What is collateral coverage, and how do lenders discount collateral value?

Why lenders discount collateral

Collateral is the lender's second way out. It matters only when the first, the business's cash flow, has failed. By then the business is usually in trouble, its assets have been run hard, and the lender is selling into a market that knows it is a forced seller. Its recovery is also reduced by the costs of getting there: appraisers, auctioneers, legal fees, rent while the assets are removed, and the time it takes.

So lenders ask not what an asset is worth to a going business, but what it would bring in a liquidation. The discount from book or market value to that figure is the haircut, and what is left is the lendable value. Collateral coverage compares the total lendable value with the loan. When lendable value equals or exceeds the loan, the loan is fully secured. When it falls short, the lender is relying more heavily on cash flow, the guarantors, or a government guaranty to cover the gap.

Every lender sets its own discounts, and they vary with the asset, its condition, the market for it and the lender's experience. What follows is how the discounts are built, not a schedule any lender publishes.

How each type of asset is valued

Two appraisals come up constantly. For equipment, the gap between fair market value and orderly liquidation value is often wide, and lenders lend on the lower one; see OLV vs FMV in an equipment appraisal. For inventory, net orderly liquidation value is what an appraiser estimates the stock would fetch in an orderly sale after costs; see net orderly liquidation value and how lenders advance against inventory.

Receivables are the most lendable operating asset because customers pay them in the ordinary course, but only the eligible part counts. Receivables more than 90 days past invoice are typically ineligible, and borrowing bases commonly cap any single customer at 20% to 25% of eligible receivables. See eligible vs ineligible receivables.

A worked example: why an acquisition looks under-secured

A buyer agrees to pay 5,000 for a profitable services business. The price is set on earnings. The business's assets are modest: some equipment and vehicles, receivables and a little inventory. The buyer puts in equity and the seller carries a note on standby, leaving a senior loan of 3,800.

On paper the lendable collateral covers less than a quarter of the loan. That is not a flaw in this deal; it is the nature of buying a business on its earnings. The gap between what the assets would fetch and the price is goodwill, and goodwill only has value while the business keeps earning. A lender financing this deal is lending on the cash flow, and the collateral is a partial backstop.

In an acquisition, collateral coverage tells you how much of the loan is really a cash-flow loan. For most buyers of service businesses, that is most of it.

How different lenders treat a shortfall

Lenders respond to the same shortfall in different ways, and that difference decides which lenders a deal fits:

• Conventional banks lending to smaller businesses generally want substantial collateral coverage, or strong cash flow and guarantees to make up for its absence. They commonly look for debt service coverage of at least 1.25x. A deal like the example above is hard for many banks to do conventionally at that size. See SBA 7(a) vs a conventional acquisition loan.
• SBA lenders can finance the shortfall, because SBA's guaranty covers much of their loss. SBA guarantees 75% of 7(a) loans above $150,000. The lender must take the collateral that is available, including personal real estate of the owners where business assets fall short, but SBA does not let it decline an otherwise sound loan only for lack of collateral. See will an SBA loan take my house?
• Senior cash-flow lenders to lower-middle-market companies look past asset coverage to enterprise value: what the whole business would sell for as a going concern. They commonly lend 2x to 3.5x EBITDA and rely on the business's earnings and its sale value. See senior leverage ratio.
• Asset-based lenders turn collateral coverage into the loan itself. The borrowing base is a running calculation of lendable value, and the line can never exceed it.
• Equipment lenders lend against the specific equipment financed, sized to its liquidation value and useful life.

Where no senior lender will reach the whole gap, the structure fills it: more buyer equity, a larger seller note, or a second lender behind the first. Structure pages such as financing a business that is mostly goodwill and what an airball is show how that gap is handled.

What improves coverage, and what doesn't

Owners and buyers can do little to change the discounts, but they can make sure the collateral is counted fully:

• Get the equipment appraised. Book value after years of depreciation often understates what equipment would fetch. An appraisal shows the lender the real liquidation value; it can also show it is lower than hoped.
• Include the real estate where the business owns it. Buying the building with the business adds the asset lenders discount least. See financing an acquisition that includes the real estate.
• Clean the receivables. Collecting old balances, resolving disputes and separating affiliate accounts raises the eligible amount.
• Know where every asset is. Collateral at a leased site without a landlord waiver, or at a third-party warehouse, can be discounted or excluded.
• Keep liens clear. Assets already pledged to another lender, or covered by an equipment lender's purchase money security interest, do not count for the new lender.

Paying a higher price does not improve coverage; it widens the goodwill gap. Nor does rewriting the balance sheet: lenders value collateral from appraisals, agings and inventory counts, not from book values.

Collateral in a lender package

A credit memo sets collateral coverage out asset by asset, next to cash flow coverage, so an approver can see both sources of repayment. Transparent's lender package does the same: its financing model and underwriting memo list each class of collateral with its basis of value and a lendable estimate, and show where the loan relies on cash flow instead. That lets each lender in a book of 1,800+ see quickly whether a deal fits how it lends, whether that is on assets, on earnings or with an SBA guaranty. See how we underwrite and what goes into a credit memo.