Evaluating Notes Receivable & Inventory as Collateral PDF

DIMENSION 5 - 18 NOTES: EVALUATING NOTES RECEIVABLE Notes receivable are promissory notes payable to your customer and may arise in the course of trade, such as converting an account receivable to a formal note when extended terms are granted. A note may also be the evidence of debt when an owner, e...

DIMENSION 5 - 18 NOTES: EVALUATING NOTES RECEIVABLE Notes receivable are promissory notes payable to your customer and may arise in the course of trade, such as converting an account receivable to a formal note when extended terms are granted. A note may also be the evidence of debt when an owner, employee, or other party receives an advance from the company. Regardless of the reason for the underlying debt, it is important to ask the following questions when evaluating whether to take a promissory note as collateral: Who is the maker (signer) of the note? Does the maker demonstrate both ability and willingness to repay the loan evidenced by the note? What are the terms of the note, including term, payment schedule, and interest rate? If the note currently requires performance, is the debtor making timely payments? Is the note secured, and if so, what are the nature and value of the collateral? Is the note guaranteed, and if so, does the guarantor have the resources and motivation to repay the loan evidenced by the note? Is the note negotiable or non-negotiable? To be negotiable, the note must be in writing, signed by the debtor, contain an unconditional promise to pay the named amount, and be payable either on demand or at a specified date. Most important, the note must be payable either “to the order of [XYZ Company]” or “to bearer.” If payable to a named creditor only (payable to XYZ Company) the note is not negotiable. CRC US Body of Knowledge The bank can take either a negotiable or a non-negotiable note as collateral, but the bank has greater flexibility in disposing of the note (perhaps selling it) and greater protections in defense of taking the note as collateral if it is a negotiable note. DIMENSION 5 - 19 INVENTORY AS COLLATERAL NOTES: The quality of inventory as collateral is measured in a number of dimensions. Some of these areas are related to complex inventory accounting considerations outside the scope of this reading. In general, key considerations include: If you are lending on a formal borrowing base, one significant risk is that the borrower may reclassify one component of inventory to another for the fraudulent purpose of increasing the advance rate on the collateral. For example, when the bank does not advance funds against work-in-process inventory, the borrower may prematurely advance not-quite-finished goods into finished goods to qualify them for working capital advances. Marketability of the bank’s collateral may be nonexistent if the product cannot be sold in an incomplete condition. See the “‘General Collateral Guidelines” discussion following for collateral considerations by class of inventory. Costing/accounting methods. The true cost of the inventory needs to be considered. When inventory advances are structured as a percentage of funds loaned against the inventory’s cost, understanding the inventory cost is essential. In many instances soft costs, such as overhead components, can be absorbed into inventory cost figures. Similarly, if freight is a large component of inventory cost, liquidation value will be impaired. The lender needs to verify that costing methods used are reasonable and that the carrying cost on the books reflects an accurate cost or market value, whichever is less. There is also the risk of deliberate overstatement of quantity or value. Fictitious inventory reports may be submitted, overstating the quantity of inventory on hand and thus diluting the bank’s true collateral value. Alternatively, costs to produce the inventory may be overstated or if the market value of the inventory has deteriorated, write-downs may not have been taken. In either of these cases, the bank’s advances, typically tied to inventory cost, will be excessive in comparison to the realizable collateral value. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Contents. Inventory is often comprised of multiple components, such as raw materials, work-in-process, and finished goods inventory. Generally, these components do not have equal value, so it is important to determine how much of overall inventory is represented by each of these components. DIMENSION 5 - 20 NOTES: Physical condition. The inventory should be fresh and in salable condition. Accordingly, it should be stored properly, kept in good condition, and sprinkler systems and security procedures should be appropriate to the nature of the inventory. Perishable inventory requires extra care and shortens the window of opportunity for liquidation. Keep in mind that in a liquidation, the bank will need to take responsibility for maintaining the condition of the inventory until it is sold. Inventory that requires costly care and maintenance will yield smaller proceeds, net of the incremental handling costs. Marketability. The inventory should be easily marketable. There should be good distribution channels to facilitate sales. The current state of the industry must also be considered, including whether there is an excess or shortage of the product on the market, or whether a new or substitute product is diverting sales. Marketability impairments include being outdated or out of style, obsolete (or approaching obsolescence), requiring significant time or funds to complete, or being highly customized or specialized. Note that some types of inventory may not be legally marketed by the bank, such as alcohol or tobacco products. The worst-case scrap value of the inventory (by component) should be estimated to determine the lowest likely value to be realized in liquidation. Significant quantities of inventory tagged as returned or defective indicate impaired marketability. CRC US Body of Knowledge Verifiability and control. Verification of inventory value is another key consideration. Tests to confirm inventory value are important to ensuring that the value of the collateral is as represented by the borrower. Some inventory may not be the borrower’s property at all, such as tool and die property on the borrower’s premises but owned by the company’s customers. In addition, the lender must evaluate the borrower’s inventory control systems to confirm that the borrower’s ongoing representations of collateral types, values, and locations can be relied on. Ready access to inventory is key to realizing proceeds in a liquidation. The borrower must be able to demonstrate adequate control and tracking of inventory, i.e., be able to identify quantities by type and location and to regularly update this information. In the event of a liquidation, it is essential to have quick access to accurate records, so the bank can take control of the collateral in time to prevent any shrinkage while trying to verify its content and location. In addition, if there are special systems or equipment needed to maintain the inventory in salable condition (such as refrigeration units or security systems) it is