Collateral Law and Legal Definition
Collateral is an item of value that is pledged to guarantee repayment of a loan. Collateral items are generally of significant value—property and equipment are often used as collateral, for example—but the range varies considerably, depending on the lending institution and variables in the borrower's situation. The value of collateral is not based on the market value. It is discounted to take into account the value that would be lost if the assets had to be liquidated in order to pay off the bank loan.
A business that has a long history of profitable operations may be able to obtain an unsecured loan, a loan without collateral. A new or a small business wishing to expand is almost always going to be asked to secure a loan with collateral. Unlike unsecured loans, in which a borrower is able to get a loan solely on the strength of its credit reputation, secured loans require borrowing companies to put up at least a portion of their assets as additional assurance that the loan will be repaid. Fail to repay the loan and the bank takes the items identified as collateral. Many start-up businesses turn to collateral-based loans to get their start.
Types of Collateral
Many different types of collateral arrangements can be made by companies, whether they are experiencing a financial crunch or making plans for expansion. Common types of collateral include the following:
Purchase Money Security Interest (PMSI). Also known as a chattel mortgage, this option allows the borrower to secure a loan by borrowing against the value of the equipment being purchased.
Real Estate. Businesses that utilize real estate—usually a personal residence—as collateral are generally requesting long-term loans of significant size (the company has plenty of other collateral options for smaller loans). The size of the loan under this arrangement is predicated in large measure on the market and foreclosure value of the property, as well as the amount of insurance coverage that the company has taken out on it.
Endorser. Under this form of collateral, a company secures a loan by convincing another person to sign a note that backs up the promises of the borrower. "This endorser is then liable for the note," stated Mark Van Note in ABCs of Borrowing. "If the borrower fails to pay, the bank expects the endorser to pay. Sometimes the endorser may also be asked to pledge assets." A guarantor loan security is similar to the endorser arrangement, except that the guarantor is not required to post collateral.
Warehouse Receipts. Another option for borrowers is to put up a portion of their warehouse commodities as collateral. Van Note explained that with warehouse receipts, "the receipt is usually delivered directly to the bank and shows that the merchandise has either been placed in a public warehouse or has been left on your premises under the control of one of your employees who is bonded. Such loans are generally made on staple or standard merchandise that can be readily marketed. The typical loan is for a percentage of the cost of the merchandise."
Display Merchandise. This method of borrowing, which is also sometimes referred to as "floor planning," is similar to warehouse inventory. Under this plan, display merchandise such as furniture, automobiles, boats, large appliances, and electronic equipment can be used as collateral to secure loans.
Inventory. This encompasses all the various assets (merchandise, property, equipment, etc.) owned by the borrowing business that could be liquidated to repay the loan.
Accounts Receivable. "Many banks lend money against accounts receivable; in effect, counting on your customers to pay your loan," explained Van Note. "The bank may take accounts receivable on a notification or nonnotification plan. Under the notification plan, the purchaser of the goods is informed by the bank that the account has been assigned and is asked to make payments directly to the bank. Under the nonnotification plan, customers continue to pay you and you pay the bank." Under this collateral agreement, lenders sometimes advance up to 80 percent of the value of the receivables once the goods are shipped. Typically, a lender will buy or advance 70 to 80 percent of a company's accounts receivable balance and in turn assess a finance charge or "discount" on the total amount of the receivable. That discount is usually between 4 and 5 percent.
Savings accounts and certificates of deposit.
Stocks and bonds. Publicly held companies have the option of offering stocks and bonds within the company as security.
Life insurance. Some lenders are willing to accept the cash value of a life insurance policy as collateral on a loan.
SEE ALSO Assets; Cash Management; Loans
Brealey, Richard A., and Stewart C. Myers. Principles of Corporate Finance. McGraw-Hill, 1991.
Linton, Heather. Streetwise Business Valuation. Adams Media, 2004.
Pinton, Linda, and Jerry Jinnett. Steps to Small Business Start-Up. Dearborn Trade Publishing, 2003.
U. S. Small Business Administration. Financing for the Small Business. n.d.
U. S. Small Business Administration. Van Note, Mark. ABCs of Borrowing. n.d.
Walter, Robert. Financing Your Small Business. Barron's Educational Series, 15 March 2005.
Hillstrom, Northern Lights
updated by Magee, ECDI