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Hey in this video, I will show you what asset based lending is, how it works and why this could be a great choice for you if you have a fast growing business, we will cover that and much more.
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Hey everybody. Welcome. This is Leo Landaverde with Greenland Advisors, creating more profit, more value, more freedom for your business. So in today’s video, we’ll discuss business law and particularly asset based lending. That comes a lot in my line of work as a CFO and my staff, we are constantly dealing with two things. Raising capital cash or risk. Risk and cash are the two biggest responsibilities we have here at Greenland Advisory. And so this topic is perfect for what we do and we deal with on a daily basis.
So what is asset based lending? Asset based lending is a loan that is secured by tangible assets. Be it business accounts, receivable, inventory, machinery, or other forms of collateral. Hence it’s collateralized with assets. Typically, businesses can borrow up to 85% of the value of their accounts receivable and around 50% of the inventory equipment. This is just for you to kind of … from the get go, you’re not going to get 100%.
In a worst case scenario, an asset based lender can recoup their losses by seizing the collateral. This is why I think it’s a great option for you if you have credit challenges. If you’ve researched traditional small business loans, you’re probably aware that you need to have a profitable business, a strong revenue history, and a robust personal credit score to qualify for the best options I.e. banks. And I always say that you don’t want to go to a bank when you need money, because when you need money it’s too late. You want to be strategic about your banking relationships, and I’m not down with banks, I think you have money to have multiple options. There’s a place and a time for a bank, but there’s not one size fits all. But if this doesn’t describe your business yet, an alternative to consider is asset based lending.
An asset based loan is secured by tangible assets, which could be quickly and easily liquidated. Assets like accounts receivable, equipment and inventory are common types of collateral. Asset based lending is most often a revolving line of credit, but those loans can be structured as turnarounds as well. And there’s another video where I go deeper into what difference between business loans and lines of credit. So please it’ll be, the link will be at the end of this video and please watch that one because that’ll help you understand the difference, so I’m not going to go into too much detail here.
To qualify for an asset based loan, your lender doesn’t focus as much on your business financial history and personal credit worthiness, so I know that video that I did on personal guarantees will not come into play. You have to stay away from personal guarantees, whenever you can. So this is why I’m always very hopeful and bullish about asset based lending. So as I said, your lender doesn’t really focus much on the business financial history and the personal credit worthiness, because they’re going to be looking at the collateral, that’s their go to. They will weigh heavily your business assets because the lenders can use those assets, as collateral.
How does asset based lending work? Lenders base the amount of money you can borrow, AKA the borrowing base, and the market value of your assets. Typically, business can borrow as I said earlier, between 75 and 85% of the value of their accounts receivables and around 50% of the value of the inventory. In asset based lending, tangible collateral source, an important purpose beyond determining the borrowing base too. It also provides security to the lender.
Here’s the operative word, lenders are not out there to lose money so they want to recoup the money if things go bad. Even if things go South with your business and your defaulting your loan, if there’s a security pledge that will satisfy the lender. And that’s the whole theory that they could recoup their losses if there’s a need. In theory, the collateral you offer up against your loan is a valuable asset. And liquidating those assets into cash allows the lender to make up most of their losses in case you default in your payments. For that reason, lenders consider the value of your assets heavily during the underwriting process, more on that later. Asset based lending may seem like a bad scenario for the borrower who wants to risk putting their business valuable asset, who wants to do that? However, what is the alternative you’re personally guaranteeing? And you don’t want to do that.
Asset based lenders pose a significant benefit. The security provided by this collateral mitigates the risk to the lender. As a result, you might have an easier time qualifying for an asset based loan than an unsecured loan, because an unsecured loan relies heavily on your credit worthiness. And it personally may tie you into the business, which I did a whole other video on why you want to stay away from personal guarantees. However, I digress. As I said earlier … as with any small business loan you apply for, you still have to meet the lenders qualifications.
Asset based lenders also require potential borrowers to undergo a pre-involved due diligence process, more on this later. Also keeping in mind that most small business loans require some kind of collateral to secure even if they are called unsecured. There is nothing as an unsecured loan, just so you know. Very few lending products are truly unsecured and if that is the case, I haven’t heard many of them. I don’t know of any of them, a lot of them. The difference here though, is that an asset based loan requires a specific balance sheet of collateral to secure the loan and it has to be attached to your business and I’ll cover that in a little bit.
All right, let’s move on. Why choose asset based lending? Excuse me, most borrowers turn to asset based lending because they just had bad luck getting approved by traditional lenders. I mean, here’s the deal. Most business owners will turn to their local bank, the local community bank and there are thousands of banks, there’s at least 5,000 banks in the U.S. And some are community banks, some are the larger banks, but this will be the go to for small business owners, is the traditional bank and the mortality rate, I’m sorry the reason why banks don’t really like giving that is because they have very stringent requirements. So 70 or 80% of all small business owners will actually be turned down by their local bank. But you might also, if you do your research, you might find that an asset backed loan is just the best choice for your business.
