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Jim asks:

A lender is proposing to use ‘going concern’ as the collateral for a business loan. My take is that going concern would already be badly damaged if the company’s financial condition has deteriorated to the point that it is unable to pay our loan as agreed. I prefer to see assets we could sell rather than an enterprise value for our collateral. Which of us is right?

Linda says:

You are right, this time, Jim. Collateral is our back-up plan if things go wrong, and in my view it comes in after all of our preferred sources of repayment, which include cashflow generated from:

  • Operating income
  • Excess Liquidity
  • Additional owner capital contributions or additional borrowed funds
  • Selling other assets that are no longer essential
  • Selling the collateral for this loan

Just what is going concern?

I like this explanation from accounting-simplified.com.

Going concern is an assumption that a business entity will continue to operate in the foreseeable future without the need or intention on the part of management to liquidate the entity or to significantly curtail its operational activities. Therefore, it is assumed that the entity will realize its assets and settle its obligations in the normal course of the business.

Possible indications of going concern problems:

  • Deteriorating liquidity position of a company not backed by sufficient financing arrangements.
  • High financial risk arising from increased gearing level rendering the company vulnerable to delays in payment of interest and loan principle.
  • Significant trading losses being incurred for several years. Profitability of a company is essential for its survival in the long term.
  • Aggressive growth strategy not backed by sufficient finance which ultimately leads to over trading.
  • Increasing level of short term borrowing and overdraft not supported by increase in business.
  • Inability of the company to maintain liquidity ratios as defined in the loan covenants.
  • Serious litigation faced by a company which does not have the financial strength to pay the possible settlement.
  • Inability of a company to develop a new range of commercially successful products. Innovation is often said to be the key to the long-term stability of any company.
  • Bankruptcy of a major customer of the company.

How is a ‘going concern’ value determined?

This might be based on a multiple of annual revenue common to that type of business. If it is a franchise, for example, there may be a market in those franchises that could be used as a basis for the valuation.

By definition, it is not the value of all the assets less any liabilities that would need to be liquidated if the company ceased. Remember, going concern is the assumption that the entity will continue.

What do the regulators say about using going concern as collateral?

Interagency Appraisal and Evaluation Guidelines issued 12/10/2010 covers the Comptroller of the Currency, the Federal Reserve System, the Federal Deposit Insurance Corporation, the Thrift Supervision Office, and the National Credit Union Administration.

Found in the Federal Register, the guidelines include the following:

VIII. Minimum Appraisal Standards
Value opinions such as “going concern value,” “value in use,” or a special value to a specific property user may not be used as market value for federally related transactions.

NCUA updated the NCUA Examiner’s Guide for the new rules which will be effective January 2017. The relevant section follows:

Commercial and Member Business Loans

Enterprise Value (Going Concern Value)

Enterprise value is an economic measure that reflects a business’ market value. It is a sum of claims by all claimants, including creditors (secured and unsecured) and shareholders (preferred and common). Enterprise value is also referred to as total enterprise value, firm value, or going concern value. The going concern premise assumes a business will continue operating indefinitely.

Consideration of enterprise value may be appropriate in the credit underwriting process, but not as collateral for a loan. Enterprise value is not appropriate for use in real estate transactions and is not appropriate as a secondary source of repayment for most other types of lending transactions.

When a lender forecloses on collateral, it usually means other sources of repayment have failed. In such circumstances, the business has most likely failed and is no longer a “going concern.” Furthermore, going concern value is not property in which a credit union can perfect a security interest. Therefore, an appraisal based on going concern value would be inconsistent with established industry guidance.

The bottom line…

For collateral, stick to items you could sell. The less saleable they are, the lower the loan to value.

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Linda Keith, CPA

Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis.
She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans.
Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.