December 4, 2010

A Possible Solution To The Small Business Collateral Crisis

Over the past several weeks I’ve blogged and talked in the press about the collateral crisis facing small businesses.  Essentially, with the declined values in commercial and residential properties, most small business owners have little equity left in their real estate that they can use to support loans.  And they (and we) need these loans to grow their companies, hire employees, and get our economy moving again.

At MultiFunding, we have the unfortunate role of telling dozens of entrepreneurs and small business owners every week that they don’t have sufficient collateral to get a loan and jump start their dreams.  We encourage them to go ask a parent, rich uncle or friend to put up some collateral so they can get the job done.  Unfortunately, most aren’t in that situation.

So here is a suggestion.  How about we create “individual future earnings” as a form of collateral?  A loan agreement would look something like this:  If after X amount of years, the loan has not been paid back or goes into default, the lender has the right to take an ongoing percentage of the borrower's earnings until the obligation is paid off.  We could use mechanisms and infrastructure that we used to enforce child support payments to get the job done.

There would be risk in this form of collateral for a lender.  They would have to look at the historical earnings and income tax returns of a small business owner, and forecast future earnings.  Unfortunately, sometimes borrowers might get disabled or have life changing events.  But ultimately lenders take risks, and this should be able to be assessed and evaluated.

Our lending system is in desperate need of innovation.  We need new ideas and new solutions to respond to our new economic reality.  How can we build a forum to evolve, discuss, and debate these ideas?  I welcome your thoughts.

26 Responses to “A Possible Solution To The Small Business Collateral Crisis”

    Jack Miller said...

    I think most of the problem rests at the governments feet, they will not let banks lend and keep kicking the free market in the nuts…almost ever. Move they make is the wrong move

    December 4, 2010
    John l said...

    Ami. I like the idea and the mechanism to avoid the moral hazard we face in the real estate world today

    December 4, 2010
    Jesse Henry said...

    My personal opinion is that this would be very risky for obvious reasons however it is very interesting. My thought would be somewhat of a hybrid form of this program. Instead a program not 100% collateralized by “future earnings” but also investment accounts, 401(K) and Life Insurance with Cash Value. This would provide more concrete collateral and more value to the lender. The problem with the Life Insurance piece would be the Age of the borrower. If the borrower is to young this would obviously be less attractive, however it would provide guaranteed available capital in time and could be monetized by the bank by other institutional investors at a certain age. This is already being done in the consumer market.

    Aside from this, I of course believe we are seeing and will continue to see more business owners becoming much more comfortable with new and improve techniques of monetizing their best collateral which in my opinion is “Accounts Receivables”. This is a very attractive form of collateral for institutional investors.

    December 4, 2010
    Brenner Green said...

    We could actually securitize people’s future income streams so they could increase their personal leverage and borrow even more money, like the way David Bowie did with his future album sales…

    Maybe I am being a little cynical here, but I think that you are looking down what might be the only path that the wall streeters haven’t thought of yet as to how to allow the consumer to further leverage himself.

    Basically, I agree with Jack above. The more the government tries to stimulate the economy by taking balance sheet risk the more the regulators have to involve themselves basically negating the intended benefit to the entrepreneur and the economy.

    December 4, 2010
    Tim Farrell said...

    Interesting idea, but there are so many loop holes with proving “actual earnings” when it comes to taxes, expenses etc. It could be a nightmare to implement unless these things were taken into account. Also, I’d guess failing businesses would be the ones most apt to default on loans. Would more people file for bankruptcy in cases like this? And if the government implemented something like that for a loan, would credit cards demand the same?

    I just wonder if this is something that could be done privately. In other words, what about implementing this from the start with some kind of an irrevocable auto-pay system and a contract that specifies the details. So the auto-pay would apply to all funds generated, whether from the business or not. I could go on and on here to solve what “would happen if this happened”, but you get the idea…

    In the end, there’s always Judge Judy.

    December 4, 2010
    Tom Spadea said...

    It certainly has been a difficult few years and without new lending we won’t be able to pull out of this stagnant economy. I like your creative thinking Ami as always. That is the problem with many banks and certainly the government, they don’t think creatively and it is easier for them to just say no. They don’t understand small business like you do.
    Perhaps another solution is that in addition to the banks taking on a collateral position in future earning maybe they should share in some of the reward. If the business goes bad they are stuck and I am not sure what contract, claim on future earning, etc. is ever going to help them not get burned. The challenge I see the banks have is that if the business does great they still just get paid their interest. Maybe they need a higher return if the business does well, kind of a preferred stock type of arrangement.