So here are the five major reasons why you might not pursue an asset based lender. Number one, you have less than perfect credit or revenue history. So if you had a great growth quarter over quarter or year over year for some time, but recently your credit has actually been on the downward spiral and your credit took a hit for whatever reason, we’re talking about FICA scores of low 600s, and your revenue history is declining, your traditional bank is not going to be very bullish on your business. Or your business has grown quickly, almost too quickly for the traditional bank. I cannot tell you how many times I’ve gone on behalf of a client to a bank, just to learn that 45% year over year growth is just much more than a bank can handle.
I know, you would think growth good. Well, when you’re growing too fast, the banks [inaudible 00:08:57] says that you’re going to be quickly running out of cash and they’re going to assume that you’re going to not going to be able to collect your cash over 90 days, your IAR over 90, which they will discount. So I repeat, any accounts receivable over 90 days, a bank will discount. So if you’re really not in the business of securing cash immediately, like in a restaurant where you actually go and pay a right away, there’s no AR, that may be a turnoff for a bank.
You have business assets you could use, I think most businesses will have some type of assets. whether that is inventory, whether it’s AR as we mentioned, whether it is machinery and equipment or cost of goods sold that sort of inventory that turns into cost of goods. There is no need for personal guarantees. So nine out of 10, when I am advocating for a small business owner to get an asset-based loan is simply because I don’t want them to personally guarantee it. And you also need flexibility. Asset based loans are often structured as lines of credit. A lot of my clients come to me with wanting to have a line of credit, but they don’t have assets and it’s very, very hard to get an unsecured line of credit, it’s hard to get a line of credit period, let alone just being unsecured. So that’s what makes asset based lending a great financial solution for a business that has cashflow issues.
With a line of credit, you only take as much as you need when you need it. And you only pay interest on the funds that you draw. So say for instance, you had $100,000 line of credit secured by some of your assets, but you only need $10,000, you’re only going to pay interest on the $10,000 that you borrow and the goal is that when you ready to use a line of credit, you want to pay it back. So you want to keep reusing it, you don’t want to keep using it to the limit, or you may risk turning it to a loan. Anyway, that’s a conversation for another day.
Okay, so let’s get into the five most common types of collateral used an asset based lending. Number one, first and foremost, Accounts Receivable also known as AR. If you’re in a service based business, I.e. Engineering firm, law firm, accounting firm, any type of high level business that invoices customers, any receivables due within 30 to 90 days window can be illegible as collateral for an asset based loan. In this case, the size of the loan business qualifies for this in proportional to the receivables outstanding. The more you’re invoicing, the greater the value of your invoices, the more you’ll be able to borrow.
It is important to know that asset-based loans that use invoices as collateral, it’s different than factoring, which is another term. When working with a factoring company, the lender purchases your astounding invoices outright. So they’ve purchased them from you in exchange for a flat sum. A lot of business owners don’t know that. And this is why I stress, you have to read the fine print with any loan agreement and understand what the security that you’re pledging for the loan is. So when you do, back to factory, when the lender purchases your outstanding invoices in exchange for a flat sum, then it collects your customer’s payments for you. Once they collect the full amount and your accounts are zero, they pay you the difference, but keep a percentage. This is when I noticed that in factory, that you are instructed to send the checks you collect from your customers, that don’t longer belong to you into a mailbox that goes to the lender, so it may seem a little weird to you. Well, that’s different than having AR pledge your security. So understand the difference.
Number two, inventory, if you operate a manufacturing wholesale, or even retail businesses, chances are you’ve got a stock pile of product inventory on hand, just like you see in this picture. That inventory could be saved for a rainy day waiting to be solved or even transport it. But for now, it accounts as an asset on your balance sheet, which is great. And why the formula for the balance sheet assets equals liabilities plus equity. So it could be a potentially valuable asset for asset based lending, no pun intended.
Machinery and equipment, number three. Manufacturing equipment vehicles, commercial kitchen appliances, computer systems, almost any kind of machinery equipment that your business owns can be eligible for an asset based loan, like an equipment loan or a business auto loan. As we mentioned earlier, if you can liquidate it into cash, you most likely can put it as collateral. Generally speaking, the higher the value of your business on fixtures, the more funds you’d be eligible to borrow because they are just worth more. But remember, you need to own your equipment outright to be eligible, to be as collateral. It would be like you have a car that has a loan and trying to get a car loan from another lender where you haven’t really paid the first loan. It’s exactly the same and people sometimes have, when you actually bought equipment and you didn’t buy it out cash and you have a loan, you really can play something that is not free and clear.
