Your eyes gaze at the man in front of you, then quickly dart to the stack of papers on the desk separating you and he. That desk also separates you from the man who could make or break your entrepreneurial dreams. You have researched, calculated, and organized all your information, but is that enough? The other man clears his throat and interrupts your thoughts "What kind of collateral do you have to offer?"
It's a straightforward question with a complex answer and one that a borrower must be prepared to answer thoroughly with knowledge of the fine print that goes along with various types of collateral. The collateral you offer will provide insurance to the lender in the event that payments aren't being met, funds can be procured from one of the previously offered sources of collateral. Lenders are running a business and they are trying to protect themselves. For this reason, the lender has varying types of collateral categories that will match the loan being made.
Ideally, lenders will look to take collateral that will meet or exceed the term of the loan in order to fully protect themselves. For example, in cases where there is a short-term loan, such as a line of credit, short-term assets like receivables and inventory are deemed acceptable securities. In the case of a long-term loan, receivables and inventory would not be valid forms of collateral. People seeking loans often incorrectly assume that anything with value can be offered up as collateral, but this is not the case. Certain collateral is more attractive to the lender according to the type of loan being sought.
Another important and relatively unknown condition to collateral is that often the lender will want to verify that their claim to the offered collateral is the first secured interest. This will guarantee that the collateral will be used solely as insurance against the loan they offer to you. It would also mandate that no prior or future liens would be created against that particular form of collateral. This would guarantee the lender priority over any other claimant in the event that foreclosure proceedings take place in the future.
Don't attempt to fool your lender by offering the same collateral to different lenders as not only is it dishonest and likely to hurt your credibility, but they can easily find out. The lender can search public records for security interest in real estate or personal property. They will want to ensure that no prior claims exist on that specific collateral. In circumstances where the collateral is in the form of real estate, a title insurance company can be consulted to conduct a search of public records. This outside company will compile a title report that will highlight the details on the property, such as pre-existing recorded secured interests.
If you are offering collateral in the form of personal property, the lender will run a U.C.C. search through public records that will reveal any existing claims on the property. Be straightforward, the lender will be offering their funds to you, so you must earn their trust.
Another important point to be aware of is the loan-to-value ratio that is used amongst lenders. To further limit their risks, lenders will place a lower value on the offered collateral rather than meeting the collateral's highest market value. The type of collateral being offered will also play a role in the loan-to-value ratio.
The following is a guide to typical loan-to-values used by banks. Each lender's formula for discounting collateral will vary, so be sure you understand your lender's method of discounting.
Real estate - Real estate is common collateral for startup ventures, as the entrepreneur will take out a first or second mortgage on their home. If it is occupied, the lender might lend up to 75 percent of the highest appraised value. Property that is unoccupied, but has been improved in some way can meet a value of up to 50 percent of the appraised rate. Unfortunately, vacant and unimproved property will likely only receive 30 percent of the appraised value. The reason behind these dramatic drops in rates is simple, if sold, it is likely the first scenario would receive the most money at a more rapid pace than the other two cases. The bottom line always returns to the numbers.
Inventory - A lender may advance up to 60 percent to 80 percent of value for ready-to-go retail inventory. A manufacturer's inventory, consisting of component parts and other unfinished materials, might be only 30 percent. The key factor is the merchantability of the inventory - how quickly and for how much money could the inventory be sold.
Accounts receivable - You may get up to 75 percent on accounts that are less than 30 days old. Accounts receivable are typically "aged" by the borrower before a value is assigned to them. The older the account, the less value it has. Some lenders don't pay attention to the age of the accounts until they are outstanding for over 90 days, and then they may refuse to finance them. Other lenders apply a graduated scale to value the accounts so that, for instance, accounts that are from 31-60 days old may have a loan-to-value ratio of only 60 percent, and accounts from 61-90 days old are only 30 percent.
Equipment - New equipment can be given an estimate value by the lender at 75 percent of the purchase price. This is a best-case scenario, as some lenders seriously mark down the equipment value as soon as it is classified as "used".
Securities - Marketable stocks (usually stocks traded on the NYSE or NASDAQ) and bonds can be used as collateral to obtain up to 75 percent of their market value.
As a budding entrepreneur who might be tightening your belt and strapped for collateral to offer, this can be disheartening, but don't lose hope. This is another plan the lender puts in place to further limit their risks, because just as you are safeguarding your future, so must they.
What is important to remember, is that beyond the red tape and formulaic analysis of your finances is the infusion of funds that will ultimately benefit you. The steps you are taking now, such as reading this article, are invaluable in cultivating an informative and thorough business plan for evaluation. When you find yourself sitting across the desk from that seemingly omnipotent lender, take a deep breath, remember what you've learned, and enjoy the realization that you can answer his question with confidence.
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