"C" #4 - Collateral or Security for Your Business Loan

The single thing I admire most about entrepreneurs is their willingness to bet on themselves. Against all odds and sometimes in the face of tremendous adversity, they honestly believe that they are right and that they will win! That said, I have been a strategic banking advisor long enough to see that sometimes a business idea just doesn’t make it. When this business has bank financing, it makes the situation a bit more emotionally charged and difficult.

The fourth “C” of credit is collateral. Of all the “Cs,” I hate this one the most. This is because if a bank must exercise the right to obtain and liquate collateral, it means that someone’s dream has died, and that absolutely sucks!

There is not a single banker that has intentionally made a loan and hoped for it to go bad, so that the bank would “get” the collateral. Banks are not real estate companies, car dealers, and inventory liquidators. They provide clients with capital to help entrepreneurs and HATE taking collateral back. However, they also realize the bank has to stay healthy in order to serve other entrepreneurs, and sometimes that means they have to reduce their potential loss by taking collateral back.

There are 3 key characteristics of collateral that all entrepreneurs need to understand:

1. Value
2. Perfected Documentation
3. Control

 Value

Imagine, a 1-ton container of soy protein isolate. To the right business (Powerbar), this container is a valuable input. However, if you are a bank that had to liquate this in order to pay back a loan, it would not be as valuable. I’m not sure, but I don’t think that the market for a ton of soy protein isolate is very large (or liquid). In other words, the value of the collateral to the entrepreneur and the bank can be very different.

All collateral has value. Otherwise why would the bank insist on tying it to your loan? A key aspect to remember when it comes to value is that the value you place on your collateral and the value your bank places on your collateral are two different things. The value that the bank places on collateral depends upon 1) how easy it is to determine with worth of the asset and 2) the number of potential buyers of the asset and 3) how easy it is to sell the asset.

Real estate has strong collateral value because it is easy to determine the value, the pool of potential buyers is large, and it is easy to complete the transaction. The soy protein discussed above is easy to determine the value (it is a commodity), the number of potential buyers is limited, and transporting the container is relatively easy. Due to the limited buyer pool, it is easy to see why the entrepreneur and the bank place different values on the collateral.

Perfected Documentation

I once heard a story of an unethical farmer that got a loan from a bank and signed a deed of trust 100 acres of his land as collateral. He told the banker that the land was free and clear, and the pre-closing research validated this. The problem came when the banker went to take the deed to the courthouse for recording and found that 10 minutes before another bank recorded a deed against the same property. As a result, the bank now had a junior lien on the property, which was not what they had agreed to.

Perfected loan documentation has 3 elements:

1. Proper description of the asset.

2. Loan documents are signed by authorized representative of the business.

3. If required, the document is recorded (deed of trust) or filed (vehicle titles and UCC-1 filing statements).

 The bank above had a good deed of trust that had both a proper description of the land and signed by an authorized owner. However, since they were not the first to file the deed, they did not have proper recording.

 Control

Imagine a loan given to a gold broker who uses the loan funds to purchase more inventory. When the inventory is sold, the loan is paid back. The collateral for the loan is the gold inventory. The inventory has a clearly defined value, the market is large and easy sell. The document assigning it to the bank is properly executed and recorded. However, the bank has very loose control because the inventory is not locked away in a vault that the bank has access to. There have been actual cases where banks have lost money because of this structure and the unethical business owner sold the inventory and ran with the profits.

Control does not necessarily mean physical possession. It may mean that the inventory is inspected on a periodic basis and you submit reports, attesting to the amount of inventory, equipment, and accounts receivable you have. It all comes down to your circumstance and the bank’s policies.

All 3 concepts of collateral (value, perfected documentation, and control) are critical. The important point is to have an honest and direct conversation with your entrepreneur’s banker so that you understand exactly what is being asked of you when you agree to pledge collateral for a loan.

Today’s entrepreneur deserves a banker that is passionate about helping them achieve their goals and a banking relationship that is a strategic competitive advantage. Hit the connect button on LinkedIn and tell me about a time that you successfully had collateral removed from a loan (without selling the collateral and paying the loan off).

Greg Martin is an entrepreneur’s insider to the banking industry and passionately believes that every person was uniquely designed for a higher purpose and calling. Greg helps entrepreneurs transform their current banking relationship into one that is a competitive advantage. His deepest passion is living life with his wife of 16 years and their wonderful son.