whether you want access to cash flow for new inventory and machinery purchases or are asking for a loan to expand into an additional location, you must prove your creditworthiness as a borrower.
Collateral can help you secure the loan your business needs by guaranteeing a bank or online lender that they won't lose money. Below, we look at the various kinds of collateral accepted for several popular small business loan products and the individual loan-to-value ratio of each option:
1. Term Loans for Small Businesses
Term loans are great for just about anything, ranging from short-term cash flow issues to long-term investments in real estate and business expansion. There are a few different kinds of business term loan products that borrowers can choose from, including:
- Long-term business loans
- Short-term business loans
- Traditional bank term loans
- Business acquisition term loans
- SBA term loans
Term loans are an excellent option for purchasing inventory, machinery, or property. Plus, business owners can utilize the cash from term loans for employee payroll needs. Assets like inventory and real estate are most often used to secure a term loan. The loan-to-value ratio when using inventory as collateral for term loans is typically up to 80 percent.
2. Invoice Financing
Invoice financing or factoring utilizes your business's unpaid invoices as collateral, so you don't have to wait for improved cash flow. Customers can fulfill their outstanding debts to invoice factoring companies themselves, while the company gives you fast access to cash upfront.
Although the future earnings of your business act as collateral, most creditors only offer a loan-to-value ratio of up to 80 percent for these agreements.
3. Equipment Financing
Equipment financing is a fantastic choice for companies in certain industries requiring specialized machinery or vehicle fleets to complete projects or provide services. Although in reality, any business can take advantage of equipment financing for purchasing computers, printers, copiers, and other machinery required for daily operations.
With equipment loans, the loan amount you receive covers the costs of machinery, repairs, upgrades, and maintenance. Failure to repay this type of small business loan can result in losing any machinery bought with the funds or the cash from selling said machinery since the equipment is acting as collateral. With the equipment as collateral, the loan-to-value ratio is typically 100 percent.
4. Small Business Administration (SBA) Loans
Like the other term loans listed above, the SBA offers term loans to businesses needing financial support. The primary goal of SBA loan programs is to connect small business owners nationwide looking for long-term financing options with approved lenders and excellent terms.
The SBA is not a lender, but the agency sets guidelines, eligibility requirements, and qualifications. Instead, SBA-approved creditors accept SBA loan applications with or without collateral, for programs including:
- The 7(a) Loan Program
- The Small Business Microloan Program
- The CDC/504 Loan Program
You can offer real estate assets as collateral for the various SBA loan programs. SBA-approved lenders offer loan-to-value ratios of up to 90 percent when you provide real estate as collateral.
Figuring Out the Fair Market Value of Your Assets
Once you've determined the type of business loan that will be the most advantageous for your organization's needs, it can be easy to want to jump straight into loan applications right away. However, it's essential to determine the fair market value (FMV) of your assets.
FMV is the selling price of a business, property, or other assets in an open and competitive market. FMV is calculated based on a market where buyers and sellers are assumed to have all relevant facts, information, and the necessary time to complete a deal of their own volition.
The FMV of your assets helps lenders evaluate what your collateral is worth. It's also essential to ensure you get the largest loan amounts to meet your business needs. There are four primary ways to determine the FMV of your personal and business assets:
- Purchase cost or selling price - the price of an item that has recently been bought or sold
- The selling price of comparable assets - recent sale prices of similar assets, such as homes of equivalent sizes or cars of similar costs
- Replacement cost - how much it would cost to rebuild or rebuy a similar asset
- Expert opinions - professional appraisers provide an expert valuation of assets like real estate
Typically, your assets should be valued at the exact amount you ask to borrow from a lender. However, some lenders might require your FMV to be above your loan's asking amount to reduce their risk.
What’s Next On Business Financing with Collateral?
After working with a professional appraiser to figure out the FMV of your personal and business assets, it's time to start your small business loan applications. As a borrower and business owner, sometimes you need collateral to back up your creditworthiness with conventional lenders or online lending platforms, even if there's always an associated risk.
Collateral can have a significant impact on your small business’s approval rates for loans and financing from banks and other lenders. Work with a trusted lending partner like AdvancePoint Capital to secure loans that minimize the risk of losing your collateral.