The general requirements for the traditional small business loan have the same purpose: showing the financial institution that they can trust you. Each requirement gives the institution another reason to trust the applicant’s ability to make regular payments while maintaining their business’s financial health. Many successful businesses, however, cannot meet these notoriously high standards. Maybe they experience seasonal dips in cash flow or stagnating profit margins, despite their upward trajectory. Businesses that suffer from this all-too-common dilemma might want to consider asset-based lending, instead of the traditional small business loan.
With asset-based lending, the institution doesn’t base their decision primarily on your business’s financial health or personal credit score. It’s your business’s most valuable assets that will ultimately determine the fate of your application.
At first, asset-based lending just sounds like another term for a small business loan with collateral. But this type of financing has several major differences from the products you’re used to, most notably the application process. In this guide, we’ll explain what separates asset-based loans from traditional options as well as the information required in the application.
What is Asset-Based Lending?
An asset-based loan involves tangible assets, or assets found on your balance sheet that the institution can quickly liquidate and sell. Examples of tangible assets include accounts receivable, equipment, or inventory, as opposed to personal assets, like your house or your car. And while some institutions can structure asset based loans like term loans, most products have the same repayment system as revolving lines of credit.
Since the loan’s security comes almost entirely from collateral, you cannot borrow an amount larger than the market value of your featured asset. Most institutions allow applicants to borrow 75 to 85% of market value their accounts receivables, and approximately 50% of the market value of their equipment or inventory. Your featured asset must therefore carry significant value in order to access asset-based products. Think of the importance of personal credit in traditional loans, and replace it with your asset’s market value. Medium to small-sized asset-based loans essentially do not exist.
Though the institution will consider the value of your assets above anything else, you’ll still have to meet numerous other requirements. You’ll also have to undergo the institution’s due diligence process, which takes even more time and energy. We’ll lay out the various steps of this process later on.
Asset-Based Lending vs. Unsecured Loans
If risking your most valuable assets sounds scary, you’re not alone. Business owners might avoid asset-based lending solely because of the additional pressure it creates. If you default on an asset-based loan, you could lose an asset that your business needs to generate revenue and pay your bills.
Cautious business owners might instead pursue unsecured business loans, which do not require collateral. Most unsecured options, however, include some sort of policy to ensure the institution’s security. A blanket lien, for example, gives the institution access to any of your business’s assets (tangible or not) if you default. Other options might require the applicant to sign a personal guarantee, which allows the institution to seize your personal assets. In summary, there’s really no such a thing as a completely unsecured business loan.
Why Choose Asset-Based Lending?
If someone chooses asset-based lending, it’s usually because he or she has had trouble accessing traditional loans. But that doesn’t necessarily mean you should only view asset-based lending as your “last resort.” In fact, your cash flow and growing demand could make asset-based lending the most sensible option available.
The following five circumstances would give someone good reason to pursue asset-based lending over another financing option:
1. Difficulty Qualifying for Traditional Loans
Institutions that offer asset-based loans place much more emphasis on asset value than credit score, revenue, profitability, or cash flow. Traditional institutions, on the other hand, might reject your application solely because your credit score or monthly revenue does not meet their highly stringent criteria. If an applicant does not meet the criteria but manages to get approved, he or she will likely face higher interest rates, restrictive terms, or lower borrowing amounts.
The requirements of traditional business loans make them relatively inaccessible for young businesses. It can take several years for a new business to draw a profit or stabilize their cash flow. For this reason, asset-based lending could be a young business’s only viable gateway to higher borrowing amounts and appropriate terms.
2. You Have Low Revenue but High Projections
Growing businesses often seek business loans to obtain the resources they need to keep up with demand. But as mentioned the previous section, the business’s age and revenue might fall short of the institution’s general requirements. In this case, an asset-based lender might devote more attention to the business’s future than its sparse historical data. After analyzing the accuracy of your projections, the institution might also assess your personal capacity to reach these goals.
Hence, asset-based lending could help you overcome the dilemma of high projections accompanied by low current revenue. But you must also show the institution that you have what it takes to succeed.
3. You Have Valuable, Easily Liquidated Assets
Picture this: You look at your balance sheet from the past month and discover you have much more unpaid invoices or inventory than you thought. These assets still hold considerable value but that could change if you let those invoices go unpaid or that inventory go unsold for much longer. Asset-based lending allows you to put those large investments to good use.
