Asset-based lending refers to loans that are backed by collateral instead of based on your credit score. Here's what you need to know to tell whether asset-based lending is right for your business.
- Asset-based loans rely on the value of collateral put up by the borrower, such as real estate, inventory or equipment.
- The advantages of asset-based loans include faster approvals and funding delivery than conventional bank loans.
- The disadvantages of asset-based loans include higher interest rates than conventional bank loans and the risk of losing collateral in the event of default.
- This article is for established business owners trying to determine whether an asset-based loan could help their business grow.
What is asset-based lending?
The amount of money a lender is willing to extend for an asset-based loan is based on the value of an asset held by the borrower, which is put up as collateral to guarantee repayment of the loan. Approval for these types of loans depends less on the borrower's credit score than on the value of the asset. If the borrower defaults on an asset-based loan, the lender has the right to repossess the collateral.
"Asset-based loans are a way to get business financing by using company assets as collateral," said Nishank Khanna, co-founder and president of Indigo CPA. "The loans are usually secured by either equipment, real estate, accounts receivables or existing inventory."
Key takeaway: An asset-based loan is a type of financing that is secured against a borrower's asset, instead of the lender's estimation of the borrower's ability to repay the loan based on their credit history.
How does asset-based lending work?
Asset-based lending revolves around the asset or set of assets that will serve as collateral. This could be equipment owned by the borrower, the inventory of the business, real estate or even unpaid invoices.
Once an asset is put up as collateral, the lender will offer the borrower a loan worth an agreed-upon percentage of the asset's value, Khanna told Business News Daily.
"Lenders prefer to offer larger loans because the cost to monitor an asset-based loan is the same whether the amount of capital being borrowed is small or large," he said. [Read related article: 8 Factors That Keep You From Getting a Small Business Loan]
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The most common type of asset-based loan
To better understand asset-based lending, simply think of the most common type of asset-based loan: the mortgage.
"As the name indicates, asset-based loans put a physical asset up as collateral in case a loan is not paid back," said Ty Stewart, CEO and president of Simple Life Insure. "The most common form of asset-based lending is actually home mortgages, though small businesses experience the exact same thing in the form of their commercial mortgage."
In this case, you have a term (e.g., 30 years) and an interest rate (e.g., 4%) that will help determine your monthly payments throughout the life of the loan. Defaulting on the loan jeopardizes the collateral (in this case real estate, such as a home or storefront) and gives the lender the opportunity to repossess it to cover the loan.
Asset-based loans as revolving credit
In some cases, such as when they are based on outstanding invoices, asset-based loans can be structured as revolving credit, according to Jeffrey Bardos, CEO of Speritas Capital Partners.
"Each week or month, the lender determines the amount of accounts receivable and inventory, and this total translates into a 'borrowing base,' which in turn determines the amount of available borrowing capacity," Bardos said. "Advance rates are established upfront for each type of collateral."
Key takeaway: Asset-based loans are based on the value of collateral put up by the borrower, which also serves to secure the loan in case of default.
What assets can be used as collateral to secure a loan?
A business holds many assets that could possibly be used as collateral to secure a loan. These include equipment, inventory and even your accounts receivable. Here's a closer look at some of the collateral that can be used to secure an asset-based loan.
- Accounts receivable: Invoice factoring is an asset-based loan that leverages the value of your existing accounts receivable. A factor (lender) will pay you a percentage of the value of your outstanding invoices and, typically, assume the responsibility of collecting the payments. While you don't receive 100% of the value of your outstanding invoices through factoring, you do receive a lump sum of capital ranging from 75% to 95% of the full value. The remaining percentage, plus fees, is how the factor turns a profit.
Real estate: In some cases, such as a bridge loan, real estate serves as the collateral. For example, if you purchase a dilapidated property with the intent of rehabilitating it, a lender might offer you a bridge loan secured by the future redeveloped property. If you fail to make your payments and default on the loan in this example, the lender would be able to repossess the property you just redeveloped.
Equipment: Equipment financing provides your business equipment it needs and uses that same equipment as collateral. If you do not make the payments against the equipment, the lender can repossess it.
- Inventory: You can use inventory financing to purchase goods for later sale. The inventory financed through this method will serve as collateral, much like equipment in equipment financing. Failure to make payments means the goods are subject to repossession by the lender.
