When it comes to the different types of business loans available on the market, homeowners and business owners can be forgiven for sometimes getting a little confused. Borrowing money for your business is not as simple as walking into a bank and saying you need a small business loan.
What will be the purpose of the loan? How and when will the loan be repaid? And what kind of collateral can be given as collateral to back the loan? These are just some of the questions lenders will ask to determine a business’s potential creditworthiness and the best type of loan for your situation.
Different lenders offer different types of business financing and are structured to meet different financing needs. Understanding the main types of business loans will go a long way in helping you decide the best place to start your search for financing.
Banks vs. Asset Based Lenders
A bank is often the first place entrepreneurs go to when they need to borrow money. After all, that’s mostly what banks do: lend money and provide other financial products and services, like checking and savings accounts, and business and treasury management services.
But not every business will qualify for a bank loan or line of credit. In particular, banks are hesitant to lend to start-ups that do not have a track record of profitability, to companies that are experiencing rapid growth, and to companies that may have experienced losses in the recent past. Where can companies like these turn to get the financing they need? There are several options, including borrowing money from family and friends, selling shares to venture capitalists, obtaining intermediary financing, or obtaining an asset-based loan.
Borrowing from family and friends is often fraught with potential problems and complications, and has the potential to significantly damage close friendships and relationships. And raising venture capital or mezzanine financing can be time consuming and expensive. Also, both options involve giving up your company stock and maybe even a majority stake. Sometimes this equity can be substantial, which can end up being very expensive in the long run.
However, asset-based loans (or ABLs) are often an attractive financing alternative for businesses that don’t qualify for a traditional bank loan or line of credit. To understand why, you need to understand the main differences between bank and ABL loans: their different structures, and the different ways that banks and asset-based lenders view business loans.
Cash Flow vs. Loan Balance
Banks lend money based on cash flow, primarily looking at a company’s income statement to determine if it can generate enough cash flow in the future to pay off debt. In this way, banks lend primarily based on what a business has done financially in the past, using this to measure what can realistically be expected in the future. It’s what we call “looking in the rearview mirror.”
By contrast, commercial financial asset-based lenders look at a company’s balance sheet and assets, primarily its accounts receivable and inventory. They lend money based on the liquidity of the inventory and the quality of the accounts receivable, carefully evaluating the profile of the company’s debtors and their respective concentration levels. ABL’s lenders will also look to the future to see what the potential impact is on accounts receivable from projected sales. We call this “looking through the windshield.”
An example helps to illustrate the difference: Suppose Company ABC has just won a $12 million contract that it will pay in equal installments over the next year, resulting in $1 million in revenue per month. It will take 12 months for the full amount of the contract to appear on the company’s income statement and for a bank to recognize it as free cash flow to pay down the debt. However, an asset-based lender would view these as receivables on the balance sheet and would consider lending against them, depending on the creditworthiness of the borrowing company.
In this scenario, a bank could lend on the margin generated by the contract. At a 10 percent margin, for example, a bank lending on a 3x margin could lend the company $300,000. Because it looks at the final cash flow, an asset-based lender could potentially lend the business much more money, perhaps as much as 80 percent of the accounts receivable, or $800,000.
The other main difference between bank loans and ABL is how banks and business financial asset-based lenders view business assets. Banks typically only lend to businesses that can pledge tangible assets as collateral, primarily real estate and equipment, which is why they are sometimes referred to as “dirty lenders.” They prefer these assets because they are easier to control, monitor, and identify. Business asset-based lenders, on the other hand, specialize in lending against high-velocity assets like inventory and accounts receivable. They can do this because they have the systems, knowledge, credit appetite, and controls to monitor these assets.
apples and oranges
As you can see, traditional bank loans and asset-based loans are actually two different animals that are structured, underwritten, and priced in totally different ways. Therefore, comparing banks and asset-based lenders is like comparing apples and oranges.
Unfortunately, many business owners (and even some bankers) don’t understand these key differences between bank and ABL loans. They try to compare them like apples to apples and especially wonder why ABL is so much more “expensive” than bank loans. The cost of ABL is higher than the cost of a bank loan due to the higher degree of risk involved in ABL and the fact that asset-based lenders have invested heavily in the systems and expertise necessary to monitor accounts for collect and manage the guarantees.
For businesses that do not qualify for a traditional bank loan, the relevant comparison is not between ABL and a bank loan. Rather, it’s between ABL and one of the other financing options: friends and family, venture capital, or mezzanine financing. However, it could be between ABL and giving up the opportunity.
For example, suppose Company XYZ has an opportunity to sell $3 million, but needs to borrow $1 million to fulfill the contract. The margin on the contract is 30 percent, resulting in a profit of $900,000. The business does not qualify for a bank line of credit for this amount, but it can obtain an asset-based loan at a total cost of $200,000.
However, the owner tells his sales manager that he thinks ABL is too expensive. “Expensive compared to what?” asks the sales manager. “We can’t get a bank loan, so the alternative to ABL is not signing the contract. Are you saying it’s not worth paying $200,000 to earn $900,000?” In this case, saying “no” to ABL would cost the company $700,000 in profit.
Look at ABL in a different light
If you’ve avoided seeking an asset-based loan from a commercial finance company in the past because you thought it was too expensive, it’s time to look at ABL in a different light. If you can get a traditional bank loan or line of credit, then you should probably go ahead and get it. But if you can’t, be sure to compare ABL to its real alternatives.
When viewed in this light, an asset-based loan often becomes a very smart and cost-effective financing option.
