Asset-based lending is one of the best ways for young businesses or entrepreneurs with poor credit scores to receive large loans from lenders. When compared to other types of small business loans, asset-based loans are easier to qualify for so long as your business owns valuable collateral. Here's what you need to know about asset-based lending to determine if it is right for your business.
Editor's note: Looking for financing for your business? Fill out the below questionnaire to have our vendor partners contact you with free information.
What is asset-based lending?
Let's start with the basic logic behind asset-based lending. This is a practice that has been around for as long as lending has been an industry. It started with a simple advance of money based on a company's assets. The straightforward thinking for a lender is that if it thinks your company's assets are worth $100, they will feel comfortable advancing you up to that $100 secured by the company's assets. The emphasis is on "up to" a certain amount of a company's assets.
So, what determines how much of an advance a company receives for its assets? Using the example of a company with $100 worth of assets, how will a lender decide if they should lend a company $50, $75 or $95? The short answer is that there are a multitude of factors that determine a lender's advance rate and the actual cash they provide to their borrowers. To simplify even further, the more liquid a company's assets, the higher the likelihood that an asset-based lender will provide more cash.
You've probably heard the saying that it takes money to make money, and while we don't necessarily believe 100% in this statement, there are some fundamental truths to it. Going back to our $100 in assets example, let's say the company's main asset was all in the form of inventory. Your expected advance would be less than a company with $100 in accounts receivable on its balance sheet, the reason being that accounts receivables are closer and more likely to turn into cash – which is crucial from a lender's perspective. [Looking for a business loan? Check out our best picks and reviews.]
What are the pros and cons of asset-based lending?
Here are the benefits of pursuing – and ultimately using – an asset-based loan as a means to working capital.
- Flexibility. One of the main benefits of an asset-based loan is that the overall flexibility from a lender is much higher when a company pledges assets to secure a loan. Usually, lenders will look past credit history, underperforming, unprofitable businesses and other credit issues as long as a company has a strong asset pool. Companies that are going through a hiccup or “bump on the road” can use asset-based lending to obtain liquidity when they are in dire need of it.
- Maximum proceeds. Another benefit of an asset-based loan is that in some cases a company will have the ability to get maximum proceeds than with other types of loans.
- Frequent reporting. One less direct benefit of being in an asset-based relationship is that generally most lenders will require consistent and frequent reporting in the form of weekly borrowing bases, or monthly reports that some companies may or may not have discipline with.
- Better cash management. Companies in an asset-based lending relationship tend to develop better practices with cash management and overall financial reporting.
Although asset-based lending is a great tool for companies seeking additional liquidity, there are some downsides that you need to consider before going down this path.
- It takes time. While lenders are constantly working to improve the customer experience, there is still a rather burdensome and time-consuming aspect of an asset-based lending relationship. This time consumption means that a company’s finance department needs to be strong and capable of handling the reporting needs of an asset-based lending relationship. [Don't have time to wait? Learn about fast business loans.]
- Increased monitoring. Another less attractive feature of most asset-based loans is the supplementary monitoring needed from the lender to make sure that the collateral values assigned are maintained through the life of the loan. Lenders tend to require more field exams, audits and, in certain cases, appraisal updates as a way to manage their loan.
What types of assets are used to secure an asset-based loan?
Most asset-based lenders structure their loans with an advance on accounts receivable, which is a very liquid and desirable asset to lenders. However, this doesn't mean that lenders don't make aggressive advances on other collateral types. Common asset-based loans include advances on inventory as well. There's a select group of asset-based lenders that focus on lending on machinery and equipment as well as real estate.
Some of the most common assets used to secure asset-based loans include:
- Accounts receivable
- Product inventory
- Specialized equipment
- Real estate
Over the years, there has been a rise in specialized asset-based lenders that focus on one particular type of collateral. These lenders are experts in their field and have an added appetite for specific collateral after years of lending to one particular type of asset. One additional collateral type that is less common is intellectual property. This particular asset is generally ignored by most lenders. There are just a few instances where an asset-based lender would find comfort lending on intellectual property. One such instance is when there’s a company with an established brand that an asset-based lender can find a specific value for the intellectual property through market research.
What terms does asset-based lending offer?