Naturally, putting up these assets as collateral against a loan creates a big incentive on your end to avoid a default. Losing your commercial real estate, for example, could be a fatal blow to your business. Always have a plan for how you will pay back any amount borrowed before you accept a loan.
Key takeaway: You can use assets such as accounts receivable, inventory, equipment and real estate to secure an asset-based loan.
What are the pros and cons of asset-based lending?
Asset-based loans have some advantages over conventional loans, such as term loans from a bank or credit union. However, they also present some disadvantages and risks that you should be aware of before accepting a loan.
Benefits of asset-based-lending
The clearest benefit of asset-based loans is that they are relatively easy to obtain, even if you have less-than-stellar personal or business credit. Using an asset as collateral assures the lender that they will be able to recoup the value of the loan even if you default.
Asset-based loans also tend to be approved and funded more quickly than conventional term loans from a bank or credit union.
"Asset-based loans can provide capital much quicker than other lending vehicles, specifically when you need funds for things like sudden expansions or ramped-up production," Stewart said.
Securing an asset-based loan is typically easier than securing a bank loan, which usually requires a good credit score, significant financial history, healthy debt-to-income ratio and more.
"Securing an [asset-based loan] should be fairly easy if your business has proper financial statements, inventory and products that have an existing market, and a history of paying bills on time," Khanna said.
Fast funding and more flexible approvals make asset-based loans suitable for businesses looking to invest in a significant expansion, as well as businesses unable to access more conventional loans. [Read related article: Small Business Financing Options Without a Traditional Bank]
Drawbacks of asset-based lending
The primary drawback of an asset-based loan is that you are putting an asset at stake, one which might be critical to your business's survival and success. Defaulting on an asset-based loan also impacts your personal and business credit.
"The most obvious drawback is the double whammy of having your physical asset taken from you if you fail to pay back the loan combined with the hit to your personal and business credit scores," Stewart said.
Moreover, while an asset-based loan can get your business fast funding, even if your credit history isn't great, other lenders could look upon it negatively if you seek additional financing in the future. You can typically mitigate this risk by limiting the value and number of asset-based loans you accept.
"Small businesses too reliant on asset-based loans may wave a red flag if they approach other lenders, who may view this history as playing fast and loose with business decisions," Stewart said.
Finally, asset-based loans sometimes come with additional fees, such as a fee for any unused funds you borrowed, Bardos said.
"Most asset-based loans have 'unused fees,' which can increase the effective cost of a facility," he said. "For example, if a small business obtains a $2 million asset-based loan but only needs $1 million over the next 24 months, they may be charged an unused fee on the unused $1 million."
Key takeaway: Asset-based loans are more flexible, approved more quickly and provide faster funding delivery than conventional loans, but they sometimes carry additional fees and create the risk of losing your collateral in the event of default.
Asset-based lenders to consider
If you're considering an asset-based loan for your business, you have plenty of lenders to choose from.
"There are a wide range of asset-based lenders," Bardos said. "The global and regional banks offer asset-based loans. Private, nonbank firms provide asset-based loans to small businesses. And there are numerous lenders who lend against one specific type of collateral, such as accounts receivable."
Here are a few lenders that offer asset-based loans:
Balboa Capital issues multiple types of asset-based loans to small businesses, including equipment financing. It also offers standard term loans. Visit our full review of Balboa Capital to learn more.
Crest Capital provides equipment financing options to small businesses, with loans ranging in value from $5,000 to $500,000. Visit our full review of Crest Capital to learn more.
Fora Financial is a versatile lender that extends asset-based loans to businesses in the form of equipment loans, inventory loans and bridge financing. Visit our full review of Fora Financial to learn more.
Noble Funding offers asset-based loans to small businesses, including invoice factoring and lines of credit. Visit our full review of Noble Funding to learn more.
Rapid Finance offers a wide range of financing options to small and midsize businesses. It also offers term loans, lines of credit, bridge loans, SBA loans, commercial real estate loans and healthcare cash advances. Visit our full review of Rapid Finance to learn more.
- SBG Funding provides flexible loans to young businesses with a minimum credit score of 500 and $150,000 in annual revenue. It also offers lines of credit, equipment financing and invoice factoring. Visit our full review of SBG Funding to learn more.
For more information on each of these lenders and how to choose a business loan that's right for you, visit our best picks page for business loans.