Asset-based lending guide for startups

What is asset-based lending for startups?

Asset-based lending is a business financing option in which you secure a loan using your business assets as collateral. Unlike traditional loans, which are heavily dependent on your cash flow and profitability, ABL focuses on the value of your assets, such as accounts receivable (money owed by your customers), inventory, machinery, or real estate. This makes it a viable choice for startups that may not yet have a strong cash flow but have valuable assets.

How does ABL differ from traditional loans?

Traditional loans typically assess your business’s financial health based on cash flow metrics like:

• Debt-to-EBITDA ratio: Your debt compared to your EBITDA (earnings before interest, taxes, depreciation, and amortization).
• EBITDA margin: Your EBITDA as a percentage of revenue.
• Operating cash flow: The cash your business generates from daily operations.

ABL, on the other hand, focuses on the quality and value of your assets. This can include:

• Accounts receivable: Outstanding invoices due from customers.
• Inventory: Stock that can be sold.
• Fixed assets: Equipment, machinery, or real estate.
• Intellectual property: Brand names, patents, or trademarks.

Also, ABL loans often have fewer restrictions (covenants) than traditional loans, allowing you more flexibility in managing your business.

Why startups and small businesses might choose ABL, and risks

Unlike conventional financing, which relies heavily on strong cash flow and credit history, ABL focuses on the value of assets like accounts receivable, inventory, or equipment. However, before deciding to opt for these loans, make sure you have a thorough understanding of its pros and cons:

Benefits of ABL loans

ABL is particularly beneficial in the following scenarios:

• Limited cash flow but significant assets: ABL can provide the funding you need if your business has valuable assets but struggles to show consistent cash flow.
• Seasonal or cyclical industries: Businesses with fluctuating cash flow, such as retail or agriculture, can use ABL to maintain regular operations during low-revenue periods.
• Growth and expansion: If you want to scale your business or invest in larger projects, ABL can offer flexible financing by leveraging existing assets.
• Working capital needs: ABL is useful for covering day-to-day operational expenses, such as payroll or inventory purchases, without restrictive usage terms.

ABL also offers greater flexibility than some traditional loans. The funds can be used for various business purposes without strict limitations, making it suitable for startups navigating uncertain market conditions.

Risks of ABL loans

While ABL offers unique benefits, it’s important to weigh the risks:

• Loss of collateral: If you cannot repay the loan, the lender can seize the assets pledged as collateral. Losing critical assets, such as equipment or real estate, can significantly impact your operations.
• High costs: Loan origination, underwriting, and collateral assessments can make ABL more expensive than conventional loans.
• Borrowing limits: Not all assets qualify as collateral, and lenders may undervalue certain items. For example, specialized equipment or assets with low resale value may limit your borrowing ability.
• Overmortgaging: If the value of your pledged assets decreases, you might owe more than the collateral is worth, leaving your business financially vulnerable.
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What can be used as collateral?

In an asset-based loan, lenders focus on the value of assets to secure financing. These assets, also known as collateral, act as security for the loan. Here are some common types of collateral and how asset-based lenders evaluate them for loan qualification.

1. Accounts receivable
   • Money owed to your business by customers is one of the most common forms of collateral in ABL.
   • Lenders typically only accept current receivables, which are invoices that are either less than 90 days old or not overdue by more than 60 days.
   • The reliability of your customers and the likelihood of payment impact the value assigned to these receivables.
2. Inventory
   • Businesses with substantial inventory can leverage it for financing.
   • Lenders usually prefer non-perishable goods with a stable demand. Perishable items or customized inventory with limited resale value may not qualify.
   • A field examination (an inspection of your assets) and third-party appraisals often determine inventory value.
3. Machinery and equipment
   • Fixed assets like manufacturing equipment, vehicles, and specialized tools can be collateral.
   • Lenders evaluate these assets based on their resale value, depreciation rate, and usefulness to other businesses.
4. Real estate
   • Commercial properties owned by your business, such as warehouses, retail locations, or offices, can provide substantial collateral.
   • Lenders typically require appraisals to assess the market value of the property.
5. Intellectual property
   • Certain intangible assets, like brand names, trademarks, or patents, may also qualify as collateral.
   • The lender will assess these assets' market value and transferability to determine eligibility.

Note: Not all assets qualify as collateral. Specialized inventory, goods with limited resale value, and assets tied up in legal or contractual obligations may not be eligible. Additionally, lenders often include clauses that prevent business owners from reusing pledged assets as collateral for other loans.

How do lenders evaluate collateral?

