Borrowers should be aware of the wide range of collateral options

On the Money
From the August 2, 2002 print edition

If you’ve ever applied for a loan, you’ve no doubt heard the term “collateral.” During the early stages of a business needing capital, the word “collateral” may have been uttered so many times that the very sound of those syllables causes gastric distress. Lack of traditional collateral may force the frustrated borrower to think back to the old Bob Dylan song: “But I went into a bank, to get some bail for Arab, and all the boys back in the tank. They asked me for some collateral, and I pulled down my pants!”

Collateral is an asset pledged to a lender until a loan is repaid. If the loan is not repaid, the lender may seize the collateral and sell it to pay off the loan. (Making the Dylan song even more fun to think about-but hardly practical in the banking biz.) Obvious forms of collateral include houses, cars, stocks, bonds, and cash; all things that are readily convertible into cash to repay the loan. Some of those assets are “hard,” such as houses and automobiles; others are “paper,” such as the stocks and bonds. That difference is important because of the amount of effort necessary for the lender to liquidate the asset. Lenders like assets that are easy and inexpensive to liquidate. Keep in mind that the collateral’s worth is not based on the market value. It is discounted, taking into account the value that would be lost if the assets had to be liquidated quickly. However, there are other forms of collateral assets that are sometimes overlooked that can assist the new business in obtaining operating funds.

An asset is defined to be anything that has commercial or exchange value that is owned by a business, institution or individual. While exploring some of these less traditional forms of collateral, remember that you need a lender familiar with non-traditional lending. Federally and state chartered banks are constrained by regulations that strictly define collateral acceptance.           Also, the riskier the collateral, and the more difficult it is to liquidate, the more expensive the loan.

In additional to intrinsic or “hard” value, anything that has revenue or a potential future earnings stream can be used as collateral. This includes contracts for purchase or purchase orders. As the borrower, a purchase order issued to you from one of your customers represents future sales on your part. The purchase order can then be used to secure a loan for cash today, “collateralized” by the promise of future payment by your customer.

Another form of collateral is loans you have made to other people, either simple accounts receivable, or formalized promissory notes. Those payments to you represent a revenue stream. It is possible to pledge the loans you hold as collateral for another loan to yourself. This goes on frequently on a larger scale of in the form of “collateral backed bonds” traded on Wall Street.

Often overlooked as a source of collateral is “future earning power.” Basic to a lender’s willingness to make a loan is an assessment of the future earning power of the organization or individual. To the extent that earning power is enhanced, the lender will look more favorably at the borrower. This is the principle behind all manner of educational loans; that is, with more education and training, the earning power of the borrower will be enhanced. However, universities and colleges are not the only organizations that increase earning power. There are lenders who specialize in more specific forms of training, such as: truck driving or bartending schools, medical procedures, commercial “learning centers,” seminars, and even dating services. (Children are still not acceptable in most cases.)

In the very imaginative category, other items that have been used as collateral include: watches, jewelry, interests in box seats at a sports arena, golf club memberships, lawn mowers, suits of armor, opera tickets, antique furniture, art collections, vinyl record collections, insurance policies, medical instruments, lottery tickets, wine collections, tires, and even specialized pumpkin seeds.

The Atlanta Business Chronicle reports that at a time when recent Federal Reserve statistics show that 45 percent of domestic banks have tightened lending standards for small businesses, some non-traditional lenders such as the financial services division of brokerage houses, have doubled its loan volume in the Atlanta area.

As the economy struggles out of its current distressed state, both lenders and borrowers are searching for more creative and non-traditional ways of facilitating cash flow. This means an increased willingness on the part of lenders to look at non-traditional collateral. It also means that borrowers should be open-minded and probing about what they may be

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.