Entrepreneur: Start & Grow Your Business

Asset-Based Loans

Use your assets--like accounts receivable and inventory---to help you land funding.

URL: http://www.entrepreneur.com/money/howtoguide/article52726.html

What It Is: Asset-based loans are usually from commercial finance companies (as opposed to banks) that are offered on a revolving basis and collateralized by a company's assets, specifically accounts receivable and inventory.

Appropriate for: Companies that may be rapidly growing, highly leveraged, in the midst of a turnaround or undercapitalized. In addition, asset-based financing works only for companies with proven accounts receivable, and a demonstrated track record of turning over their inventory several times each year.

Supply: Overall, the supply of asset-based financing is vast. A large number of commercial finance companies, as well as many banks, have massive pools of capital to lend to businesses. However, for asst-based loans of $500,000 or less, the market is considerably smaller. Most asset-based lenders would prefer to make larger loans because the cost to monitor an asset-based loan is generally the same whether it's large or small.

Best Use: Financing rapid growth in the absence of sufficient equity capital to fund receivables and inventory. Well suited to manufacturers, distributors and service companies with a leveraged balance sheet whose seasonal needs and industry cycles often hamper their cash flow. Asset-based loans can also be used to finance acquisitions.

Cost: More expensive than bank financing, since asset-based lenders generally have higher expenses than bankers. Still, pricing is competitive among asset-based lenders. Small asset-based loans can be pricey, though, running 12 percent to 28 percent. Funds typically available are $100,000 and greater.

Ease of Acquisition: Comparatively easy if your company has good financial statements, good reporting systems, inventory that is not exotic and, finally, customers who have a track record of paying their bills. If you don't have any of these, your path to an asset-based loan will be challenging.

Range of Funds Typically Available: $250,000 to $1 million from small finance companies and financial institutions. Larger lenders tend to specialize in financing amounts of $1 million and greater.

First Steps
Here are the typical steps of a typical asset-based loan:

Step 1: The process starts with the company selling its product or service to customers. Unless it's a cash business or a business in which customers pay for all of their purchases by credit card, a receivable is created. The receivable, a debt to the company, is, in most cases, repaid to the company in 10, 15, 30 or 45 days. This asset, in combination with inventory, which is not shown in the diagram below, starts the process.

Step 2: The lender makes a loan to the company based on the value of the receivables. As discussed, the lender won't advance 100 percent of the receivables but will advance 90 percent of the eligible receivables. The moment funds are advanced, the company starts paying interest, and the lender starts earning interest.

Step 3: Pay close attention here. Note that with an asset-based loan, in most cases, the customers do not send their payments to the company that sold them the product or service but instead directly to the finance company. Asset-based lending can be uncomfortable for some businesses because a third party gains control of the company's cash flow.

This discomfort is warranted. Under such a scenario, certain events may turn out bad for the borrower. For instance, suppose a borrower has a large outstanding balance that is continuously revolving, and an entire group of the borrower's customers experienced some sort of financial peril. Say they all sold products to a region of the world that experienced financial meltdown. The lender, who closely monitors the assets, and begins to see the length of these customers' receivables expanding, may take a "reserve" to protect itself against possible loan losses. This reserve might come from the company's customer payments. Instead of remitting customer payments to the company, the lender hangs on to some of them to create this reserve against future loan losses. Suddenly, the company does not have the funds it was counting on.

Step 4: The lender remits to the company invoices paid, less the principal on loans it has already advanced, less interest.

Timothy Gannon of Independence Community Bank in New York City says that to successfully negotiate an asset-based deal, borrowers must come to the table with financial information that not only paints a positive picture but also is detailed and accurate. They must also be willing to make the lender comfortable. Among the requirements he cites:

The business must have a reasonable net worth and long-term viability.
Financial statements must be reviewed by a certified public accountant whom the lender deems acceptable.
Borrowers must submit a year's worth of monthly projections.
The business's principals must guarantee the loan, and the guarantee must be supported by personal financial statements.
Keyman (or keywoman) life insurance may be required.

Excerpted from Financing Your Small Business. Buy it today.