Summary: Asset-based lending is a type of financing that allows a company to leverage its assets. It provides revolving lines of credit and term loans depending on the assets used as collateral.
Asset-based lending is common among smaller middle-market companies that need a solution with flexible covenants. This article provides an overview of asset-based financing and explains how it works. It also explains the solution’s benefits and limitations. We cover the following:
- What is an asset-based loan?
- How are loans structured?
- How are the costs structured?
- Advantages
- Disadvantages
- Financing alternatives (A/R only)
1. What is an asset-based loan?
Asset-based lending allows companies to get financing by leveraging their assets. This financing is typically secured with Accounts Receivable (A/R), inventory, machinery, equipment, and corporate real estate.
Asset-based loans (ABLs) are more flexible than conventional financing. They support mixed collateral and have less restrictive covenants. Consequently, they are popular with middle market companies that are growing quickly. Read “What are Asset-Based Loans? How Do They Work?” to learn more.
2. How are ABLs structured?
The structure of an asset-based loan depends on the collateral that secures the transaction. Lenders typically structure the facility as revolving lines or term loans. Transactions with mixed collateral usually offer both a revolving line and a term loan.
a) Accounts Receivable
Accounts Receivable are financed using a revolving facility structure. Lenders typically finance about 85% of the A/R. However, that percentage can change based on your industry and transaction risk profile.
b) Inventory
Inventory is typically financed with a revolving facility. Lenders usually finance about 50% of the appraised value. They can finance the remaining percentage once the inventory is sold and an Accounts Receivable is created. Lenders typically use the Net Orderly Liquidation Value (NOLV) to determine the inventory’s value.
c) Machinery, equipment, etc.
Machinery, equipment, and corporate real estate are typically financed using a term loan structure. The percentage that can be leveraged varies depending on the transaction profile.
3. How are fees structured?
Fees generally fall into three areas: the due diligence cost, the financing, and maintenance expenses. However, this structure varies by lender. Read “Asset-Based Loans: Costs and Rates Explained” to learn more.
a) Due diligence
Due diligence is an upfront fee lenders charge to examine your business and collateral. It varies based on the transaction complexity, asset mix, and size. Transactions with inventory, machinery, and equipment may also include the cost of appraiser visits.
b) Financing
The financing cost is typically charged using a “Prime + X%” model, where Prime is the prime rate or similar benchmark.
c) Maintenance
Lines may have maintenance and management expenses as well. This fee varies by lender and transaction. These expenses can cover several items, such as line management, ongoing collateral assessments, etc.
4. What are its advantages?
ABLs have several advantages that make them more appealing than other options. The following three benefits are the most important ones.
a) Simpler qualification criteria
Asset-based loans have simpler qualification requirements than comparably sized and structured bank facilities. This feature makes ABLs an ideal solution for companies undergoing changes and rapid growth.
b) Less restrictive than bank financing
The facilities have fewer covenants than comparable bank lines. Consequently, management and compliance are simpler.
c) Available for distressed companies
Asset-based loans are an option for distressed companies and companies assigned to their lender’s Special Assets department. This benefit makes ABLs a great option for middle-market companies that cannot secure bank financing.
5. What are its disadvantages?
However, asset-based loans have some limitations. These include the following.
a) More expensive than bank financing
Asset-based loans are more expensive than similar bank financing options. The higher cost is a tradeoff for the line’s flexibility and fewer covenants.
b) Due diligence cost
ABL due diligence costs, though comparable to banks’ costs, are typically higher than those of some alternatives. Note that assets may need to be inspected and appraised by a third party. This scenario may require travel to your location.
c) Line monitoring cost
Lenders typically monitor the collateral regularly. This activity may require outside appraisers and additional site visits.
6. Financing alternatives
Companies that want to finance only their A/R have two alternatives that provide similar benefits to an ABL but have simpler requirements.
a) Ledgered lines of credit
Some lenders offer ledgered lines of credit, also called sales ledger financing. Ledgered lines provide a revolving line secured by your accounts receivable. However, these lines don’t finance other assets.
Ledgered lines tend to be easier to use than ABLs, don’t require substantial due diligence, and have simpler covenants. However, the tradeoff is that they are slightly more expensive than ABLs of similar size.
b) Factoring
A factoring line is a good option for companies that are unable to qualify for an ABL or a ledgered line of credit. Lines have simple qualification requirements and few covenants. Furthermore, they can be deployed quickly.
However, factoring lines are more expensive and have ongoing lender controls. Factoring is best used as a steppingstone to less expensive financing. Read “How Does Factoring Work?” to learn more.
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