If you ever tried raising debt capital from a bank, you know that lenders base their decisions on business cash flow. In other words, the key consideration is whether the business can repay the loan in full and on time.
Lenders build in the risk into the debt service coverage ratio. This gives the bank the extra margin of safety if the business earnings dip temporarily. Typical DSCR expected by commercial lenders is in the range of 1.25 – 1.5.
Banker’s main worry: default
In addition, banks expect that some loans may go sour. To address the risk of default, your bank will look for some collateral. Business owners can expect that only a fraction of their business asset values can be pledged as a loan collateral.
Typical business asset values as loan collateral
Accounts receivable, adjusted for uncollectible bad debt may fetch close to 75% of their book value, the finished goods inventory around 50-60%. Hard business assets such as furniture, fixtures and equipment (FF&E) are likely to be worth about 50% of their fair market value when offered as collateral.
Some banks may even be willing to accept certain intangible assets, especially the readily marketable trademarks, copyrights and patents. If a licensing agreement is in place, you can use the Discounted Cash Flow method to determine the value of such assets. Otherwise, you will need to research typical royalty rates and prepare a defensible income forecast for your intangible asset valuation.
Lenders: what are the business assets worth in a liquidation
Business owners and lenders often disagree on the value of business assets used as business loan collateral. The reasons are obvious: from the lender’s perspective a low-risk loan is one offered to a business with plenty of stable cash flow backed by a valuable, highly marketable asset base.
If the loan goes bad, the bank will look to dispose of these assets quickly. Hence, your lender is likely to use the so-called liquidation premise when valuing your business assets.
Business owners: what is the cost to replace business assets?
The fair market value of these assets can be considerably higher. Business owners often object to the lender’s business valuation results – after all, they know what their inventory is worth when sold in the normal course of business. Besides, it seems far more reasonable to value the FF&E on a replacement cost, value in use or going concern basis.
Different assumptions lead to differences in business valuation results!
Whose valuation is right? Actually, both sides are correct! As is the case with any business valuation, the assumptions drive the results. Put differently, the business owners and the lender use different premises of value – each based on their respective position.
Both the lender and business owners need to understand that this business value spread is normal, then work together to find an acceptable compromise.