Lenders perform detailed assessments to determine which assets qualify as collateral and how much financing they can secure. Common evaluation methods include:

• Field examinations: Lenders conduct on-site inspections to verify the existence, condition, and value of physical assets like inventory and equipment.
• Appraisals: Third-party appraisers may be hired to estimate the market value of real estate, machinery, and intellectual property.
• Advance Rates: Lenders calculate the percentage of an asset's value they are willing to lend, known as the advance rate. For example, accounts receivable might qualify for 80% of their value, while inventory might only qualify for 50%.

How to prepare for an ABL loan

Preparing for an asset-based financing loan requires careful planning and understanding of the process. Here’s a step-by-step guide to help you:

1. Understand your financing needs

Start by determining the exact purpose and amount of the loan. Identify whether it’s for working capital, equipment purchases, or debt financing. A clear picture of your needs will help you choose an appropriate loan structure and lender.

2. Research and shortlist lenders

Look for lenders specializing in asset-based lending and have experience in your industry. Compare their terms, fees, and services to find one that aligns with your business goals. Reputable lenders often have a proven track record, so seek recommendations or read reviews to narrow your options.

3. Review your eligibility

Understand the criteria required by the lenders on your shortlist. These may include your revenue size, credit history, and the type of assets you’re offering as collateral. Make sure that your business meets these requirements to avoid unnecessary rejections.

4. Prepare financial documents

Compile accurate and detailed financial statements, including income (P&L) statements, balance sheets, and cash flow reports. You may also need to provide a comprehensive list of your assets. These documents let the lender assess your financial stability and determine eligible collateral.

5. Negotiate loan terms

Once you’ve chosen a lender, negotiate the terms of the loan. Focus on aspects like:

• Loan amount: Make sure it meets your needs based on the value of your assets.
• Advance rate: Understand the percentage of asset value you can borrow.
• Interest rate: Aim for competitive rates to reduce costs.
• Repayment terms: Discuss a schedule that matches your cash flow.

6. Understand reporting and covenants

Lenders may require regular financial reporting and adherence to specific conditions (covenants). Clarify these requirements and negotiate terms that are realistic for your business operations.

7. Verify collateral requirements

Work with the lender to determine the assets eligible as collateral. Understand how the lender values these assets and confirm that your asset profile matches their criteria.

8. Reassess borrowing base calculations

If the lender requires a borrowing base (calculating your loan limit based on collateral), make sure the calculations are accurate. This helps you receive the maximum funding available without complications.

9. Review the agreement carefully

Finally, go through the business loan agreement in detail. Pay attention to borrower default provisions, fees, and any disclosures affecting your business. If needed, seek legal or financial help to clarify complex terms.

Considerations for startups 

Asset-based loans can be a practical funding option for startups but require careful planning. As a startup, you may face unique challenges like limited assets and irregular cash flow. Here's how you can minimize risks and prepare for long-term growth:

1. Assess your asset profile

Since your assets, such as inventory secure ABL, accounts receivable (unpaid invoices), or equipment, you should evaluate what you can offer as collateral. Lenders typically prefer assets that are easy to value and liquidate. If your startup has intangible assets, like intellectual property, these might not qualify.

2. Mitigate risks with diversified assets

Relying on a single asset, such as inventory, can be risky if market conditions change. Diversify your asset base to reduce dependency on one category. If possible, include equipment or receivables.

3. Plan for loan covenants

Loan providers often include financial covenants (specific conditions) in the loan agreement, such as maintaining a certain debt-to-equity ratio or submitting regular financial reports. Understand these terms thoroughly and make sure they are achievable based on your current borrowing capacity.

4. Focus on scalability

ABL can support short-term growth, but you need a plan for scaling your business without relying solely on borrowed funds. Use ABL strategically, such as for working capital or a one-time investment, rather than regular operations.

5. Monitor market conditions

External factors like demand fluctuations or depreciation can impact your collateral's value if your collateral includes inventory or equipment. Regularly reassess your assets to maintain loan compliance and prevent surprises.

Wrap up

Asset-based lending (ABL) offers startups and small businesses a flexible way to access funding by leveraging their assets. It can help them maintain cash flow, meet short-term needs, and support long-term growth without overrelying on traditional lines of credit. If they have valuable assets like inventory or receivable financing, ABL can be an important tool in their financing strategy.

That said, having ongoing and steady access to capital is essential for a startup’s success. As you grow your business, focus on what matters—your product and customers. Rho's finance platform helps you manage cash and automate finance busywork, so you can focus on growing your business.

With Rho's Corporate Cards, you can make the purchases you need to keep your business operations running smoothly, all while enjoying up to 1.25% cashback¹. Combined with our expense management platform, you can make more strategic spending decisions and gain the insights you need to take control of your budget.

Want to learn more? Schedule time with a Rho finance expert.

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