An asset-backed loan is one of many ways that company’s obtain access to the capital needed to run their business. Small businesses who have significant assets – such as heavy equipment, investment accounts, or properties – can leverage these assets to do more than just run their business. By using them to secure an asset-back loan, they can do double duty and fund an expansion or growth opportunity.
But, like any loan product, there are pros and cons to asset-based lending. It’s important that borrowers understand the risks to these loans, which can be higher than an unsecured loan, to make an informed borrowing decision. And, if an asset-backed loan isn’t for you, to find a better alternative.
Asset based lending is a term that refers to a business loan secured by a company’s assets. An asset-backed loan could be equipment financing, a merchant cash advance, invoice factoring, or a business loan that has recourse to investment accounts or other assets in case of default. With asset based lending a small business owner can convert accounts receivable, equipment, and inventory into cash.
With asset based lending, the lender evaluates the strength of your assets. They then advance you a sum of money, or fund a loan, based upon these assets. The percentage of the underlying asset you receive, the method of funding the loan, and the way it’s repaid will all depend on the type of ABL product you choose.
A lender calculates a loan-to-value ratio when funding an ABL loan. A loan-to-value, or LTV, ratio, represents the percentage of the asset’s value that the lender will advance as a loan. For example, if the LTV on an invoice financing transaction of $100,000 in invoices is 50%, you’ll receive $50,000.
Below are some of the common types of asset based lending. Industries tend to use one or more of these ABL products more than others depending on common invoice terms, or assets held.
In the case of invoice factoring or financing, the lender may look at the underlying credit quality of your accounts receivable. Once they’ve determined its collectability, they could either purchase the invoices outright, at a discount (invoice factoring), or advance you a percentage of the total amount but you continue to own the invoices (invoice financing). In both cases, you won’t receive the face amount of the invoices but will get cash quickly.
Equipment financing funds the purchase of a piece of machinery or equipment you need to run your business. This purchase could replace older, outdated machinery, or be necessary to expand a product line. The equipment serves as the asset securing the loan.
With an equipment financing loan, the lender may request an appraisal or valuation of the equipment. This ensures that the asset securing the loan has enough value for them to recoup their funds if you default.
A merchant cash advance or MCA turns credit card sales into cash in the bank. Future sales serve as the advance’s collateral.
When you apply for an MCA, lenders request several months of credit card transactions. Based upon past sales history, they predict the next few month’s sales and then advance you a sum based upon this prediction. Like invoice factoring and financing, it won’t be 100% of the future sales.
The MCA agreement will give the lender the right to collect a percentage of future credit sales as their repayment. Those sales are the asset securing the loan, even though they haven’t happened yet. The lender has a right to collect their repayment on each credit card swipe until paid in full.
Other common types of ABL include advancing a percentage of the value of marketable securities, a mortgage that’s secured by a building, or a loan based on a percentage of your inventory’s value.
There are many reasons that a company might consider ABL. Companies that need working capital for operations can structure an asset based loan as a revolving credit facility. This allows them to borrow from less liquid assets on an ongoing basis to pay expenses. They’ll have the cash to pay their bills while waiting on customers to pay invoices.
A company that chooses ABL may have cash flow problems caused by rapid growth – for example, orders are coming in, but haven’t been paid yet. The company needs to purchase inventory and supplies to fulfill the orders, but doesn’t have cash on hand. Invoice factoring or financing could solve that problem.
Manufacturers, distributors, and service companies that operate in industries subject to seasonality or cycles often use these loans to smooth over cash flow bumps. An ABL helps them meet operating expenses while waiting for the expected seasonal pick up.
Common industries that engage in ABL include:
What are the advantages and disadvantages of asset based lending?
Pro – Lower Interest Rates
Because the lender has recourse to the assets securing the loan, they have less risk. If you defaulted on an equipment financing loan, they could repossess the equipment. A failure to pay on a loan secured by marketable securities gives them the right to claim and sell the securities.
