Collateral Based Funding

An important element of debt funding is that it's collateral based funding. The lender usually requires the pledge of some assets as collateral against the loan in case of default by the borrower. These assets can either be business assets or personal assets of the business owners. And the smaller your firm is, the more likely you will be asked to provide personal assets as collateral for debt financing.

When considering collateral based funding, keep in mind that lenders usually use 5 C's of credit to evaluate loan applications. It is used in conjunction with an overall review of a business plan, and the purpose of the loan. These 5 C's are:

• Capacity: Your business's ability to repay the loan.
• Capital: The money you have personally invested in the business.
• Collateral: Additional forms of security you can provide the lender.
• Conditions: The conditions of the economy and the industry.
• Character: The general impression you make on the potential lender or investor.

Collateral based funding usually can be obtained from the following sources:

• Credit Card. Usually, the money you can raise from your credit cards is modest and the interest tends to be exorbitant. And if you don't pay minimum amounts on time, it will more than likely ruin your credit. So only use credit card for short term financing if necessary.
• Friends and Family. Sometimes, people call money borrowed from friends and family as "love money", course they know your are trustworthy and they want you to succeed in your business. But if your business fails and you can't repay the loan, the relationship can also be threatened. So make sure that you treat the loan as a business arrangement and fully document the loan just as the bank would.
• Suppliers. Most suppliers allow you to defer payment from the time of delivery to anywhere from 15 days to 90 days interest free. Although this is not specially a loan, it still helps you in your start-up period.
• Leasing Company. Equipment vendors are another source of collateral based funding. Since leases are secured by the equipment, many vendors don't require additional collateral.
• Banks. Banks are probably the most visible source of business financing. They can provide you with many types of financing like: line of credit, receivable loans, loans secured by property or equipment, loans secured by owner's assets and mortgage financing, etc.
• SBA. Small Business Administration make low interest, long term loans available to business owners that would otherwise have a hard time finding capital. However, it is important to note that the SBA is primarily a guarantor of loans made by private and other institutions. Loans made by private lenders are guaranteed up to 90% by SBA.
• Hard Money Lenders. Hard money lenders might be the "lenders of last resort". They know you have been turned down for other types of financing and because of the increase risk to the lender, the interest rates charged in these types of situations may be as high as 25 to 40% per year.

Based on the priority of lien on the business assets, collateral based funding can also be divided into senior debt and subordinated debt.

• Revolver and Senior Debt. Both revolver and senior debt are secured by a first priority lien on the business inventory, accounts receivable, or both. However, revolver is usually a short term debt that due on demand or within one year; senior debt, on the other hand, is long term capital. It is usually used to fund operations rather than to buy capital assets.
• Subordinate Debt. Debt that does not have first lien on the business's asset is called subordinate debt. Subordinate debt can be any of the following forms:
  • Term debt is due to be paid over a period of time, or calls for a balloon principal payment at maturity.
  • Mezzanine debt actually incorporates both a low-priority debt and equity-based options, such as warrants. Since mezzanine lenders have lower claim on business assets, they usually ask for higher interest rate.
  • Convertible debt can be exchanged for a specific amount of common stock or preferred stock, it's a type of mezzanine debt because of the equity portion built by the conversion feature.