The first option for borrowing is “unsecured.” If you have solid personal credit, unsecured debt is usually the easiest to obtain and involves the least amount of risk to you. Because the debt is not backed by some form of asset or collateral, lenders consider this type of debt more risky to them so it usually comes at a higher cost as compared to secured lending. Unsecured debt will also be limited by lenders, the amount of risk they are willing to take on an unsecured basis will normally be below $50,000 and in many cases below $20,000.
In some cases it will be necessary to find security or collateral for the loan. Lenders like assets that hold their value and are easily marketable. The more difficult an asset is to sell, the least desirable it is as collateral. Several examples of weak collateral include leasehold improvements, furniture, office supplies, computers, software, phone systems and even your company itself. Wow, that pretty much lists all the assets of your business with the exception of accounts receivable, your client relationships, and your employees.
Loans Against Receivables
Accounts receivable can be leveraged into cash by two methods. The first is using the accounts receivables as collateral to a loan. Usually the lender will limit the amount of the loan to 80% of the “good” receivables. Lenders will put a definition in the loan documents to describe what “good” receivables are. In most cases, lenders will only accept receivables that are under 90 days past due. There is a hidden risk for us when using this type of debt and collateral – falloffs. When using accounts receivable to secure a loan, a falloff could cause your loan balance to become greater than the amount of receivables. If this occurs, the lender will want the loan immediately reduced to meet the requirements of the loan. Obviously this could cause a severe cash crunch to your business.
The other way to leverage your accounts receivable into cash is to “sell” them to a third party that specializes in buying accounts receivables. These companies are called factors, and this form of business financing is called factoring. You have probably received advertisement emails for such services.
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Factoring is not a loan; rather it is the sale of an asset. Factoring caries a high cost in comparison to borrowing. The accounts receivable are bought at a discount to the face value of the invoice, usually 2-6%, but will vary based upon the perceived risk from the factor. For example, a $20,000 invoice factored with a discount of 5% will be sold for $19,000 resulting in a cost to you of $1,000. Considering the invoice would normally be collected within a month or two; that is an extremely high cost as compared to lending sources. Also, factors will also limit the amount of money provided upon the sale of the invoice to usually 75-80% of the face value of the invoice. The remaining amount less the discount will be paid upon collection of the invoice.
Collateralizing Against Personal Assets
Finally another option is to use personal assets as collateral for your business loan. Again lenders will want assets that hold their value and are easily converted into cash. Examples include marketable securities, real estate, and vehicles. Some personal assets specifically are not allowed as collateral including retirement accounts such as 401(k)s and IRAs.
In business, debt is a necessary evil. Careful consideration must go into the type and amount of debt that you need, and debt should always be controllable. And when times are good, bank the cash – savings. This cash will allow you to take advantage of opportunities as they arise and will be your buffer should the market take a turn for the worse.