With asset based lending, the lender has a higher likelihood of being repaid, one way or another. When lenders have less risk, they charge less for the loan. With ABL, you could pay a lower interest rate than on an unsecured loan.
Con – The Lender Can Take Your Assets
The trade-off to a lower interest rate is more risk to your company. When you pledge assets to secure a loan, you must always take into account the risk of losing those assets.
Could you fulfill existing orders if you lost a key piece of equipment? Would losing marketable securities put you in default on a debt covenant on another loan? Consider the risk of losing important assets before applying for an ABL loan.
Pro – ABL Could Have Fewer Covenants
A traditional bank loan or line of credit agreement often contains debt covenants. The lender may require that you maintain a certain current ratio or have EBITDA above an established range. Failure to comply with these covenants could result in fees, or paying a higher interest rate.
Many businesses prefer not to manage their business to a bank’s specifications, and not necessarily to what’s best for the business. Asset based loans could have fewer of these covenants in the loan agreement due, again, to the lower risk from pledged collateral.
Con – ABL Can Take Longer to Fund
If you need money quickly, an asset based loan isn’t always the best choice.
For equipment financing or inventory financing, you could have to wait on an appraisal or valuation of your inventory. If it’s your first time working with an invoice factoring or financing lender, it could take them longer to verify the creditworthiness of your customers. Lenders will perform due diligence on the assets securing the loan before funding it, which takes time.
Pro – Gives Financial Stability
An asset-based loan can bail you out of tough financial times, preserving important relationships with key vendors and suppliers. The extra cash can help you stabilize your business if you’ve gone through a rough patch.
Con – Extra Fees May Increase the Loan’s Cost
Borrowing has a cost to it – and extra fees may increase this cost. Lenders could charge a loan origination fee, an underwriting fee, or a fee to keep a line of credit open. Don’t forget to include these fees in your overall financial analysis when picking the best loan for your business.
Shield Funding offers two asset based lending products and several alternatives.
Shield Funding offers merchant cash advances to qualified borrowers. If the bulk of your customers pay by credit card, this is an excellent option.
To qualify, you’ll need a credit score above 500, two months in business, and a minimum of $8,000 in monthly revenues. Merchant cash advances charge a factor rate – a flat fee – of the total advanced amount.
Not all businesses take credit cards, or have customers who pay primarily through credit. If you have a large balance of accounts receivable, or receive payments into your bank account, consider a revenue based loan.
Qualifications include three months in business, a credit score above 530, and $10,000 in minimum monthly revenues. You will have to provide documentation of your revenue streams to a lender – most likely through bank statements. They will fund a loan that’s a percentage of your total revenue, and could take repayment through ACH withdrawals from a business bank account.
If the thought of losing your collateral makes you too nervous, consider an unsecured loan. While you’ll pay a higher interest rate for a loan where the lender has no recourse to collateral to recoup any losses, you have the peace of mind that you can keep your assets.
Unsecured business loans don’t require collateral, though you may have to sign a personal guarantee. You must have a year in business and $10,000 minimum monthly revenues to qualify. Repayment terms can be anywhere from two months to three years, which gives you a lot of flexibility.
For small business owners with multiple forms of debt, a business loan for consolidation could ease the bookkeeping and financial strain. When starting or running a business, you might have opened a credit card, a business line of credit, and taken out a small business loan. Juggling multiple monthly payments and the debt servicing costs can quickly become too much.
Debt consolidation loans pay off all of your existing debt and roll it into one, new loan. While the interest rate on the new loan could be higher than some of your previous forms of credit, it could be lower than the blended interest rate on all your debt.
Many businesses use asset backed loans to keep running smoothly, but others prefer to pay slightly more for access to capital that has less risk. If it’s time for you to borrow, reach out to a loan specialist at Shield Funding. They’ll help you weight the pros and cons and direct you to the best loan product to meet your capital needs.
