Collateralized Debt and Compartmentalized Debt

Now there’s a stimulating topic!

My father used to take me along with him to work, decades before “take your kid to work day” and one of those days he went to see his banker. I sat quietly and listed to them talk about a business loan. I must have been about 6 yrs old. My father joked that the fillings in my teeth were the collateral for the loan so he needed me there for proof. Guess my oldest brother must have been pledged for a bigger loan!

Funny thing about collateral, it morphs all the time.

I had a client that had used stock he was holding for the dividend income, to pledge as collateral for a business loan to expand inventory. Not a bad strategy pledging something he planned to hold anyway. No one was expecting the stock crash this past year, and on a particular day, the stock price dropped to a low number, and oops, a margin call. The financial institution liquidated the stock at the low point to satisfy the loan. OUCH!!!

In another article I spoke about Goodwill verses hard assets. Banks hate loaning anything for goodwill. Not to say it isn’t done, they just don’t like to do it. Funny thing, banks think nothing of rolling in the financing costs, fees and points. No collateral there.

Inventory seems to morph in and out of those categories. In a business acquisition, inventory is often not looked upon as a collateralized asset. Oddly enough, the minute after the business is acquired, that same inventory is great collateral for an operating loan.

Accounts Receivable (A/R) can be factored, or sold to a factoring company for a discounted price to give a business instant access to the cash. Not my favorite method. A bank will look at A/R and loan 80% on invoices 30 days or less, and zero on those over 90 days. Kind of tough if your customer is a big corporation that pays in 48 to 90 days.
For that matter, credit card companies give you access to the funds in a couple days, but there are percentages (1.7% to 5%) plus processing fees.

Lately I like to advance the method of compartmentalized debt. New term, I just made it up. Here is what I mean. Say a business market value is composed of hard assets, inventory and goodwill. Split the financing into three compartments; think a box with a sealed lid so one doesn’t leak into the other. Have the Seller finance some of the goodwill portion, the SBA loan finance the business portion with the hard assets as collateral, and have the conventional bank loan finance the inventory portion using the inventory as collateral.

We have to find new ways to finance business to get the economy growing, but please don’t use the kids as collateral.