Collateral refers to assets that a borrower signs over to a lender to secure a loan. If the borrower stops making the promised loan payments, the lender can sell the asset to recover the money loaned. What this means is that if you have ceded an asset to a lender as collateral for a loan, you CANNOT sell that asset without the written consent of the lender. Once the loan has been repaid in full, the lender no longer has a claim on the asset and you are free to sell it if you wish.
Because collateral offers some security to the lender in case the borrower fails to pay back the loan, loans that are secured by collateral typically have lower interest rates than unsecured loans. A lender's claim to a borrower's collateral is called a lien.
To answer this question you need to “get into the shoes” of the lender. The only reason they want collateral is that they need to guarantee they will get their money back even if your business fails and you cannot repay the loan. As a result lenders only work with items that can be quickly sold and converted into money.
The harder it is to sell the item, the less likely it is that you can use it as collateral. Common types of collateral are:
Often lenders and business owners view the value of assets differently when it comes to collateral.
While you may value an asset based on what it cost, its use, current value and the upper end of what it might sell for, lenders take a more cautious and sometimes pessimistic view of your asset.
As always there is a cost to ending a loan agreement before time and particularly when the business can no longer pay its loan instalments. Understanding these costs helps you understand why lenders value assets at less than you would expect.
Some assets, such as a house, might already have bonds against them. In this case the asset cannot be used as collateral but, if a fair amount of money has already been paid into the bond, it might be possible to secure a second bond on the house.
Other assets, such as insurance policies, only have value up to the amount that you have paid so far. This will be the surrender value of the policy, less the costs associated with the administration of the policy and the act of closing the policy.
The point is that there are costs attached to selling an asset and the future is always unpredictable. Imagine if you were a lender and had loaned money to a small business. The owner had offered his house as collateral for the loan and you had valued the house at a specific value. Then an economic recession hits and the business crashes and house prices fall dramatically. This would be a disaster for you if you had valued the asset at its full value, because you would clearly lose money. To avoid this type of risk, lenders value assets at significantly less than their true value.
You know the value of your assets, but the lender might not. This is something you and your business advisor can work on together to educate your lender. It is important to understand that the lender doesn’t always know the industry in which you operate. In light of this, they may place a low collateral value on a specialised industry-related asset, such as a machine or stock, simply because they do not understand its value in your industry. If you can present a good argument and evidence not only of the value of the asset, but also of how easily it could be liquidated, it may be possible to convince a lender to place a higher collateral value on an asset.
If your business sells on credit, an option may be to offer your debtors book as collateral. Generally, a lender will place a collateral value of between 30% and 75% of the face value, on payments that are owed to you. Usually, this is only for invoices that are less than 90 days old. If you have more business customers than individual customers, the lender values your accounts more. The bigger the businesses and the more business customers you have, the better, as the lender views this as an opportunity to spread the risk. The quality of your customers is also important and will influence how the lender values your debtors’ book.
Keep in mind that lenders are wary of invoices for customers who are difficult to chase, such as businesses based in other countries. These invoices won’t fetch a high value.
Maybe you have a business that can offer stock as collateral. The value that the lender will attach to your stock will range from 10% to a maximum of 50%. This depends on whether the lender thinks the stock would sell easily under a forced-sale condition. These are the types of questions a lender might ask:
You won’t get more than 75% of the value of equipment and machines in your business. The collateral value can go down to as little as 10% if it is highly specialised and therefore has a limited market willing to buy, or if it is second-hand (these types of goods are considered to be high risk), or even if it is difficult to move or store and/or can easily be stolen.
Land and buildings usually fetch the best collateral values, sometimes as much as 90% of the book value. Bear in mind though, that anything that makes the sale more difficult is likely to bring the value down to less than 50% of its official valuation. A property will be less easy to sell if it is a building that has been specifically designed for specialised needs, if the building is in a less wealthy area or if it is anticipated that the property market is going to drop.
Any existing mortgage on the property will, of course, be deducted from the value.
Does your business deal with contracts? If so, a lender will sometimes consider the cession of the proceeds of a contract (or order that you have landed) as collateral for finance. This means that the contract and its associated income is signed over to the lender in return for the financial loan. The proceeds will then be paid into the lender's account, or into an account jointly held by you and the lender. The lender fisrt takes their payment and then pays the rest over to you.
As collateral, this kind of surety usually only fetches a fraction of its face value, mainly because the lender doesn’t know if you will fulfil your side of the contract or not. You can raise the value if you have:
A lender will only consider the surrender value of your life or endowment insurance policies as collateral, and will then usually attach a value of no more than 90% of the surrender value of that policy, which will be ceded to the lender.
Stock exchange shares are usually valued at less than 50% of their current value. This is to make provision for the fluctuations in value that will happen should the market dip. If you have less risky assets, they may fetch a higher collateral value, but that will depend on how easy they are to liquidate (turn into cash). Retirement annuities cannot be used as collateral unless you have already reached retirement age where you are entitled to access the money.
Very few lenders will accept forms of investment that are not liquid (available in cash) as collateral; for example, pieces of art, stamp collections etc.
Bear in mind that the interest on the loan will be much higher than the interest received on your savings or cash investments, so think carefully about using your savings as collateral.
This fund has been designed to assist SMMEs who are unable to offer the required collateral. For details on how this fund works, read What to do when you don't have collateral.
SEFA, the government’s small business finance agency, provides a guarantee scheme for business owners who don’t have enough collateral to cover the loans they need for their business.
For information on how to use this scheme, read What to do when you don’t have collateral
Finfind provides its services free of charge to businesses seeking finance. Our primary purpose is to link SMEs with all the relevant finance providers and finance products that match their funding needs. As a matching service we are not required to be a registered finance provider as we do not loan money directly.