There are as many different types of loans as there are types of assets. When looking for a loan for your business you should try to match the asset type to the type of loan you are requesting. Long term assets such as real estate and equipment make the best collateral for long term loans. Short term assets such as accounts receivable and inventory work best for short term loans.
How a lender values collateral is really not a mystery, but the value you place on it may not be what a lender thinks it is worth. In the case of real estate and equipment, a certified appraiser estimates its value using several customary methods and the lender loans XX% of the appraiser’s valuation.
Things get a little grey when it comes to “soft” collateral such as accounts receivable, inventory, purchase order and contracts. Recently I spoke to a small business owner who wants to borrow against his inventory in order to buy more products so he can make more sales. His product is very unique, a one of a kind miracle cure for middle aged men and women. He is sure that once it hits the market it will ‘sell like hotcakes’. Listening to him describe his product I could tell that not only was he excited about what the product could do, but was sure he’d hit upon a gold mine.
As he explained how things worked I asked about the numbers. Well, …. he starts to explain, he will sell each unit of product for $40. The really impressive part is that it is only going to cost him $2 to make each unit. He has 20,000 pieces of product so far in his warehouse. The big question is how much can he borrow against his inventory?
- $ 40,000
- $ 20,000
- $ 10,000
To the owner, he believes his inventory is worth A. $800,000. That is, after all, what he plans to make selling his product. But to a financial lender, his inventory is worth somewhere between C & D, if he is lucky. The actual cost of the inventory is $40,000, but if the lender is going to lend against it, he will have to calculate what he would be able to sell the inventory for if the small business owner defaults on the loan. This value is often referred to as the salvage value by lenders. For some products the salvage value is often only pennies of the original cost.
The more unique the product is the harder it will be able to sell.
Inventory products that are manufactured for other companies and use their name and trademark are nearly impossible to value as collateral. I once had a customer that manufactured laptop carry cases for Dell Computer. They had Dell’s name all over them. The snaps were stamped with Dell’s logo. My customer was being asked to manufacture them and inventory them for Dell, but Dell made no guarantee to purchase any inventory other than what they actually needed. If my bank was to lend against that inventory as collateral and if the borrower defaulted on it, the only party who could legally buy the inventory is Dell. Even though my customer had great expectations that Dell was going to treat him well, my lender couldn’t make the loan because of Dell’s trademarks on the carry cases. If they had been plain black carry cases the story would have been different.
When borrowing against your company’s soft assets you need to think like a lender. It’s not what the collateral is worth to you; it is what it is worth to the lender that matters.