A typical asset-based loan is structured over a two- or three-year period. A grand majority of asset-based lenders seek to be more of a transitional credit provider. In most scenarios, asset-based lenders are coming into situations where the company they are lending money to is in the middle of a transition period.
Because of this dynamic, terms and relationships with asset-based lenders tend to be on the shorter end. However, capital-intensive businesses are great examples of a certain type of company that benefits from an asset-based loan over the long term. [Read related article: Do You Understand the Fine Print of Your Loan Agreement?]
What type of businesses should use an asset-based loan?
Most types of businesses can benefit from using asset-based loans as a means to help with growth capital or general working capital. Small and midsize businesses that are in a growth, turnaround or acquisition mode can find great value with an asset-based loan. All companies with assets in their balance sheets that include accounts receivables, inventory or fixed assets should consider an asset-based loan as a viable financing option.
There are exceptions for businesses that are not generally built for an asset-based loan. Such exceptions include businesses that use a recurring revenue model, companies that carry no assets on their balance because of the nature of their business and companies that are doing mostly cash transactions.
What are the best industries for this program?
Industries with a capital-intensive nature tend to be a great fit for asset-based lending. If you're a distributor or a manufacturer, you're a "down the fairway" prospect for an asset-based lender. The stronger your collateral pool, the more attractive a lender will find your company's situation.
A majority of industrial businesses thrive with asset-based loans. Businesses in industries with expected seasonality also benefit from the fluid aspect of an asset-based loan. Long-standing industries that participate in asset-based lending include retail, apparel, staffing and business service companies that extend credit to their customers.
What does the asset-based loan approval process look like?
The process of getting approved for an asset-based loan can take 30 to 90 days, depending on the complexity of each business. On average, most underwriting processes for an asset-based loan last 30 to 45 days.
During those 30 to 45 days, an asset-based lender conducts appraisals on any collateral they deem needs an examination in order to determine its value. This is usually followed or, in some cases, simultaneously run with an audit or field exam. A field exam typically takes place in the company’s headquarters or where the company keeps its books and records.
The goal of the underwriting and due diligence period is to give an asset-based lender insight into the company, its assets, and its financial reporting. After field exams and appraisals are completed, the lender and the potential borrower enter the legal drafting of the loan document. A loan closing is accomplished when all parties come to an agreement on all terms on the loan and all parties execute a loan agreement.
In some cases, where there’s a complex legal situation or out of the ordinary business structure, the underwriting process can extend beyond the usual timeframe. SMB Compass has compiled the most common situations that tend to slow down the underwriting process:
- When borrowers are not transparent with their potential lender on specific numbers, data or other information shared prior to due diligence.
- The ability of a borrower to provide all necessary information and reporting needed by a lender in order to complete their due diligence.
- Legal representation from the borrower's side that does not have experience with an asset-based lending relationship and loan documents.
- Volatile and unpredictable changes to the business, which cause fundamental aspects of the initial deal structure to change (e.g., loss of major customers, lawsuits and change in ownership).
Overall, asset-based lending programs can be used for a variety of different situations and for all types of industries. Understanding the options and how they will impact your business is a crucial component in your search for financing. The best thing you can do before applying for an asset-based loan is to know who you are working with, if you have the assets to secure a loan and if it's the right solution for your business.
Example of asset-based lending
To qualify for an asset-based loan, a business pledges its highly-liquid marketable securities – assets that can be quickly converted into cash – as collateral. The lender then decides to grant a loan based on a percentage of the face value of the securities. If the securities are valued at $100,000, and the lender is willing to provide 85% of the face value of the securities, the business will receive a $85,000 loan.
Depending on the type of asset and how liquid it is, the rate the lender provides upfront may change drastically. When marketable securities are highly liquid, lenders may provide a higher percentage rate, such as 85%. Real estate or equipment is less liquid, so the lender may only offer 50% of the face value.
How to qualify and apply for an asset-based loan
When compared to other types of business loans, lenders who offer asset-based loans are usually less concerned with your credit history, cash flow, or overall profitability. Instead, these lenders are more interested in the value and liquidity of the collateral you provide. For this reason, to qualify for an asset-based loan, you generally only need high-value assets to get started.
Additional reporting by Sean Peek.