After doing some calculations, you might find that leveraging your assets in exchange for funding could actually give you the means to generate more revenue than if you just sold the inventory or asked your customers to pay up.
4. You Don’t Want to Risk Your House or Car
Unlike traditional secured business loans, asset-based loans only involve tangible assets on your balance sheet. You don’t stand to lose your home or your car if you stop making payments. This puts less personal risk on the business owner. If your business falls on hard times, you would lose the asset but keep your house, which could then be used as collateral for another, much larger loan.
5. Rocky Cash Flow
Earlier, we noted that many businesses cannot obtain traditional loans due to tumultuous cash flow. This common obstacle would also make it difficult to fulfill monthly payment obligations. Asset-based loans usually have the same repayment structure as business lines of credit, which provide quick access to cash at any time. You only have to pay interest on the funds you use, as opposed to paying interest every month, even if you haven’t used any borrowed funds.
Businesses often take out lines of credit in anticipation of gaps in cash flow or sudden, lucrative opportunities. For example, you could buy new inventory to satisfy an unexpected shift in demand despite having little working capital at your disposal.
You might have to explain how you plan on using the funds in order to access asset-based loans. Most institutions, however, will probably accept something vague but realistic, like “additional working capital.”
The 4 Most Common Types of Collateral Used in Asset-Based Lending
Technically speaking, anything that the institution can liquidate into cash (without much difficulty) can count as collateral for an asset-based loan. This broad definition makes asset-
based lending accessible to countless types of businesses. Most asset-based borrowers, however, use one of the following four assets as collateral. If you offer an asset from this list, you’ll have the success of previous borrowers to support your application.
1. Accounts Receivables
Businesses that offer trade credit to customers typically give them 30 to 90 days to pay. Unpaid invoices that are due within this time frame can be used as collateral. This does not include invoices that were supposed to be paid within 90 days but are passed due. Like unused inventory, the value of an invoice decreases significantly when it goes unpaid for more than three to four months.
Though the value of your invoices does determine the size of your loan, asset-based loans do not work the same way as invoice factoring. With the latter option, the institution purchases the unpaid invoices in exchange for approximately 85% of the actual value. The institution then assumes full responsibility for collecting from your customers. Upon collection, the institution pays you the remainder from the first payment, minus another percentage. The two deductions function like interest on a loan. But invoice factoring is more like a sale than a loan because you don’t have to pay anything back.
As mentioned earlier, asset-based lending is especially appealing for younger businesses that cannot not fulfill the “time in business” requirement for traditional loans. It’s very common for new retailers and wholesalers to buy massive amounts of inventory in order to provide exemplary customer service. That inventory can then act as collateral for an asset-based loan.
Before approving the loan, your institution will appraise the inventory to determine its market value. Yes, you can sell the inventory to your customers after receiving the borrowed funds. But if you default on the loan or stop making payments, the institution will need to seize something of similar value to make up for their loss.
If you take out an asset-based loan, that inventory is yours to work with however you want, as long as you make your loan payments on time. But if you fail to make payments or default on your loan, your asset-based lender would have the right to repossess that inventory (or other inventory of similar value) as repayment for your debt.
You can use just about any type of equipment as collateral, as long as the institution won’t have trouble liquidating it into cash. This can include manufacturing machinery, company cars, computer systems, or even commercial appliances. Your company, not you, must also own the equipment.
4. Real Estate
This one really depends on the institution. When it comes to real estate, two institutions might have different definitions of “fixed assets.” One might only allow you to use retail or manufacturing space, while another might additionally allow real estate owned by a development company. Some institutions might allow you to simply use any type of real estate that your business owns. Then you have other factors, like the type of land or building in question. In sum, you cannot assume that every institution will accept your company’s property as collateral. And even before you contact the institution, you’ll have to pay for an independent appraisal to determine the property’s market value.
Also, if you have a mortgage on the property, most institutions will only allow you to use it as collateral if you’ve paid off a considerable portion of it. Remember, you can only use assets that you own outright as collateral for asset-based loans. The institution will therefore base your borrowing amount on the portion of your mortgage that you’ve paid off. Since the mortgage provider still technically owns the property, you cannot borrow in proportion to the total mortgage value.
