Asset-based lending is a form of business financing that uses a business asset as collateral for a loan. If you default on the loan, the lender can take possession of the asset. Typical types of asset-based loans include accounts receivable financing, inventory financing, equipment financing, or real estate financing.
What Asset-based Lending Is
Asset-based lending utilizes your business assets to secure financing for your business. An asset is used as collateral for the loan and, in the event of borrower default, the lender can repossess the pledged asset. Invoice financing, invoice factoring, and equipment financing are the most common types of asset-based lending, allowing businesses to capitalize on current invoices.
How Asset-based Lending Works
When applying for an asset-based loan, the lender will determine the borrowing base, which is the amount that can be loaned against a given asset. The lender will conduct a valuation of the asset to verify the amount that can be borrowed and due diligence to make sure the asset isn’t already collateralizing a loan. If the lender finds everything to be satisfactory, your loan will be approved, and you will receive funding.
When you take out an asset-based loan, the underlying asset will be used to collateralize the loan, meaning that failure to make payments could result in the lender repossessing or taking possession of the collateral. To avoid default, be sure to make your payments on time and in full.
Who Asset-based Loans Are Right For
Asset-based loans are a good financing choice for small businesses that have existing assets they can pledge as collateral on a new loan. These loans often have lower credit score requirements, involve less personal risk, and can offer easier access to funding than other lending options.
Some small businesses that may benefit from asset-based lending include:
- Businesses with lower credit scores: Financing that is backed by assets typically has lower credit score requirements than unsecured debt.
- Businesses in need of fast capital: Many asset-based financing products are set up as a line of credit; this allows you to use the funds for working capital as needed without having to apply for additional financing.
- Businesses with existing assets: Asset-based financing can leverage your existing assets, allowing you to utilize the equity in your assets to invest back into your business.
- Business owners that want less personal risk: Most small business loans require a personal guarantee. However, asset-based loans have less risk associated with the lender, and many do not require personal guarantees.
An asset-based loan can be a good way for businesses to improve their immediate cash flows by leveraging their existing assets. The types of asset-based loans available are as diverse as the types of assets a business may have.
Types of Asset-based Lending
Many types of assets can be leveraged for asset-based lending; however, some types of assets are more commonly collateralized. While real estate and equipment are commonly used as collateral, inventory, accounts receivable, and other tangible assets can also be used to back small business loans.
1. Accounts Receivable Financing
Accounts receivable financing and invoice financing use your current customer invoices as collateral for a business line of credit. You select the invoices you want to finance, and the lender advances you a portion, typically 80% to 90% of the invoice value.
Invoice financing is different than invoice factoring, which involves assigning your invoices to the factoring company. With invoice factoring, the factoring company purchases your invoices and advances a portion of the invoice value to you. The factoring company then collects payment from your customers and advances you the remaining amount of the invoice less the factor rate. With invoice factoring, it is important to familiarize yourself with common invoice factoring mistakes and to keep organized financial records to account for the advances and fees.
2. Inventory Financing
Inventory financing utilizes existing or future inventory as collateral for a small business loan or line of credit. Using inventory as collateral is slightly more complicated than using a fixed asset like real estate or equipment because inventory is always fluctuating. Lenders may require additional and ongoing reporting when inventory is used to back financing to ensure that the loan remains properly collateralized.
3. Equipment Financing
Equipment financing uses the equipment you already own or the equipment you are purchasing, as collateral for financing. Much like a personal auto loan, the business equipment protects the lien. In the event you default on the loan, the lender can take possession of the equipment in place of repayment on the remaining debt.
4. Real Estate Financing
The equity in real estate you own can be used as an asset to secure a loan. This is typically referred to as an equity loan rather than asset-based financing although, by definition, it is a type of asset-based loan. In general, financing based on the equity of your real estate is offered in the form of a line of credit, and most major banks offer commercial real estate equity loans.
5. Financing Based on Other Tangible Assets
While much less common, it is possible to pledge assets other than those named above as collateral on a loan. In general, if you have an asset, including receivables, that has value, and a lender is willing to accept it, you can use it to back a loan. Transactions of this type would require a professional valuation to determine the value of the item intended to be used as collateral.
How to Apply for Asset-based Loans
Applying for asset-based loans is very similar to applying for other forms of small business financing. You will need to prepare your financials and other supporting documentation and complete an application. The key differences for asset-based loan applications involve the details of the assets you are leveraging and how the lender evaluates those assets.
1. Prepare Your Business Financials
Prior to applying for asset-based financing, you should prepare your business financials. Lenders will often want to see a current balance sheet and profit and loss (P&L) statement. You will also be asked for copies of recent business tax returns. Even though assets will be used as collateral, the lender is still going to need to verify that your business finances will be able to support the new debt.
