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Why Do Lenders Require Collateral?
Getting an unsecured business loan is nearly impossible these days
unless you are tremendously wealthy, a multi-national organization or
don’t really need the money. The one exception would be a government
bailout. Thus, collateral does matters.
However, banks and other lenders do not really want your collateral –
they are not in the collateral business – they are in the money
business. It is too costly for them to take ownership of such collateral
should your business default on payments. Traditional lenders even have
to fund allowance for loan loss accounts when the loan is funded and
write down the assets value on their books (not market value) when a
loan comes past due – all to reduce their losses against faulty
borrowers.
Since this seems so painful for lenders, why do they (lenders, banks,
financial institutions and other business financiers) require
collateral?
Most business lenders look for three (3) sources of repayment. The first
is always the business’s ability to repay the debt through cash flow.
Cash flow in this case means operating profits or the conversion and
sale of current assets (usually inventory) – operating cycle cash flow.
If the business fails to generate enough cash flow, the banks and other
lenders what to be certain that they are made whole – not just for the
repayment of the principle amount but for any lost interest, fees and
costs of taking and selling the asset.
To cover the possibility your cash flow will falter, lenders look at a
second source of repayment – which stems from the value of the
collateral.
Just for clarity, the third source is usually in the form of personal or
business (other businesses) guarantees for repayment.
Banks look for several criteria in evaluating collateral. First, the
appraised value. The appraised value has to, at the least, cover the
amount of the loan. Additionally, if lenders have to take your
collateral they will seek to liquidate it as soon as possible.
Therefore, they would expect your collateral to cover the amount of the
loan plus 20% to 50% depending on the collateral (the amount they would
lose should they have to fire-sale the asset(s)). This protects the
lender in several forms. First, should they realize substantial costs in
reselling the collateral, they are covered. Second, should the business
(borrower) have a large financial stake in the collateral – say 20% to
50% - it is less likely the borrower will just walk away from the loan.
Banks and other lenders also look at the type of collateral being
pledged. If the collateral can easily be sold in to many different
businesses, the better the lendability of the collateral. Take for
example a delivery van. Many businesses and industries use delivery
vans. Thus, the bank could reasonably believe that it could quickly
resell the van if it had to. Should the collateral be a special mold
injection machine that produces one unique product that only you sell,
then this asset may not be lendable – either requiring higher appraised
value, more down payment or denial of the loan. This really comes into
play with real estate. Raw land is very hard to lend against. Improved
land is better as it is more saleable as long as it is not improved for
a single purpose like a car wash facility or mobile home park. Office
buildings, warehouses, manufacturing spaces are the best because
multiple businesses and industries can utilize these types of real
estate – making them better for resell.
Additionally, banks and some other lenders, in order to protect
themselves from reduced future collateral value and other market risks,
will take a blanket UCC-1 filling on all business assets including
pledged and non-pledged collateral. This helps these lenders should the
borrower walk away without ever making even one single payment; they
would be able to cover their losses by liquidating all of the business’s
assets. Keep this in mind when seeking traditional bank debt.
Thus, collateral does matter and is a major requirement of nearly all
business lenders – it’s just a fact of business life. If you plan for
this in the beginning, you should not be surprised later as well as
stand a better chance of securing the capital your business needs.
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