How to Apply for Asset-Based Loans
The application process for an asset-based loan will likely take longer than the traditional loan application. In addition to substantial paperwork, you’ll probably have to endure multiple interviews and even an in-person audit. So, if you need money right away, asset-based lending might not make the most sense.
But if you have valuable assets and cannot fulfill traditional loan requirements, don’t dismiss asset-based lending solely because of its tedious application process. Here’s what to do to ensure your approval for an asset-based loan:
1. Review Your Financial Statements and Projections
Though asset-based lenders do base their decisions primarily on the value of your assets, this doesn’t mean they’ll completely ignore your finances. Before applying, carefully examine your financial statements to gain an understanding of your assets, debts, and growth projections. Regardless of the type of financing you’re after, you should never answer “I don’t know” when asked about important financial data.
Some institutions require applicants to have their financial statements professional audited before processing the application, so check with your desired institution about planning for this extra step.
Of all your financial statements, your balance sheet contains the most information about your assets. The numbers on this document will essentially determine your eligibility for an asset-based loan. Your institution will likely want to see three fiscal years’ worth of balance sheets, including the current year.
Profit & Loss Statement
Otherwise known as an income statement, your profit and loss statement displays your revenue and expenses. You’ll probably need three years’ worth of profit and loss statements, with the most recent version containing data from the last 60 days.
Your projections should include as much data as possible to indicate an upward trajectory. Remember, institutions usually devote more attention to projections than past data when evaluating applicants for asset-based loans.
Tax Returns and Bank Statements
Established businesses should prepare three years’ worth of business tax returns and bank statements from the past four months. Some institutions require six or even twelve months of bank statements. And remember to include the full bank statement, not just the first page.
2. Identify Your Assets
The following documents will prove that you own your assets and show their value:
Accounts Receivables Aging Statement
If you plan on using your accounts receivables as collateral, you must prepare an accounts receivables aging statement. This shows your outstanding accounts (including past due invoices) as well as their due dates.
An inventory list shows all of the inventory you currently own and its approximate resale value, as opposed to the retail value. The resale value accounts for the fact that after liquidating the inventory, your institution would likely have to sell it for less than what your customers would pay.
This shows every piece of equipment your business owns, including appliances, cash registers, technology, etc. Next to each item should be its purchase price, whether it’s new or used, where it’s stored, and its current condition. Each item’s estimated value should be recorded on a separate spreadsheet. If you’re not sure about an item’s current value, you might want to pay an appraiser for an accurate valuation.
3. Check Other Outstanding Debts
Applications for any secured loans usually require a UCC (Uniform Commercial Code-1) search. The institution performs this search to see if any other creditors have rights to the assets in question. Are you currently paying back another secured loan or some other sort of outstanding debt? If so, then that creditor would have “first dibs” on your assets if you stopped paying them. The institution would have to wait for you to settle your debts with the creditor before getting their money back.
Some institutions might have issues approving applicants with outstanding secured loans or debts, but others might not. So, if you do have another debt obligation involving your assets, talk to your institution to see if they’ll still work with you.
Ready for the main reason this application is so tedious? After filing your application, you have to wait several weeks just to learn if the institution is even considering approval. That’s right: The institution must still complete the due diligence process before agreeing to distribute funding.
4. Accept Your Offer and Pay for Due Diligence
If your application looks good, the institution will present a preliminary offer. This is really just an estimation of the amount, interest, and terms they might be able to give you. The institution will not know exactly what they can offer you until they complete the due diligence process. If you approve their offer, you’ll have to sign a term sheet and pay a fee to move forward.
5. Field Audit
A field audit consists of a representative meeting with you in person to assess your character as well as the state of your assets. Instead of being intimidated by the representative’s questions, use this meeting as an opportunity to establish a long-term relationship with the institution. You’ll probably need another loan somewhere down the line, and it should be much easier to obtain now that the institution knows that you’re a responsible business owner.
This is also the first of several periodic audits the institution will perform to monitor the asset’s value. At the end of the meeting, you should be able to gauge the fate of your application.
6. Wait for Approval
After the field audit, the only remaining step is the waiting game. But once you hear back from the institution, you’ll probably just have to sign some paperwork before receiving the cash a few days later.
This is unquestionably a long and grueling process. Still, if you’re a growing business with easily-liquidated assets, this could be your only shot at obtaining substantial funding for a cost you can actually afford!