    December 4, 2010
    Barbara Weltman said...

    Your suggestion certainly has merit. There are already investment firms that have been created to offer “royaly funding.” They use a percentage of revenue to pay back loans (See WSJ article at http://tinyurl.com/2e4pd8h)

    December 5, 2010
    Bill Attinger said...

    Royalty-based financing has indeed gained some momentum since 2009. Last month, ActSeed posted an overview of this as it relates to early stage companies and listed a couple of firms that provide this kind of innovative financing here: http://bit.ly/RoyaltyBasedVC .

    While this kind of financing won’t be available for all small businesses, it does seem to fill a niche between commercial lending and conventional venture/angel capital.

    Great post, Ami and MultiFunding!

    December 5, 2010
    Darren said...

    This could a viable be alternative. It comes down to the execution. Of course, a payday scheme would be a disaster. It would also be bad if debtors were allowed to utilize this method for any purchase. Can you imagine this for purchases at Best Buy?
    However, if this were a formal structure implemented like a HSA or FSA, and only used for the purchase of legitimate businesses, then it is worth considering.

    December 6, 2010
    Michael said...

    I think the key would be to find a way to make this arrangement BK proof.

    Of course, indentured servitude and debtors’ prisons went by the way side a few years ago.

    December 6, 2010
    Dan K. said...

    An interesting idea, similar to revenue bonds on an individual or small business basis. Assuming this was done with an individual and not through a corporation, I imagine that taking a lien on an individual’s future earnings would incur all sorts of government oversight especially since “retail” lending is the most highly regulated segment of lending. I am also not sure how you would perfect a lien on future earnings, or who would regulate the banks to monitor the levying of deposit accounts in the event of default. This type of collateralization might also encourage more sheltering of personal income. And as for a business’ future earnings, if they have defaulted on the subject credit facility, then there is probably a going concern issue and future earnings are unlikely and therefore undermining the collateral support.

    December 6, 2010
    Gary Bender said...

    Ami Good creative thinking. The banks won’t consider it because they won’t be able to record the transaction. Does not mean that Multifunding could not create the documents that could work but the document has to be enforceable. Careful thought need for spousal or partner or guarantor signoff and the prioritization for collateral and future earnings. Finally, borrower has to record something, especially is a bank, SBA or some other creditor is involved and looks at financial statements or other traditional documents used to support traditional lending.

    I like the out of the box thinking. Certainly better than what is “not” out there today.

    Gary

    December 7, 2010
    Christian Jacobsen said...

    What you are describing is called Revenue Based Finance (sometimes Royalty Based Finance, or just RBF for short).

    At RevenueLoan, this is exactly what we do. We have $6m to loan using this model, and have already closed several deals.

    Generally speaking, this is a good model for funding small business growth. Established businesses with between $1-$10m in annualized revenues generally have a good track record of earnings, they know their market well, and they know exactly how much funding they need to build their infrastructure to serve a larger client base.

    But if they are an information-processing business (like medical billing, data mining, etc), there is little collateral to secure a bank loan. And there is no “big exit” for Angels or VCs to make their money. So these businesses have nowhere to turn for financing, even though the math makes sense.

    I don’t want to proselytize on your site, but more can be found about RBF funding on our site, and on the web.

    It isn’t ideal for every investor or every company, but it is another arrow in your financial quiver of arrows.

    December 8, 2010
    Marisol Perry said...

    An interesting idea, similar to revenue bonds on an individual or small business basis. Assuming this was done with an individual and not through a corporation, I imagine that taking a lien on an individual’s future earnings would incur all sorts of government oversight especially since “retail” lending is the most highly regulated segment of lending. I am also not sure how you would perfect a lien on future earnings, or who would regulate the banks to monitor the levying of deposit accounts in the event of default. This type of collateralization might also encourage more sheltering of personal income. And as for a business’ future earnings, if they have defaulted on the subject credit facility, then there is probably a going concern issue and future earnings are unlikely and therefore undermining the collateral support.

    December 22, 2010
    Latoya Bridges said...

    An interesting idea, similar to revenue bonds on an individual or small business basis. Assuming this was done with an individual and not through a corporation, I imagine that taking a lien on an individual’s future earnings would incur all sorts of government oversight especially since “retail” lending is the most highly regulated segment of lending. I am also not sure how you would perfect a lien on future earnings, or who would regulate the banks to monitor the levying of deposit accounts in the event of default. This type of collateralization might also encourage more sheltering of personal income. And as for a business’ future earnings, if they have defaulted on the subject credit facility, then there is probably a going concern issue and future earnings are unlikely and therefore undermining the collateral support.

