Asset-based lending was once the black sheep of financing. It was a last resort for companies and often signaled their demise. However, asset-based lending has shed its bad reputation in recent years, thanks to both the evolving sophistication of asset-based lenders ("ABLs") and the recession's blow to businesses everywhere.

What is it?

In simplest terms, asset-based lending means that businesses obtain loans by using assets as collateral. ABLs look at a business's accounts receivables, real estate, inventory, equipment, and other assets to make the loan, not its credit-worthiness.

Who should consider it?

Asset-based lending is now a popular choice for small to middle size companies that may not meet the underwriting requirements for more traditional loans. There is no restriction on what asset-based loans must be used for; uses vary from day-to-day operating expenses to capital for mergers and acquisitions, buyouts, or restructuring.

This financing can be advantageous to companies in cyclical industries that may have to invest in inventory, but not have sales and profits until a later quarter. For example, consider a snow-removal business in its first year. Snow plows, shovels, salt, etc. will have to be purchased immediately, but the business will not see any return on its investments until the hard-hitting days of winter. In this situation, the business will likely lack the balance sheet to support a short term loan, but an asset-based loan is possible. This type of loan is ideal for manufacturers, distributors and service companies with a leveraged balance sheet and high seasonal needs.

Companies that need cash fast because of an unforeseen circumstance should also consider asset-based loans because they can be extended relatively quickly, much sooner than it would take to gather investors.

Asset-based lending involves unique administrative requirements. ABLs generally require detailed and routine reporting. This may seem like a burden, especially for smaller companies who are short on staff, but the reporting can help a business to keep a better eye on cash flow.

Drawbacks?

As mentioned above, reporting requirements can be tedious. In addition, ABLs typically want to work with companies whose collateral easily transitions into cash. If borrowers miss payments, ABLs are legally entitled to seize the assets for which they possess a lien. Lastly, businesses should consider the lending rates, which may be higher than rates on traditional bank loans.

The Bottom Line

Businesses should always do their research and only use lenders that have a strong loan portfolio demonstrating successful lending expertise. Some ABLs specialize in certain industries and are more in-tune with the needs of specific types of businesses.

Asset-based loans can provide the funding a business needs, but every commercial loan comes with risks-to the business and the lender. Know your options and know your business.