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If you own a small, growing business and you are in need of financing real estate, equipment, or machinery, where do you turn? Perhaps you go to your local bank. But what if your business lacks the type of tangible, “hard assets” that banks favor as collateral. “Hard assets” is a banking industry slang term meaning anything you can touch or see that has value to a lender as collateral, like a building or a tractor or a machine.
The reason banks like to lend against “hard” assets is easy for anyone to understand. If things go wrong, like the borrower becomes unable to repay the bank, it is easy for the bank to go to the borrower's place of business recover its collateral. Once the collateral is in the possession of the bank, it may sell the collateral to recoup its loss on the loan. Of course, there are some legal hoops they may have to deal with like foreclosure or obtaining an order from local law enforcement to enter your property to recover property, but in any event, the collateral can be recovered and sold.
Banks do an admirable job of lending money to small businesses in need of financing hard assets. Generally, these loans are term loans—repayable to the bank in equal monthly installments of principal and interest over two to five years. To encourage banks to make these types of loans to small businesses, the U.S. Government provides incentives like loan guaranties through the U.S. Small Business Administration (“SBA”).
Essentially, the thinking goes like this: Investment by businesses in machinery, equipment, trucks, tractors, and construction stimulates the U.S. economy and generates employment. Since banks finance the bulk of this type of investment for business, the U.S. government, through the SBA, provides incentives for banks. The SBA tells banks that if a borrower meets certain minimum standards—generally lower standards than banks would otherwise require, the SBA will guaranty the bank repayment of a large percentage of the loan—even if the borrower defaults.
In other words, borrowers who may not otherwise qualify for a bank loan in the absence of an SBA guaranty, may qualify for a loan if guarantied by the SBA. Everyone wins. The government has done its job to stimulate the economy, the bank earns interest on a loan it otherwise may not have otherwise made, and the borrower gets to expand its business.
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Before you start thinking that an SBA loan is perfect for your small business, let's examine the loan requirements a little more thoroughly. First, when banks act alone, they are free to underwrite their loans in any way it make sense to them, provided they don't run afoul of the regulators. Generally, if a bank wants to lend a borrower 80% of the value of a new tractor, the bank will usually secure the loan only with the vehicle's title. No additional collateral is necessary. But a bank that is relying on an SBA guaranty for additional security has to play by SBA rules. The loan, while easier to qualify for, may be much more restrictive when it comes to its terms.
For example, the SBA may require the bank to obtain a “blanket lien” on all the borrower's assets, including even assets which are not even remotely related to the loan request. A blanket lien is a “pledge” of all assets to secure a loan. It may not be unusual therefore, for an SBA guarantied equipment loan to be additionally secured by your inventory, accounts receivable, vehicles, machinery, land and buildings. Blanket liens often lead to situations where the bank is “over-collateralized”.
While being over-collateralized my be great for the bank and the SBA, it is bad for you and your business. The bank being over-collateralized puts the bank in control of your business and makes it quite difficult (and in some cases impossible) for you to convert equity you have built up on your assets (or should we say, the bank's assets) into cash to further expand your business, make payroll, purchase additional inventory, take on larger accounts…you get the picture. Sometimes the only relief is to find the money elsewhere to pay off the bank and obtain a release.
You can protect yourself against this scenario. First, realize that everything is negotiable. Ask lots of questions. Don't assume that because you are borrowing money to buy a truck, that buried in the loan documents, you are not also giving the bank a security interest in your accounts…or your inventory. Ask up front what the collateral requirements are going to be and don't give the bank any more collateral than is absolutely necessary.
The reason for being stingy with what assets you offer as collateral may not be clearly evident to the novice business owner, but those who have been through several business cycles understand all too well. By giving a bank too much collateral, you lose the flexibility to sell the underlying assets or refinance them elsewhere to generate emergency cash. Typically, if you want to sell any assets that the bank holds as collateral, you must take part or all of the sales proceeds and pay down the bank with it. But don't forget to get the bank's permission first, or you might be accused of conversion—a legal term referring to improperly disposing of assets that are subject to a lien.
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Emergency cash isn't only needed when times are bad. You may need emergency cash to expand your business quickly to take advantage of an immediate opportunity. When times are good, and if you are really, really nice and you beg your banker, he or she may release a particular piece of the bank's collateral so that you may sell or refinance it to generate cash. But have you ever asked a lender to release its collateral when times are tough. You can forget about even asking.
Let's examine an entirely different twist. Perhaps you are a service business like a temporary staffing firm, a nurse staffing firm, or an IT Staffing firm. You don't have any “hard” assets like a manufacturer or trucking company might. Business is good and expanding. You need expansion capital to hire more people or to finance accounts receivable. You will find that most banks, despite what they may say publicly, are not thrilled about lending money to companies that don't have lots of hard assets. Why? Remember early on when we talked about the bank liking to lend against assets they can see and touch? Service businesses usually have few of those types of assets. More typically, service businesses' largest asset is their accounts receivable.
Will banks lend against accounts receivable? Certainly, if you qualify. Will they lend you anywhere near their value? No. How do you know if you qualify? Wait for weeks or months while the banker pours over reams of paperwork he or she required you to supply. Then wait for the loan committee to meet. Chances are they will ask for more collateral, more restrictive terms, a higher interest rate, or more information. Your banker will come back to you with this information and begin the process again until loan approval is granted or denied by the loan committee.
So let's examine the pitfalls we were discussing two paragraphs ago. Let's say business is pretty good, you go to your bank and qualify for an SBA guarantied (or non-SBA guaranteed) line of credit secured by your accounts receivable. Perhaps you have $100,000 of accounts receivable and the bank feels generous by offering you a $50,000 revolving line of credit secured by a blanket lien on all your assets.
Six months later, business really starts to take off. Monthly sales are increasing 10% per month and now you have $160,000 in accounts receivable, but no cash. All your cash is tied up in the hands of your customers and you are having a tough time making payroll. What's more, a large, new, profitable order just came in and you're afraid to take it, because it would mean having to hire another employee—and you don't know how you're going to pay the employees you already have.
You jump in your car, go down to the bank and say, “How about an increase in my line of credit to $100,000 to help me expand my business?” When your banker stops laughing at you, you will then realize what millions of service business owners already know and I explained earlier. If accounts receivable are your business' primary asset, don't expect your banker to be thrilled to borrow money against them, much less to increase the amount already committed. Remember, your banker cannot see or touch your accounts receivable—so likely, he or she won't want to lend you (much) against them.
Here's where the real trouble begins. You have an asset worth $160,000 today, but you borrowed $50,000 against it six months ago. Now, if the bank is unwilling to lend more against your accounts, your have to make some decisions. If your lack of working capital is causing real pain like being unable to expand further, you must consider factoring your accounts receivable.
A good factoring company will analyze your accounts in 24 hours or less and determine whether or not you are eligible. If you are eligible, the factor will make a lump sum advance to you against your entire book of accounts receivable, segregating the amount necessary to pay off the bank and obtain a release of the bank's rights in the collateral. It is not uncommon in these cases for the borrower to walk away with 50%, 100% or even 200% more net cash availability under a factoring scenario than a borrowing scenario.
To generate the most working capital, consider factoring accounts receivable rather than borrowing against them. Not only is factoring fast, flexible, and more affordable than you'd expect, but as you experience growth in your accounts receivable, there is no nasty confrontation with a banker when you need additional funds. As your eligible receivables grow, so does the amount of cash available to your company. In factoring, there are no loan committees, regulators, government bureaucrats or auditors determining your fate. Access to cash is fast and premised only on the quality of your customer's credit—not yours.
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