    December 22, 2010
    Nona Mills said...

    This could a viable be alternative. It comes down to the execution. Of course, a payday scheme would be a disaster. It would also be bad if debtors were allowed to utilize this method for any purchase. Can you imagine this for purchases at Best Buy? However, if this were a formal structure implemented like a HSA or FSA, and only used for the purchase of legitimate businesses, then it is worth considering.

    December 22, 2010
    Yvette Ball said...

    Ami Good creative thinking. The banks won’t consider it because they won’t be able to record the transaction. Does not mean that Multifunding could not create the documents that could work but the document has to be enforceable. Careful thought need for spousal or partner or guarantor signoff and the prioritization for collateral and future earnings. Finally, borrower has to record something, especially is a bank, SBA or some other creditor is involved and looks at financial statements or other traditional documents used to support traditional lending. I like the out of the box thinking. Certainly better than what is “not” out there today. Gary

    December 24, 2010
    Tracie Wells said...

    Ami Good creative thinking. The banks won’t consider it because they won’t be able to record the transaction. Does not mean that Multifunding could not create the documents that could work but the document has to be enforceable. Careful thought need for spousal or partner or guarantor signoff and the prioritization for collateral and future earnings. Finally, borrower has to record something, especially is a bank, SBA or some other creditor is involved and looks at financial statements or other traditional documents used to support traditional lending. I like the out of the box thinking. Certainly better than what is “not” out there today. Gary

    December 24, 2010
    Myrna Beard said...

    What you are describing is called Revenue Based Finance (sometimes Royalty Based Finance, or just RBF for short). At RevenueLoan, this is exactly what we do. We have $6m to loan using this model, and have already closed several deals. Generally speaking, this is a good model for funding small business growth. Established businesses with between $1-$10m in annualized revenues generally have a good track record of earnings, they know their market well, and they know exactly how much funding they need to build their infrastructure to serve a larger client base. But if they are an information-processing business (like medical billing, data mining, etc), there is little collateral to secure a bank loan. And there is no “big exit” for Angels or VCs to make their money. So these businesses have nowhere to turn for financing, even though the math makes sense. I don’t want to proselytize on your site, but more can be found about RBF funding on our site, and on the web. It isn’t ideal for every investor or every company, but it is another arrow in your financial quiver of arrows.

    December 29, 2010
    Michele Foley said...

    An interesting idea, similar to revenue bonds on an individual or small business basis. Assuming this was done with an individual and not through a corporation, I imagine that taking a lien on an individual’s future earnings would incur all sorts of government oversight especially since “retail” lending is the most highly regulated segment of lending. I am also not sure how you would perfect a lien on future earnings, or who would regulate the banks to monitor the levying of deposit accounts in the event of default. This type of collateralization might also encourage more sheltering of personal income. And as for a business’ future earnings, if they have defaulted on the subject credit facility, then there is probably a going concern issue and future earnings are unlikely and therefore undermining the collateral support.

    January 13, 2011
    Concepcion Kantner said...

    Many countries have a notion of standard or conforming mortgages that define a perceived acceptable level of risk, which may be formal or informal, and may be reinforced by laws, government intervention, or market practice. For example, a standard mortgage may be considered to be one with no more than 70-80% LTV and no more than one-third of gross income going to mortgage debt.

    January 15, 2011
    Rufus Bobet said...

    Until recently it was not uncommon for interest only mortgages to be arranged without a repayment vehicle, with the borrower gambling that the property market will rise sufficiently for the loan to be repaid by trading down at retirement (or when rent on the property and inflation combine to surpass the interest rate).

    January 15, 2011
    Dell Patanella said...

    Many countries have lower requirements for certain borrowers, or “no-doc” / “low-doc” lending standards that may be acceptable in certain circumstances.

    January 16, 2011
    Teaching Quality Discussion said...

    I think this is very important. Thanks a lot.

    February 10, 2011
    Amy Jonhs said...

    Great read..1st visit to this site. Thanks for sharing. I am going to bookmark this site. I am really fascinated with the World economy. I really believe that the United States debt is improving. I guess we will see. Thank you .!

    March 3, 2011
    wpolscemamymocneseo said...

    Thanks for the thoughts you are sharing on this blog. Another thing I want to say is getting hold of duplicates of your credit report in order to check accuracy of each and every detail is the first action you have to accomplish in credit restoration. You are looking to thoroughly clean your credit profile from detrimental details errors that mess up your credit score.

    March 11, 2011

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