2. Identify Your Business Assets
Before you can leverage your assets for financing, you need to determine what you have available to use as collateral. Does your business own real estate? Do you have healthy accounts receivable? Perhaps you have equipment that has been paid off and still retains value? Knowing the assets that you have and their value can help you determine which type of loan to pursue.
3. Make Sure Assets Are Unencumbered
To be used as collateral for a loan, an asset cannot already serve as collateral for another loan. Lenders will generally require that they receive first lien position, which is difficult to negotiate if another lender already has a claim or partial claim to the asset. To make the process easier, the asset you intend to pledge as collateral should not be encumbered by other liens.
4. Complete Your Application
With your available assets identified, you are ready to decide a lending product and lender and complete your financing application. Be certain to fill the application out completely and to provide all of the information being requested by the lender. If you are uncertain as to what is being requested, take the time to contact the lender for clarification.
5. Submit Supporting Documentation
Most applications will include a list of supporting documentation you will be required to submit to the lender. Review this list and gather each document the lender is requesting. Include all of the requested documents with your application when you submit your application. Contact your lender if you are unclear as to what is being requested.
6. Review Your Offer & Accept Due Diligence
Once the lender has reviewed your application, you will be presented with a financing offer. You will need to review the offer thoroughly. Take the time to read through the offer, including the rates and terms associated with the financing. If there is anything you don’t understand fully, ask the lender for further explanation. For complex financing agreements, it may be a good idea to have your attorney review the documents.
As part of the offer, you will accept the lender’s due diligence process, which is a period in which the lender reviews various aspects of your business and its financials. During the due diligence review, the lender will take a closer look at your financials, do a hard credit check, and confirm all of the information provided in your application. This process is often abbreviated when you are receiving financing through an online lender.
7. Proceed Through a Field Audit
As part of the due diligence process, the lender may visit your business to verify the assets are on-site and conduct their own valuation. This field audit is more likely to occur if you are using inventory, equipment, or real estate as collateral on your loan. The lender will want to verify the state of the asset and ensure that it matches the descriptions provided in the application.
8. Final Approval & Funding
After the lender has completed the field audit and due diligence, you will receive your final approval for financing. The final approval will include the rates and terms of the financing. After accepting the lending agreement, you will receive funding. The amount of time it takes to receive funding will vary by lender and loan product.
In most cases, funding will be provided to you via automated clearing house (ACH) directly to your business bank account although, on occasion, some lenders due still issue paper checks. After receiving the funds, the repayment schedule you agreed to will commence, such as with monthly payments, your first payment will be due four weeks after receiving funding.
Pros & Cons of Asset-based Lending
Asset-based loans generally have relaxed qualification requirements, lower cost of capital, and fewer restrictions on fund use than unsecured business loans. However, lenders may undervalue your assets and require ongoing monitoring of their value. Additionally, if you default on an asset-based loan, you risk losing your collateral.
Pros of Asset-based Loans
Some of the benefits of asset-based lending include:
- Relaxed qualification requirements: Because the loans are backed by collateral, and there is less risk for the lender, qualification requirements are typically less restrictive than with an unsecured loan.
- No restrictions on the use of funds: In general, there are no restrictions on how the funds from an asset-backed loan are used, aside from being used for business purposes.
- Lower cost of capital: Because the financing is secured by collateral, the interest rates charged will be lower than comparable unsecured loans, offering the borrower a lower overall cost of capital.
Cons of Asset-based Loans
Some of the disadvantages of asset-based lending include:
- You could lose your asset: If you use a construction factoring company to buy equipment for your firm and later default, you could lose the equipment you pledged as collateral.
- Potentially low asset valuations: Lenders may undervalue your asset when approving you for financing. While this further protects them against loss, it also reduces the amount that you can borrow.
- Ongoing monitoring of asset value: To ensure that the loan remains properly collateralized, a lender may require ongoing monitoring of the asset’s value, such as continued financial reporting to the lender.
Asset-based Lending Frequently Asked Questions (FAQs)
What is asset-based financing?
Asset-based financing is a lending product that uses an asset as collateral for the loan. In the event the borrower defaults on the loan, the lender can take possession of the asset. For example, a mortgage is an asset-based loan using a piece of real estate as a collateral asset.
What is an asset for a loan?
An asset for a loan is a tangible item of value that can be used as collateral. Assets come in various forms, such as real estate, equipment, customer invoices, and accounts receivable. The asset is pledged against the loan, reducing the risk to the lender, and allowing for better rates and terms for the borrower.
What do banks consider assets?
Banks consider anything that has value and can be sold or cashed-in to be an asset. The most common forms of assets that banks accept as collateral include real estate, equipment, inventory, accounts receivable, or cash accounts. These assets can be pledged as collateral to back new financing.
If your business needs funding to improve cash flows and has assets available that can be pledged as collateral, an asset-based loan may be the answer. Asset-based lending can turn the equity in your assets into cash for your business, without restricting the use of funds.