Number four, commercial real estate. In certain cases, any real estate that the business holds like owned retail or manufacturing space, land owned by a development company or any other real property can be considered a fixed asset illegible for asset based lending. Of course, this is like the Holy Grail of asset based lending because real estate is an appreciating asset. Although these situations can be tricky and they need to be evaluated on a case by case basis because you get really convoluted, you need to go for an expert that can help you kind of discern the different paths to asset based lending.
If you’re interested though in using real estate holdings to secure and asset based loan, you’ll first need to get an independent appraisal to determine the property’s market value and any appreciations. Okay, keep in mind that if you’re paying a mortgage on the property, you also need to have paid off a significant portion in order to use the property as collateral. So that’s when the loan to value kicks in, right? So if you have a $2 million property with a $1 million loan, you have your set to have a loan to value of 50-50. So 50% LTB. So with an asset based lender may take a second position, subordinate to the first, and you may get another $250,000 or up to 75% LTB, and that happens.
So other tangible assets. Typically the biggest one is land. You own a land that is either free and clear or very little loan on it and you can actually use it as potential collateral for an asset based loan.
Are you ready to Apply? Well, so here’s what you need to do if you’re ready to pursue this. You have to get a firm handle on your business financials. I cannot tell you how many times I get involved or get, this is usually one of the reasons why I get called by a company that they are in the middle of applying for a loan, or they’re being turned out by a bank and they don’t know how to handle AR. The first thing that I ask is, “Show me your financial statements” and what are they? You got your profit and loss, you got your balance sheet, and you’ve got a statement of cashflows. Usually, I’ll say eight out of 10, those are not fully reconciled, they’re not ready to be shown, there is inconsistencies in the balance sheet that any sophisticated lender will pick up on that will start to doubt your financials.
And usually what they do if they don’t really trust your financials, they’re going to ask for third party validation, which is like a compilation or review and an audit, which could be very, very expensive. So the moral of the story, be on top of the bookkeeping for your business. Reconcile your financials, reconcile your bank accounts, your credit card accounts and your loans every month and you’ll have a totally defensible set of financials, that backup to source documents that are real.
So you need to identify your assets. What does it mean? Well what is it that you want to pledge? So look through your assets on the balance sheet and is it going to be accounts receivable? Is it going to be inventory? Is it going to be machinery and equipment? So long as you follow the rules, on accounts receivable, anything over 90 would probably be discounting. Any inventory that is not fully paid for will be this we won’t be able to use and definitely machinery and equipment that is not free and clear, you can’t use.
Again, make sure your assets are free and clear. So one of the things that I like to do whenever we get involved and we have CFO responsibility, we are the CFO advisers for a client. I want to make sure that we get an asset list and make sure that that asset list jives with what the CPA is using to file for the corporate tax returns and make sure that we have all the asset lists and we know which assets are which, and how they’re be depreciated and we’ll know that there are any loans and the balance sheet will be under liabilities tied to those assets. I Can’t stress that enough.
And you got to choose the lender. There’s a lot of lenders out there, out there. In today’s video, we’re not talking to about any specific lender, but there are different lenders for different types of loan products. So there are lenders who absolutely love dealing with financing equipment. There are lenders that are love dealing with dentists and their equipment. If you’re a dentist, you know that you need a lot of equipment to operate. And some lenders absolutely love that type of industry vertical. You got to complete your application and submit your documents, that’s number five and preview your offer and commit to due diligence.
So what is the diligence? This is the time of which the lender actually is going to probe. He’s going to probe through your financial statements, he’s probably going to ask you to submit your tax returns and make sure that they jive with your internally generated financial statements. They’re going to take the time to make sure that what you say is true.
So the request for the due diligence commitment will likely come after they’ve finished an initial review of your application and financials. At that point, the lender is interested in working with you, they’ll present a preliminary offer detailing the loan amount, interest rate, in terms that they might be able to provide subject to confirming the data you provided. And what will they do next? They will pull you through it field audit. Depending on the size of the loan against the asset class that they’re using, they may actually come on site send an underwriter to verify that those assets are real, that they are free and clear, and then they feel comfortable lending on. Number eight, you will go through the whole process of approval and funding, and hopefully you get a loan. So really that’s success.
Please comment below and let me know which of the five asset types we covered today will make the most sense for your business. Also, if you want join a community of like-minded, successful entrepreneurs, just like you then join our Facebook group or the link below where I share tips, tactics, and strategies on how my clients are growing their businesses to seven figures and beyond.
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