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Asset Class Break-Down
Sadie Keljikian and David Estrakh, Express Trade Capital
What are asset classes?
Assets are valuable properties owned by a business. There is a wide variety of assets across different industries and business structures, each of which affords different financial risks and opportunities. Assets can include stocks, bonds, real estate, fixed income, invoices / receivables, commodities, cash equivalents and personal investments.
Beyond the security of possessing a diverse portfolio, holding a variety of assets allows businesses to leverage their assets as collateral to in exchange for financial assistance from a bank or other financial institution. As a rule, the wider the variety and greater the number of assets, the more potential options there are to finance the business.
Here is a collection of the most commonly used assets and how they can best be used to finance a business:
Stocks as Collateral
Stocks are shares of ownership in publicly held companies. Since the value of a business can fluctuate quite dramatically with little or no warning at any given time, stocks can be more volatile in the short term. In other words, the value of stock assets can fluctuate significantly. Therefore, if stocks are used as collateral, banks and other lenders will offer significantly less funds relative to the current value of the portfolio. Advances of 50% are common, but it depends on the lender’s level of confidence that the current value of the portfolio will not decrease beyond the amount borrowed (or the interest due on principle).
Stock Raises and Equity Financing
Equity financing is a practice typically reserved for businesses that would like to raise funds to finance growth, but do not otherwise have sufficient assets or credit to obtain traditional lending facilities to finance their growth. The most popular variety of equity finance is venture capital, which is typically a high-risk, potentially high-return investment. Equity financing requires building business proposals and selling investors on business model that they believe can be executed with sufficient certainty. After all, why invest in a company unless you believe it’s going to grow, become more valuable and therefore give you a good return on your investment?
Fixed Income
Fixed income securities, or bonds, are investments that provide returns in the form of scheduled payments over time and eventually provide full return at maturity. The payments may, however, vary in amount over time. Depending on the credit debtor of the bonds, the value is of such assets does not fluctuate as compared to stocks. The note will be at face value and fluctuates only with inflation and the creditworthiness of the debtor. US government bonds, for example, are considered extremely secure when used as collateral.
Fixed income securities can be leveraged as collateral better than stocks because the lender can better rely on the asset maintaining its value from the time the loan is given until it is repaid. This allows lenders to give higher advances relative to the value of the asset. For example, while a lender might only provide 40-50% against the value of stocks, they might advance 60-90% to the same borrower against their bonds. So, while stocks have much more potential to increase in value, the reliability of such fixed income assets allows this asset class significantly greater collateral leverage. Therefore, when used as collateral, fixed income assets should unlock more cash flow vis a vis stocks used in the same way.
Real Estate/Commodities
Real estate, which is also a form of equity, is extremely useful in financing. The most commonly known varieties of real estate financing are mortgage loans. However, in business finance, there are other ways to use real estate and commodities to fund day to day operations. Commodities can include precious metals like gold, agricultural land, and oil.
Personal Property Assets
Property assets are quite unique. They are often items of value that will depreciate, or even lose their value entirely over time, including things like cars, art, construction equipment, computers, and even race horses. Such assets can also be sold or leveraged as collateral. However, since they are not as easily bought and sold as stocks and bonds, their value is less liquid and thus, lenders price the extra risk into the cost of borrowing funds. This also impacts how large a percentage of the value of the asset lenders are willing to provide.
Due to liquidity concerns and depreciating value, borrowers should expect higher interest rates and lower advance rates. Lenders giving only up to 30-50% of the value of collateral is not uncommon. There are lenders who specialize in certain assets (e.g. art) and are better able to protect themselves against the risk. These specialized lenders can therefore provide higher advance rates and more accurately price the asset and any secured loans against it.
Common Business Assets
Invoices, equipment, machinery, and inventory are typical business property assets and are very appealing to lenders as a form of collateral.
Although these are all business assets, they are not created equal. For example, the value of an invoice depends on the creditworthiness of the customer who must pay that invoice and the likelihood that they will pay the full amount. In contrast, equipment and machinery loans are typically given by banks or specialized lenders who know how to price and sell machines if the loans default. Inventory also fluctuates in value depending on the nature of the inventory, how easily it is sold, how much its price fluctuates, the business owners’ track record for selling similar inventory, and other potential factors.
Other Types of Assets and Getting Creative
While an asset usually has a fixed value and can be readily bought and sold, some transactions require more creative tools. For example, many wholesalers obtain purchase orders from their customers in advance of production but don’t have enough funds or credit lines to pay for their goods. Certain lenders specialize in outlaying funds to pay for production in exchange for either interest or a share in the profits of the underlying transaction. This is called purchase order fund or “P.O. funding” and it is unique because it is neither a regular unsecured loan to a company based on financials, nor is it a secured loan against assets. Such lending is basically a hybrid of an inventory loan (since the funds are being used to pay for pre-sold inventory and the inventory purchased is used as collateral to secure the loan) and regular business line of credit.
Technically, a purchase order (or “P.O.”) is not an asset because it has no inherent value; it is simply a customer’s order to produce goods or services at an agreed upon price. While the PO funder is secured by the inventory that they finance and they often take a security interest against other assets of the business, the PO itself does not have any value until the goods are delivered as per the instructions of the customer. However, once the PO is complete and the customer is invoiced, many lenders are happy to take the resulting assets (i.e. receivables – invoices with payment due on a later date) and advance cash against them. This is called factoring. Unlike PO funding, which has what we might call “soft assets” or no assets, a factor advances funds against the value of a receivable, which is a common, bankable asset.
The point is that certain situations require creative solutions to accommodate the business and the transaction. Knowing how to leverage your assets (and sometimes even your non-assets) can be the difference between growth and stagnation or success and failure.
The bottom line is that in each of these instances, a business can leverage assets it already has and requires in its normal course of operations. By leveraging its assets as collateral, a business can access funds that are otherwise locked or frozen in value of those assets usually while still controlling, possessing, and deriving the full benefits of the assets. So, you can run your machines while using funds advanced to you by giving the lender a security interest (or “lien”) in the machine.
If a business intends to grow, it is, in the vast majority of instances, preferable to finance as much as possible through unsecured credit lines and credit lines secured by assets because interest will almost always cost less in the long run than selling equity (and often control) in your business for much less than it would be worth once you’ve had a chance to increase revenues through traditional financing vehicles.