Getting a business line of credit can be a challenge for small business owners. Most lines are difficult to qualify for and have hefty collateral requirements. For many business owners, this challenge represents an obstacle that a few businesses can overcome.
From this article you will learn:
- Why all lines of credit need collateral
- The truth about so-called “no-collateral” lines of credit
- About alternative lines of financing that use sales as collateral
- Which solution is right for your business
1. Lines of credit and collateral
One of the most common misconceptions is that lenders provide lines of credit by investing in the potential of your business. Unfortunately, this is simply not true.
Finance companies are interested in your ability to repay the loan. The reality is that business lenders provide lines of credit based on two things: cash flow and hard collateral. You need at least one of those things, and, often, you need both.
Unfortunately, getting a conventional line of credit (including SBA loans) if your business does not have cash flow or hard assets is nearly impossible. The bottom line is that lines of credit are designed to help companies that have collateral.
2. Are “no-collateral” business lines of credit real?
Some lenders offer so-called unsecured (“no-collateral”) business lines of credit for small businesses. While this term is technically true, most of these “no-collateral” lines are misunderstood by business owners.
Lenders don’t offer these lines to businesses owners who have little or no collateral. Quite the opposite. Lenders often require that the business and the owners have plenty of available collateral. However, the line does not have specific collateral pledged to it. That point is the main difference and is an important distinction.
If you default on one of these loans, the bank often pursues your corporate and personal assets to collect. In the end, if things don’t go as planned, you are still on the hook even for a “no-collateral” loan.
Many small “no-collateral” lines of credit are actually structured as personal lines of credit for business use. These lines often have low limits and require that the business owners have great personal credit. Some require that the owner also have a certain amount of personal assets, even if they are not pledged to the loan. Most importantly, many require a personal guarantee.
3. What if you don’t have collateral?
If you truly have no collateral, unfortunately your options will be limited. One ideal alternative for new businesses with no collateral is an SBA Microloan. However, these loans are capped at $50,000, so they won’t help if you need more than that.
Small business owners usually overlook two sources of collateral – their sales and their purchase orders (POs). In some cases, sales and POs are great collateral that can be used for funding.
a) Use your sales as collateral
Companies that sell products and services to other businesses or to government agencies can often use their accounts receivable (invoices) and purchase orders as collateral for business financing. They can be used to access financing that provides many of the benefits of a line of credit but is much easier to get. Three solutions that offer this type of funding are accounts receivable factoring, purchase order funding, and asset based financing.
#1 Accounts receivable factoring
Companies that work with commercial and government clients often have to wait 30 to 90 days to get their invoices paid. This delay often causes cash flow problems and is one of the reasons small businesses look for a line of credit. Your company can solve this problem and get many of the benefits of a line by factoring its accounts receivable.
Factoring allows you to finance your invoices and provides you with immediate funding. It can solve most cash flow problems related to slow-paying clients and help you grow your business. The line is flexible and is designed to increase as company sales grow.
One important advantage of receivables factoring is that it’s relatively easy to get. To qualify, you must have clients with good credit, your invoices must not be pledged as collateral, and your clients must pay in 30 to 90 days. Learn more about receivables factoring.
#2 Purchase order funding
One common problem for small and growing business is getting very large orders. Now, few companies would consider a “large order” to be a problem. However, if you don’t have the financial resources to fulfill the order – it’s a real problem.
This problem leaves you with three options, none of which is good. You can take the order and risk cash flow problems. Or worse, you could take the order and fail to deliver. The last option is to not take the order at all and lose the revenue.
An alternative for some companies is to use purchase order funding. This solution provides you with funds to pay your suppliers, which allows you to process the order, deliver it, and get the revenue.
Purchase order funding does have limitations. It can be used only by companies that resell finished goods at high margins (above 20%). They must purchase the goods from the supplier and sell them to the client without modification or additional services. As a result, only certain companies can benefit from this option.
#3 Asset based financing
Asset based financing is used by more mature companies that can’t get a line of credit, usually due to difficult lending covenants. An asset based line allows companies to leverage receivables, inventory, machinery, and, in some cases, real estate.
The structure of the line depends on the assets that are being funded. Lines backed by accounts receivable and inventory are structured to operate like revolving lines of credit. You can get funding against assets as their values increase and pay it down as cash becomes available. Lines backed by other assets are often structured as term loans.
Most lines require that the client finance a minimum of $500,000 to $1,000,000 per month. They also require that the company have two years of operating history, good accounting controls, and reasonable financial statements.
Learn more about asset based financing here.
4. Which solution is right for your business?
Which solution works best for your business depends on your individual circumstances. However, keep the following in mind:
- If your biggest problem is that clients pay in 30 to 60 days, consider accounts receivable factoring
- If you need funds to pay supplier expenses for a large order, consider purchase order funding
- If you need to improve working capital and have assets, consider asset based financing
We are a leading provider of factoring, PO financing and asset based loans. For more information, fill out this form or call us toll-free at (877) 300 3258.