Collateral on business loans are assets that the borrower leverages. The borrower contractually agrees to provide these to the lender in the event of a default so that the lender may sell the assets and recover their losses. Lenders ask for collateral so they can reduce their risk when lending money for short- and long-term business loans regardless of the amount and type.
If the lender does not require collateral, the loan will be called unsecured. Unsecured business loans are very rare. In order to get an unsecured business loan, the borrower will need a strong financial history, at least a few years in business, a relationship with the lender or strong reputation, an excellent business credit score, and other trust builders that make them creditworthy.
Being asked for collateral is normal, and if you do not default on the loan, you won’t have to worry about the lender seizing and selling your assets. With that said, while you’re paying back the loan, you won’t be able to sell the assets used as collateral unless you get the lender’s permission or there is a clause set in the loan agreement.
Want to learn more about collateral? Below you’ll find more information including how much collateral you may be asked to provide, which assets can be used as collateral, how you can protect yourself from lenders that may ask for too much, and ways to try and reduce the amount of collateral requested.
How the Amount of Collateral Is Calculated
The amount of collateral you will be asked to provide varies by lender and by the type of business loan. Some business loans carry more risk. For example, financing for certain industries like hospitality or loans with longer payback periods (like for commercial real estate) tend to carry more risk, so the lender may ask for more collateral.
Meanwhile, inventory or equipment financing and working capital business loans may require less, as the payback periods are shorter and the risk is generally lower. In any case, the required value of collateral is calculated using the Loan to Value (LTV) ratio.
LTV is calculated with this formula:
LTV = (Loan Amount / Appraised Asset Value) x 100
Here’s an example. If you are taking an equipment financing loan for $100,000 and the equipment itself costs $80,000, the lender will likely ask for the equipment to be used as collateral. Because that piece alone brings them to 80% coverage:
80% = (80,000/100,000) x 100
The goal as a borrower is to reduce the ratio as much as possible. The lower number means you’re a lower-risk borrower. This can be done by making a larger deposit, adding more collateral than the equipment’s appraised value in the example above, or borrowing less money.
Assets That Can Be Used as Collateral
Any asset can be used as collateral for business loans as long as it meets the lender’s criteria. The criteria typically emphasize asset value and the ease of turning that collateral into liquid assets (cash).
Assets that retain their value and are easy to liquify (i.e., accounts receivable) are normally accepted. Ones that increase in value, like a bond that collects interest or commercial real estate, could be appealing as well. Meanwhile, assets that depreciate quickly, including older vehicles and machinery, may be less desirable from the perspective of the lender.
Assets lenders normally accept include:
- Property that your company owns
- Equipment and vehicles the company owns (or that the loan is being used to purchase)
- Stocks, bonds, and investments
- Inventory
- Personal assets if you make a personal guarantee
- Accounts receivable or outstanding invoices
The lender can and likely will require collateral, but that doesn’t mean you have to give them everything, or that you cannot protect certain assets to set yourself up for taking another loan. This is where UCC filings come in.
UCC Filings and Loan Collateral
A UCC filing or Universal Commercial Code filing is a publicly available document at the Secretary of State’s office. It lists the specific assets a lender has a claim to based on the borrower’s leveraged collateral. If there are two UCC filings on the same asset, the first one to file gets the first claim to the asset listed. This is why you want to check out UCC filings to make sure your lender filed it accurately based on your agreement.
A lender may try to use general wording like “vehicles” or “inventory” on the UCC filing, as this lets them go after all of your vehicles and inventory if you default. You do not have to agree to this generic wording, though. Instead, have them list specific details to specify only the assets agreed upon. Details could include a VIN number for a vehicle, specific types of inventory, and specifically named bonds or stocks.
By being specific, you can protect other assets from being seized and sold if you default, and if you need more financing in case an emergency happens or you need to buy materials or increase inventory quickly, you’ll have more assets available to use as collateral. Keep this in mind: If a lender already has a claim to your assets, a new lender will be less likely to provide you with secured financing, because they’re second in line for your collateral and at greater risk because of it.
Alternatives to Collateral
If your company is new or does not have many assets yet, you may not have anything to list as collateral. You have to own the assets in order to leverage them. If you rent your office space for example, you can’t offer it as collateral. If you own the property and building, then you can.
When you don’t have many assets to offer as collateral, try:
- Offering a larger deposit.
- Using personal assets like your house, a 401(K), or your personal car.
- Providing unpaid invoices the lender can collect on.
- Having a colleague, investor, or third party co-sign in exchange for equity or a percentage of future sales.
Putting assets up as collateral when taking a business loan is a normal part of the process. But by being specific on the UCC filing and making payments on time, you shouldn’t have anything to worry about.
SmallBusinessLoans does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
