What is Collateral and Do I Really Need it for a Business Loan?

Written by
• 3 minute read
What is collateral?

Traditionally, collateral has been considered an important part of qualifying for a small business loan. In fact, it’s one of the Five Cs used by many traditional lenders to help them evaluate a potential borrower.

Traditional lenders, like banks, typically look for secure assets like real estate or equipment as collateral, although anything of value the lender can easily sell, to satisfy your debt should you default, might be accepted—depending on the lender.

The SBA requires collateral as security on most SBA loans (when worthwhile assets are available). With that said, according to the SBA, “The SBA will generally not decline a loan when inadequacy of collateral is the only unfavorable factor.” In other words, if the rest of your application looks good, but you don’t have adequate collateral, your application won’t immediately be rejected because you don’t have sufficient collateral.

The SBA’s definition of collateral, which is pretty straightforward and is a good guide for other traditional financing, goes like this:

“Assets such as equipment, buildings, accounts receivable, and (in some cases) inventory are considered possible sources of repayment if they can be sold by the bank for cash. Collateral can consist of assets that are usable in the business as well as personal assets that remain outside the business.

“You can assume that all assets financed with borrowed funds will be used as collateral for the loan. Depending on how much equity was contributed by you toward the acquisition of these assets, the lender may require other business assets as collateral.

“Certified appraisals are required for loans greater than $250,000 secured by commercial real estate. The SBA may require professional appraisals of both business and personal assets, plus any necessary survey and/or feasibility study. When real estate is being used as collateral, banks and other regulated lenders are required by law to obtain third-party valuation on transactions of $50,000 or more.”

Once your proposed collateral has been accepted, the banker will determine the loan-to-value ratio of your collateral based upon the nature of the asset. In other words, you may be allowed to borrow, for example, 70 percent of the value of the appraised real estate or 60 to 80 percent of what they call ready-to-go inventory. Be aware, individual lenders consider the loan-to-value ratio differently, so you’ll need to ask your lender how they intend to set that value.

Most traditional lenders require collateral with a small business loan, but there are other lenders who do not require a specific type or value of collateral to approve a loan.

A General Lien on Business Assets vs. Specific Collateral

Some lenders, including many online lenders, don’t require specific collateral, but rather require a general lien on your business assets (without valuing those business assets) and a personal guarantee to secure the loan. This may make qualifying for a loan easier and/or faster, depending upon the nature of your business and your business assets.

What’s more, because the loan is not based upon the loan-to-value ratio of specific collateral, the lender is using other data points to evaluate a business owner’s creditworthiness. For example, by looking at the overall health of your business, your cash flow, and your personal and business credit profile, you might even qualify for more than you would with a traditionally collateralized loan.

By looking at the loan process differently, many lenders are making more capital available to small business owners who don’t have the required assets needed to collateralize a loan at the local bank. Meaning, a lack of sufficient business collateral doesn’t mean you can’t get a small business loan.

This content is for educational and informational purposes only, and is not intended as financial, investment or legal advice.