Asset-Based Lending: An In-Depth Guide

Businesses need capital to grow. Expansion requires investment, whether it's opening a new location, purchasing equipment, or hiring more staff. Traditionally, companies take out loans or lines of credit from banks to fund growth. However, these financing options come with stringent criteria around various factors. Think credit scores, financial history, and existing debt levels. These requirements are too difficult to meet for many growing companies, especially newer ones.

That's where asset-based lending can help. Asset-based loans use assets rather than relying solely on a company's creditworthiness. It gives more businesses access to the funding they need to scale up.

This guide will explain asset-based lending, its benefits and downsides, what assets can be used as collateral, and how the loans work. Read on to determine if asset-based financing suits your company's growth needs.

What is Asset-Based Lending?

Asset-based lending (ABL) is a form of financing where the loan is secured by a company's assets rather than its credit score or financials. Eligible assets used as collateral in an ABL facility include accounts receivable, inventory, and equipment. Yet, it may consist of real estate and sometimes even personal assets.

In asset-based lending, lenders issue loans based on a percentage of the value of the pledged assets, known as the advance rate. The maximum amount a company can borrow is determined by a borrowing base formula. It takes into account the value and quality of the collateral assets.

ABL allows growing companies to access funding they may not otherwise qualify for with unsecured debt products. The financing can be structured as revolving credit facilities or term loans. Compared to traditional bank lending, asset-based loans come with more flexible limits. The repayment options are also tailored to each business's needs.

Why Would a Business Need Asset-Based Lending?

There are several reasons a business may need to utilize asset-based lending:

Obtaining Working Capital – Asset-based loans allow businesses to access the working capital necessary to meet growth goals. For example, a barbershop looking to open another location could use its existing equipment and accounts receivable as collateral for funding.

Meeting Financial Obligations – Sometimes, revenue fluctuates seasonally for businesses. ABL facilities provide flexibility to borrow against assets to cover obligations during slower sales cycles.

Quick Capital – The underwriting process for asset-based lending tends to be faster than other bank loans. For time-sensitive projects, ABL represents a rapid way to obtain financing.

In short, the relative ease of qualifying for asset-based lending makes it an attractive option for businesses. If you need capital to execute strategies and lack other cost-effective financing options, it may be worth the thought.

About the Loan-to-Value Ratio

An important metric lenders consider when extending ABL loans is the loan-to-value (LTV) ratio on assets. The LTV ratio compares the size of the loan to the appraised value of the collateral assets backing it.

To calculate the LTV ratio, divide the amount of the ABL loan by the valuation assigned to the pledged assets. For example, a $100,000 loan secured using inventory valued at $200,000 would have an LTV ratio of 50% ($100,000 / $200,000).

Lenders prefer lower LTV ratios because it means loans are covered by a sufficient asset buffer. Typical LTV ratios range from 30-90% depending on the asset type and assessed risk level of the deal. Maintaining adequate collateral coverage on ABL facilities is essential for the lending relationship.

Benefits of Asset-Based Lending

What makes asset-based lending so attractive for business? It goes beyond simply providing access to capital. ABL comes with several unique benefits for borrowers:

Access Capital Based on Assets, Not Credit

Asset-based loans rely on pledged collateral rather than a company's financial position. That means even startups and businesses with bad credit can qualify. Companies that may not be eligible for a traditional line of credit can still access funding to invest in their objectives.

Flexible Lending Limits and Terms

Since the borrowing base changes as assets fluctuate on the balance sheet, lending limits can scale up or down accordingly. It allows companies to borrow more when times are good and pay down debt during slower periods. Loan terms like interest rates and repayment schedules can also be adapted to match cash flows.

Funding Can Scale With Your Business

As a company grows, assets like accounts receivable and inventory also expand. With an ABL facility in place, the lending capacity rises in proportion to the strengthening health of the business. This built-in scalability enables companies to invest the capital needed to fund their rapid growth.

