What Every Business Owner Should Know About Collateral

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Given the way banks are getting the hairy eyeball from the Feds these days, if you want a loan you can be sure you'll have to pledge something as collateral — your signature won't be good enough. The bank will require something of value they can sell — if worse comes to worst — to recoup the money they gave (rented) to you. Sounds straightforward, but establishing the collateral value of an asset is often a point of contention in loan negotiations.

Let's say you bought a truck just last week with $75,000 of your hard earned cash. (Bad move using your cash, by the way, but that's a different issue.) Still spanking new, and paid for, you offer your truck as collateral on an equipment loan for your start-up business. But the bank says it's only going to assign a collateral value of $45,000 to your vehicle. What gives?

The difference in value is due to the reality that, if the bank has to sell your truck because you can't make your loan payments, there's no way they'll get 100 cents on a dollar.

Anyone who's tried to sell a relatively new car understands the problem. The same principle applies in spades if, say, you're in the ditch digging business and want to use that custom built backhoe as collateral. If the bank thinks they'll have a hard time selling it, even if it's dirt cheap, they'll assign a low collateral value.

Consider this extraordinary example: Lehman Brothers offered JPMorgan over $8 billion in cash and securities as collateral on a guaranty. Not long after the transaction Lehman declared bankruptcy. JPMorgan figured they were in good shape because they had all that collateral until they discovered the securities couldn't easily be converted to cash and their value was hard to determine. So, as part of a bankruptcy settlement reached a couple weeks ago, JPMorgan is transferring the securities back to Lehman and accepting a cash payment of about $560 million — less than 10 cents on a dollar.

Even when you're talking thousands — never mind billions — of dollars, valuing collateral is always a source of contention between you and your lender. They want as much as they can get, and you want as high a value as possible for what you're offering. Part of the problem is that details about the value of your collateral may be common knowledge to you, but your lender may not understand the basis for your understanding. The best thing you can do is educate them on what your collateral is really worth, and you need to know where they're coming from.

Here are some rules-of-thumb to help you understand how a lender's likely to value your collateral:

1. Accounts receivables (A/R) less than 60-90 days old are generally valued at 50-85%.

The collateral value of your A/R will be valued on the high end of the range if you sell to:

• Businesses vs. consumers;
• Large businesses vs. businesses;
• Many businesses vs. just a few.

Your A/R will be valued lower if you sell to:

• High risk businesses (say, restaurants);
• Foreign customers;
• Slow paying customers;
• Customers with past due balances.

2. Inventory will be valued, as collateral, at anywhere from 10-60% of the Balance Sheet value. It will be valued on the low end of the range if:

• Inventory turnover is slow;
• You sell many locations especially out of state;
• It's in a leased facility (unless your lender has a landlord's waiver);
• Most of it's work-in-progress (unfinished stuff that the lender would have a hard time selling);
• It's perishable, fashionable, or requires special storage.

3. Furniture and equipment will be valued from 10-80%. Lower values will be assigned if it's specialized equipment that will difficult to sell or if it has little value in the secondary market.

Here's a good example of why it's important to educate your lender: A transportation company owned hundreds trailers that rode piggyback on freight trains. Fully depreciated their Balance Sheet value was zip so the bank wanted to give them zero collateral value. But these trailers spent most of their life on a train and had very little wear. With a fresh coat of paint they could actually sell at greater than their purchase price, given favorable market demand. An appraisal proved the point and a 30% collateral value was established. If the trailers weren't located all over the country, and difficult to find, the assigned value would have been a lot higher.

4. Real estate generally is given a collateral value of 50-90% of the appraised value (less any liens or mortgages). Real estate will be valued lower if it's investment real estate, special-use property, located in a distressed area, or if the real estate market is experiencing a "trough of demand," such as, say, 2010.

5. Cash, believe it or not, can be used as collateral. You can pledge money to borrow money? Don't laugh! Lenders will accept cash in the form of a certificate of deposit (CD) from their bank as collateral. But, because of liquidating it, even a CD from their bank won't be given 100% collateralization value, and one from another bank will be valued even lower. Some lenders will accept stock, bonds, or other people's assets (like real estate or certificates of deposit) as collateral, too.

6. Contracts or purchase orders might be accepted by some government lending programs, and occasionally by conventional lenders. In either case, their worry will be how they'll be paid if you don't perform — in most cases it won't be easy for them to find someone else to fulfill the order so they can collect the proceeds.

These may not be the best economic times, but if you're refinancing or trying to negotiate a loan, keep the guidelines we've listed above in mind. More importantly, make sure your lender understands the realities about what you're offering as collateral so you get the best possible valuation.

This is a guest post by Tom Harnish. Tom is a serial entrepreneur. He learned what works (and what doesn't) when raising money by spending countless (and often fruitless) hours in front of lenders and investors.