Collateral is defined as an asset that is pledged as security for repayment of a loan, to be used to recover the loan in the event of a default.
What types of loans require collateral?
Usually loans that are offered to new (less than 2 years) and start up businesses require collateral to be pledged to the loan. Existing businesses that are showing a profit and have more than 2 years of tax returns and financials to evaluate may not be required to pledge personal collateral to a business loan.
Existing Business (2+ years)
Underwriters are able to analyze the profit and loss statements, balance sheets and cash flow of an existing business and may not require collateral when offering a loan.
Startup Business
This is not the case for newer businesses or start up businesses. When businesses are new, there is no historical financial data to evaluate to determine whether the business has the ability to repay a loan. Therefore, the lender will likely ask the owner(s) of the business to pledge something as collateral to the loan to secure the loan in case of default. This is especially true for higher loan amounts.
What assets can possibly be used as a pledge of collateral?
- Real Estate
- Cash
- Payment Reserve
The most common forms of collateral pledged to a loan are real estate assets or cash. If real estate assets are pledged, the lender will put a position lien on the property or properties being pledged. If there is a mortgage on a property being pledged, the mortgage itself is the first position lien. The lender providing the business loan will put a second position lien (after the mortgage) on the property. If there is a mortgage (first position lien) and a home equity loan or line of credit (second position lien) the lender providing the business loan may put a third position lien on the property. This may not mitigate enough of the risk for the lender, so they may want something in addition to the third position lien depending on the loan amount.
Cash collateral is the other most common form of collateral. Cash collateral can be in the form of a CD (Certificate of Deposit) that is held at the financial institution offering the loan. When a CD is pledged it is usually for the same term as the loan term. If the loan is a 10 year term, the CD will be a 10 year CD.
Another option of cash collateral that is commonly used is called a cash payment reserve. The payment reserve option is a bank-controlled savings account that is held for a period of two years. If the loan payments are made in full and on time every month and the business is showing a small profit above break-even, the payment reserve fund is released back to the borrower plus any small amount of interest that accrued over the two year period that the funds were held.
What amount of collateral is required?
Lenders providing SBA loans will follow the guidelines set forth by SBA.
Loans less than $350,000
For loans less than $350,000 lenders are able to make their own determination of the amount of collateral they will require. The amount of collateral required will depend on whether the business has historical financials that are profitable. For start up financing, it will depend upon the loan amount and also the percentage of equity that a borrower is providing for his or her project.
Collateral may not be required for a start up project if the borrower is putting in 50% or more of his or her own personal funds into the business. This is not a set rule, but likely a possible way to avoid pledging collateral to a loan. Most borrowers are not able or do not wish to invest personal funds of this percentage. Many borrowers prefer to invest 25% or less into their project and want the lender to provide 75% to 80% of the funds. When this is the case for start-up financing, most lenders will require collateral to be pledged to the loan. The amount is highly dependent on the total project cost and loan amount.
Loans greater than $350,000
For loans greater than $350,000 the SBA requires the lender to take all available business and personal assets of the borrower to be pledged as collateral. Dollar for dollar collateral is required by the SBA. If there is a shortfall (collateral being pledged does not add up to the same amount of the loan) the most common way to make up for the missing funds is an assignment of a life insurance policy.
After all business assets, real estate assets, and cash assets are pledged, the remaining balance of shortfall will become the benefit amount of term life insurance the lender will require from the borrower. The life insurance policy will be payable to the lender as a collateral assignment with lender named on the declarations page of the policy. If the borrower does not own any real estate and they have large cash accounts, the lender will usually negotiate an amount of cash to be held as a CD for the term of the loan or a payment reserve with an additional collateral assignment of a life insurance policy.
The borrower can also elect to protect the assets of the business with the full loan amount protected by a life insurance policy given as collateral assignment to the lender. If a borrower does have real estate assets and their loan is $350,000 or higher, it is a requirement as per SBA that the lender put a lien on all business assets, all real estate assets and to make up any shortfall with cash or life insurance assignment. Borrower’s are not able to refrain from pledging their real estate assets (if they have any) by using a life insurance assignment. It is just a way to make up a shortfall if real estate assets are not available.
Is there flexibility with respect to the collateral pledge during the term of the loan?
Flexibility is a common concern for borrowers. If a borrower pledges a real estate asset and wants to sell the property during the term of the loan what happens?
Most lenders that provide SBA loans are very accustom to dealing with changes that occur during the common ten year term of the SBA loan. Should a borrower want to move or sell their property, the lien can be lifted and moved elsewhere (the lien can be moved from one property to another).
Alternatively, sometimes borrowers make a profit on the sale of a real estate asset that was originally pledged to their business loan. They can negotiate with the lender to possibly pay down the loan amount using the funds from the profit of the sale to bring the loan amount down to a level where a collateral pledge is no longer needed.
Another option would be to lift the lien on the property and to create a payment reserve in lieu of moving the lien from one property to another. The important point to understand here is that the collateral pledge should be one that the lender allows a borrower some flexibility to adjust.
Borrowers should ask about the lender policies with respect to their collateral pledge(s) during the initial loan discussion. It is best to be fully informed about the lender’s policies in the event of changes that might occur during the term of the loan. For this reason, it is a very good idea for a borrower to be sure they are working with a lender that is easy to communicate with and one who has policies that are negotiable.