For example, a fast-growing consumer goods company could start with a $1 million ABL loan backed by inventory. In two years, boosted sales may allow them to expand that facility to $5 million based on 5x growth in eligible collateral assets.

Assets Used as Collateral in ABL

As mentioned above, credit scores or personal guarantees aren't defining factors here. In asset-based lending, the loans are backed by different types of business-related collateral. As such, it's a good idea to familiarize yourself with these assets to know which ones might be suitable. Common eligible asset classes include:

Accounts Receivable

One of the most popular assets used to secure financing is unpaid customer invoices, known as accounts receivable (A/R). This represents money owed to the company that will ultimately be turned into cash. Lenders are willing to issue loans against A/R because it diversifies their risk across multiple customers whose credit has already been extended.

Different approaches exist when using accounts receivable in ABL facilities:

Notification Factoring – Lenders directly collect payment on invoices. Customers are notified of the factoring arrangement.

Non-Notification Factoring – The borrowing company continues managing collections on receivables. Customers are unaware accounts have been factored in.

Inventory

Asset-based loans can also leverage a company's inventory. That may include raw materials, work-in-progress goods, and finished products. These physical assets can be pledged as collateral through blanket liens without needing to record specific inventory parts.

What's more, specialized products assist manufacturers and distributors using inventory as collateral. Namely, these arrangements finance daily working capital needs to keep operations humming. That means purchasing production inputs, making payroll, or keeping assembly lines running.

For instance, a craft brewer may secure funding against hops and grain stockpiles to fund expansion.

Machinery and Equipment

Capital equipment retaining resale value is also commonly collateralized funding. We're talking production machinery, transportation vehicles, and office furnishings. For example, a medical device startup could pledge proprietary manufacturing tools to access lending for R&D.

Additionally, niche asset-based lending facilitates raising money against industry-specific equipment. Examples include manufacturing tools, energy infrastructure, technology, fleets of trucks and tractors.

Real Estate

Commercial real estate, industrial warehouses, and office spaces used by businesses represent another asset class supporting asset-based financing. Commercial mortgages and bridge loans allow companies looking for temporary funding to tap into their real estate equity for liquidity.

Other Business Assets

Specialized asset-based lenders may also extend loans against alternative forms of business collateral:

• Intellectual property – patents, trademarks, licensing rights
• Mineral rights – oil, gas, coal, gold reserves
• Investment assets – stocks, bonds, mutual funds

In some cases, lenders even accept unique collateral like fine art collections, antiques, wineries, manufacturing equipment, or shipping containers to back loans. Of course, specialist lenders must be comfortable assessing and monitoring these unique collaterals.

Personal Assets

For startups and SMEs, owners will sometimes pledge personal assets as additional collateral. Doing so for asset-based loans boosts their borrowing power or chances of approval. Examples include personal vehicles, marketable securities accounts, and even real estate like primary residences.

However, placing personal assets at risk should not be taken lightly. Owners should always consider the potential consequences of defaulting on these loans, which could result in personal asset loss.

How Asset-Based Loans Work

Asset-based lending comes in different structures, mostly depending on the lender. Here are some common mechanics that underpin these specialized financing arrangements.

Borrowing Base and Advance Rates

A borrowing base formula determines how much capital can be accessed through an ABL facility at any given point based on eligible collateral. The first step evaluates pledged assets and assigns an advance rate, typically 30-90%, depending on class, quality, and risk. The advance rate shows the percentage of an asset's value accessible through the lending agreement.

For example, let's say a company pledges $1 million of accounts receivable, and the advance rate is 90%. In that case, the eligible borrowing base against those assets would be $900,000.

The aggregate potential borrowing capacity can be determined by applying advance rates across all collateral put up. However, lenders will typically establish maximum caps well below 100% of the theoretical total to protect their interests against market fluctuations.

Revolving Lines of Credit

ABL facilities come structured as revolving lines of credit rather than term loans. As money gets repaid, those funds can be drawn again for later needs up to the designated cap. Companies can access more working capital simply by putting up extra collateral assets to expand the borrowing base.

