August 28, 2014 Finding Funding en_US What is asset-based lending, and is it worth the risk?
Finding Funding

What is asset-based lending, and is it worth the risk?

By Suzanne Kearns August 28, 2014

Nearly every business needs a line of credit at some point. Unless you’re running a small lemonade stand, it’s virtually inevitable.

A business may need a loan for a number of reasons. Maybe, there’s a big project you want to tackle? Or, you’re looking to expand your retail space? No matter the reason, virtually every business gets a loan as a result of having too little working capital. And, while loans can pose a certain risk, the short-term burst of cash can lead to long-term periods of growth.

While loans are often a required part of business growth, they’re not always easy to get. Business credit can take upwards of a year or more to build, and you may need money now. This is where asset-based lending comes in.

This form of lending allows businesses to obtain loans that would typically not be given. But, what exactly is asset-based lending and who is it right for?

What is asset-based lending?

An asset-based loan is a type of loan that’s based on collateral — the “asset” in the name. A traditional loan is based on credit and one’s ability to pay it back, whereas an asset-based loan places a heavier emphasis on the collateral than on one’s credit.

This type of loan is ideal for a business that has a lot of inventory, accounts receivable or equipment, but needs funding to grow their business or get through a cash flow crisis. This is because these factors all make a business more likely to have a valuable amount of collateral to offer for the loan.

In the past, business owners would typically turn to their banks for a line of credit, but these days banking requirements make that impossible for those without pristine credit and a solid business history.

High credit requirements immediately disqualify many new businesses and startups, as their credit is likely too new to qualify for a loan. The solution for many is an asset based loan, which is essentially an immediate cash infusion based on the value of your assets.

How do asset-based loans work?

It should come as no surprise that asset-based loans aren’t handled like traditional loans. As an alternative financing solution, it has an alternative approval process. In fact, the process is quite different from the usual loan process. But, there’s still a high level of due diligence the lender must go through.

Again, typical business financing involves having a solid credit rating and the financials to prove your ability to repay a loan. In asset-based financing, the loan is secured through accounts receivable, finished inventory, raw materials, equipment, machinery, real estate or other assets owned by the business.

These loans are different from say, factoring, because you don’t sell the assets, only borrow against them. But, since the assets are used as collateral, if you don’t make the payments, the lender can take them. Some loans are based on only one asset, while others are based on a combination of them. Once approved for the loan, the lender will advance a percentage of the total value of the assets.

For example, typical advances for accounts receivable are 70-80% while inventory-based loans are generally determined based on the type of collateral. It’s important to shop around for the best deal because the terms can vary wildly. The interest rates are higher than traditional loans, but lower than unsecured loans, such as merchant cash advances.

In addition, depending on the lender, there will likely be accounting fees attached to the loan because the lender will conduct audits in order to monitor the business. Some lenders don’t charge these fees, but make up for it with higher interest rates. Be sure to take the interest rate, the advance amount offered, and all fees into account when comparison shopping at various finance companies or banks.

What assets can you put up for a loan?

When it comes to which assets can be used in an asset-based loan, the options are open. But there are some common assets that most businesses choose to use.

  • Accounts receivable: You can use your accounts receivable, the money owed to you by customers, as collateral in an asset-based loan. If you default, the lender will be able to claim the money that comes into your accounts receivables until the loan is covered.
  • Inventory: Any inventory you have on hand can be used as collateral, assuming it covers the loan. If you default, the lender will take that inventory to cover the cost of the loan. This can leave you scrambling to recoup any production costs to replace that inventory.
  • Equipment: Your business likely uses some equipment. This equipment can, in some cases, be used for collateral depending on its value. If you default, the lender will take that equipment. This can leave you struggling to continue operating if the equipment is essential.

All three types of collateral are different as far as their role in your day-to-day operations. But, losing any of the above can be a major setback for your business.

What happens if you can’t repay the loan?

With a traditional loan, if you can’t repay it, you’re typically out the money, stuck with numerous fees and possibly faced with bankruptcy. These things can all spell disaster for a business, but it’s not always the end of the company as a whole. With asset-based lending, the risks are undoubtedly higher.

In the event you can’t repay an asset-based loan, the lender will claim whatever item or items you promised as collateral. If the items depreciate in value and can’t cover the cost of the loan, the lender can come for additional assets to cover the remaining portion of the loan.

This can leave you in a worse spot than when you started. It’s possible to have your assets taken while your original objective and reason for taking the loan out is still not met. This means you’re left trying to find the funds to replace the asset — sometimes be a valuable piece of equipment you need to do business — and still without the funds to complete your business project.

Asset-based loans, while potentially useful, carry a lot of risk. Be sure you consult with an independent financial advisor who’s not connected to any loan agencies beforehand to ensure you’re not getting in over your head.

Who benefits from asset-based loans?

Any business owner who needs cash but is unable to secure it with a traditional lender might benefit from an asset-based loan. Sure, you may have some fees tied to the loan, but most forms of business lending will have fees. Asset-based loans typically have lower interest rates, which can balance out the fees and make the loans even more appealing.

But, not all businesses will get as much out of an asset-based loan. For the right type of business this kind of loan can be great. If you find yourself in any of the following situations, you could be a good candidate for asset-based lending.

  • You’ve been turned down by a financial institution or other traditional lender because your credit isn’t pristine.
  • You need to hire more employees, but don’t have the cash flow to make additional payroll.
  • You’re short on cash to pay your suppliers and you don’t want your credit rating or business relationships to suffer.
  • The market is ripe for expansion, but you lack the funds to purchase more commercial real estate.
  • You need to purchase more materials to fill the orders you have and credit cards won’t cover it.
  • You need cash immediately and don’t have time to wait for the traditional loan approval and funding process.

A traditional small business loan can be great when your credit history allows it. But for businesses that can’t have their financing needs met through a traditional loan, asset-based lending is often a solid option.

Do asset-based lenders work with small business owners?

Asset-based lenders are known for working with large manufacturing businesses and those in the high dollar business-to-business industries. But, many asset-based lenders will also work with smaller businesses as well, as long as they have the assets to cover a loan. QuickBooks also works with lending partners to make financing available to qualified customers.

Even if your business isn’t some mega-corp, you could be a solid candidate for an asset-based loan. As long as your business is doing fairly well and you have some assets to back a loan, you’ll likely qualify for lending services based on assets. As always, talk with a financial advisor first and see what your options are.

Find the funding you need

One of the traits that defines entrepreneurs is that they never give up, even in the face of adversity. If you’ve been unable to qualify for a traditional loan and it’s hurting your business or keeping you from expanding, talk to some asset-based lenders to find a deal that suits you.

If you can’t find an asset-based loan that’s right for you, don’t lose hope. There are always more funding options for small businesses. Take your time, continue exploring your options and before you know it you’ll have the funding you need to turn your big dreams for your small business into reality.

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Suzanne has been a full-time freelance writer for 20 years. She’s written for numerous business and financial publications such as Entrepreneur, Reason Magazine, Home Business Magazine, and Money Crashers. Read more