One question we are often asked by clients is why does the Bank want security when I am seeking finance for my business?
Just as we insure our cars, (even though we do not intend to have an accident), Banks’ seek security as a form of insurance for their loan. The security provides a fall-back position should things not go to plan.
Although security is a key component, it is the ability to repay the debt that is the primary determinant of any loan provided.
Business risk vs. financier risk
The foregoing said, a key barrier to lending direct to the business is gearing and perceived risk.
When it comes to the question – why does the Bank want security – business owners can rightly state they already have everything on the line”! Which is true!
However, in many instances the reason Banks are reluctant to lend without supporting security, is because there is little equity in the business. Equity being Total Tangible Assets less Total Liabilities.
Where equity is low, Bankers will argue they are being asked to take an equity, rather than financier risk.
Why equity is important - the Lender perspective
From a Lenders perspective, the more equity held in a business:
- The more flexibility and options the owners potentially have, should things not go to plan
For example, using a Home Loan analogy; a borrower with only 10% equity would have far fewer options available to them in adverse circumstances than someone with say 45%.
So, it is with a business! A business with 45% equity, is likely to have more capacity to adjust to adverse circumstances than one with only 10%.
What can lead to low equity?
Beyond business performance and the need to sustain a lifestyle, key reasons that often lead to a lack of equity are:
- Tax planning
- Funds being withdrawn from the business for personal investment or wealth creation purposes
For many owners, the business is a vehicle that provides the means to fund what is important in their life.
This is a very different mindset to that of a corporate where the focus is retention of capital to fund growth and increase returns for shareholders.
Return of capital as security
Return of capital as security
Where funds have been taken out of a business for other purposes and the gearing is high, Banks often request that the assets that have been purchased be provided as security.
From the Lender perspective the security is simply restoring “capital” back in the business.
Provision of the security moves them to “financier” risk position.
How much equity is needed?
There are no “hard and fast” rules as to how much equity a business should hold.
It depends on a number of things including:
- The industry in which you participate
- How long the business has been established
- The business track record
- The quality of the assets in the Balance Sheet
- How well the business is run
- The systems and processes employed
- The Banks appetite to lend
The higher the level of perceived risk – the more equity (or if that is absent, security) that will be required by the Bank.
The said, in our experience, Banks will generally look for equity (Total Tangible Assets less Total Liabilities) of 40% or greater.
For start-up ventures, or those with a limited track record, the equity required will be at least 50%.
However, for a well-run business, in favoured industries, this could be 30% or lower.
Ask the Bank where you stand
For many business owners a key objective is to exclude their personal assets (home, investment properties etc) from the Banks security net.
With this in mind, it is worth asking the Bank:
- What does my business need to look like, to allow the Bank to lend direct without additional supporting security? What criteria would I need to meet?
It is always prudent to get this in writing. While their response will be highly qualified, at least it will give an understanding as to what is needed.
(One option often overlooked you can use to free your home from Bank security arrangements is Invoice Financing).
Important – Policies and appetite to lend directly to a business differs significantly between Lenders.
If you would like to learn more, or take advantage of the competitive market access we provide, give me a call me.