Ongoing reporting is essential for the lender to monitor eligible assets tied to the credit facility. These reports are usually provided monthly or quarterly. Independent appraisals may also be conducted periodically to confirm valuations.

Costs and Fees

Asset-based lending tends to come with higher costs compared to conventional financing options:

• Interest Rates – Usually a variable rate plus a spread of 5.25% to 15% over a benchmark like Prime or LIBOR, sometimes with a floor rate
• Origination Fees – Upfront fee of 1-3% of the approved borrowing limit
• Unused Line Fees – Annual fee on undrawn funds, around 0.25-1.00%
• Other Fees – Collateral monitoring and appraisal fees

On A/R factoring facilities, lenders also charge a factor rate expressed as a percentage of total invoices factored. This could range from 1-5% depending on duration, credit quality, and services offered.

Key Players in Asset-Based Lending

A wide range of lenders participate in asset-based financing. These are the partners that deliver capital to businesses needing funding. Each type of asset-based lender brings its strengths and specialties:

ABL Specialists and Finance Companies

Specialized commercial finance firms and asset-based lenders lead the market. They offer maximum flexibility around types of assets, advance rates, and creatively structuring credit facilities. However, they also tend to have higher rates and stricter servicing requirements.

Traditional Banks

Then, there are national stalwarts like Wells Fargo, along with regional banks. They have asset-based lending groups catering to commercial and middle-market clientele. They may favor extending ABL packages to existing lending clients over new prospects. Also, banks take a relatively conservative approach to eligible assets, interest rates, and borrowing limits.

Non-Bank Lenders

Various private debt funds, BDCs, and other non-bank finance companies participate in the asset-based lending scene. They promote speedy underwriting and funding around alternative assets that banks shy away from. However, their deals may come with very high rates and intense monitoring.

Conclusion

Companies struggling to qualify for conventional lines of credit should consider asset-based lending. It provides a valuable avenue to unlock capital based on the tangible value of their assets. ABL facilities allow for flexible borrowing limits that scale alongside the business. This is in stark contrast to the rigidly fixed limits tied to strict financial criteria.

ABL does come with slightly higher costs and intensive collateral management processes. Still, the funding can empower organizations to reach strategic goals and new heights backed by their hard assets.

Ready to get started with an asset-based lending solution for your business? Cirrus offers customized ABL packages tailored to your unique capital needs. With roots tied to financial excellence, we constantly keep a finger on the market's pulse. Our team is ready to get clients the best terms negotiated across their asset classes.

FAQ Section

What are the pros and cons of asset-based lending?

The pros of ABL are:

• Businesses with limited financial history can qualify
• Obtain larger borrowing limits
• Access capital quicker than traditional loans. 

Cons are:

• Higher fees and rates.
• Routine collateral reporting requirements.
• Fluctuating loan limits that depend on asset values, which can diminish over time.

What is a negative pledge clause or covenant?

A negative pledge clause is a common provision in asset-based loan contracts. It prohibits the borrower from pledging assets already pledged to their ABL lender to secure other debt. Violating this negative covenant would get the loan called and bring about a default. Lenders use these clauses to ensure collateral coverage stays consistent.

How do you qualify for an asset-based loan?

To qualify for an ABL, you don't need a strong credit score or robust financial history like conventional loans. However, you need adequate levels of approved assets to be used as collateral for your loan. Also, consistent revenues, well-defined borrowing needs, and inventory/receivables management plans help qualify and determine loan specifics like limits.

What is an asset-based loan as revolving credit?

Asset-based loans are differentiated from term loans by providing flexible access to funding as needed up to a specified limit. It is not necessarily a fixed lump sum. As money gets repaid, the funds can continue being withdrawn according to the company's needs.

Do asset-based loans have reasonable interest rates?

Since asset-based loans carry higher risks tied to fluctuating underlying collateral values, they also have higher costs. Expect to pay interest rates between Prime + 3% to 7% with added fees like origination (1-3%) and unused line fees (0.25-1%). Factoring receivables also incurs factor rate fees.