best practice to ensure the bank has legal access to these systems, so it can maintain the assets during a workout or liquidation process. DIMENSION 5 - 21 Domicile. The bank must have legal and practical access to the inventory. Where the inventory is located has implications for both. Inventory located outside the country, or located at the site of the borrower’s customer may present physical access difficulties. Inventory located out of the country may require hiring in-country legal counsel for access and disposal. For a detailed discussion of lien perfection procedures, including information about filing liens when the collateral is outside the borrower’s state of domicile, see Dimension 6. NOTES: Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Inventory that is not under proper security and control is subject to physical removal from the customer’s premises. To the extent the book value of the inventory is overstated by the pilfered amount, the bank’s collateral is undervalued with respect to advances against it. DIMENSION 5 - 22 NOTES: COLLATERAL GUIDELINES FOR INVENTORY COMPONENTS There are no universal guidelines for acceptability of inventory components as collateral. Conventional wisdom suggests that finished goods inventory is the most valuable, followed by raw materials; in most cases, it is assumed that work-in-process inventory will yield little or no value to the lender in collateral liquidation. Conventional wisdom is often valid, but there can be exceptions. General considerations for each class of inventory, with some notable exceptions you should evaluate, are: Raw materials. Raw materials inventory can be interesting to the lender because the cost is generally easily identified. Particularly if the raw materials are a commodity product, there can be an easily identifiable market for resale (although commodity goods are highly subject to price volatility, making value in liquidation difficult to estimate). Viewing the raw material as another company’s finished goods (where appropriate) can cast a more favorable light on this inventory component’s marketability. Exceptions: Raw material can be purchased partially processed, as in lumber cut to specific board lengths. In that case, the resale market is less clear. CRC US Body of Knowledge Work-in-process. Costs can be difficult to define, depending on accounting conventions and at what state labor and overhead are imputed into the product. Unless there are similar competitors, an outlet for unfinished product may not exist, and any sale can be expected to yield minimal dollar value. Exceptions: A manufacturer of custom machinery may progress-bill its customers. Where progress billing is a contractual obligation, the work-in-process (partially completed machines) may be viewed by some lenders as pre-sold inventory, with correspondingly high collateral value. Finished goods. Generally viewed as having the most assured liquidation value, finished goods inventory has an identifiable market and sale price. Cost can be difficult to determine, depending on accounting conventions. DIMENSION 5 - 23 Exceptions: If the borrower is a dominant player in its industry, unloading the finished goods in liquidation may result in significantly depressed sales values as supply potentially outpaces demand. In addition, there are many factors that can influence the liquidation outcome, including product perishability, commodity versus specialized product type, seasonality/sales timing, and cost of disposition. Private label finished goods are poor collateral, unless manufactured to specific contracts that have a high likelihood of being honored NOTES: Your inventory evaluation can include an onsite inspection (or several, if inventory is in multiple locations), review of customer inventory reports, or review of third party reports such as an inventory appraisal or an asset-based lending field exam report. Usually a combination of these methods is needed to adequately qualify inventory as collateral. Evaluating inventory entails identifying any risks related to inventory contents and costing/accounting methods. In the paragraphs to follow, we will describe asset-based lenders’ typical inventory examination objectives and procedures to help explain the nature of inquiry needed to identify inventory risks and to determine the appropriate loan-tovalue advance percentage. Whether you are employing the services of a third party inventory appraiser or field examiner, or you are conducting your own investigation, it is important to cover this full range of investigational topics to fully qualify your collateral. In addition to profiling typical inventory exam procedures, we will also describe procedures for examining the borrower’s accounts payable and tax accounts. These support exam elements complement the inventory examination; they help verify that there are no hidden claims against the proceeds of the sale of inventory collateral. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral EVALUATING INVENTORY DIMENSION 5 - 24 NOTES: INVENTORY EXAM PURPOSE AND PROCEDURES The objective of the inventory exam is to determine if the borrower’s representation of inventory is accurate and to assess the adequacy of the inventory as collateral for the company’s borrowings. There are a number of areas of exposure for loss of inventory collateral value, which we described at the beginning of this inventory discussion. The inventory examination procedures are designed to identify and quantify the inventory loss exposure areas as outlined in the preceding discussion. Examinations differ according to bank policies and procedures, as well as in response to specific needs dictated by customer relationships or industry peculiarities. Typical inventory exam procedures include: Analyze components. The examiner verifies the classes of inventory, generally raw material, work-in-process, and finished goods. A complete review of inventory components requires an understanding of the inventory conversion cycle to determine if movement of inventory from one class to another is consistent with the actual changes in the value added to the goods. Test cost of sales. The examiner reviews the method used to determine inventory cost, plus any general ledger adjustments. Adjustments are analyzed to determine if they fairly reflect the actual cost of the inventory on the books. CRC US Body of Knowledge Confirm valuation. The examiner reviews valuation procedures and verifies that the inventory is being carried at the lower of cost or market. Sale value is compared with inventory value (cost) to determine margins and to verify the goods are salable above cost. Assess marketability. The examiner reviews the overall inventory marketability, including distribution channels, gross profit margin analysis, comments regarding the general state of the industry, and a worst-case scrap value assessment. This review can include researching market trends, and includes analyzing the inventory to determine the percentage of inventory consisting of less marketable elements such as prior year’s models, styles, etc. Validate quantity. The examiner conducts a test count of inventory, noting variances and recording explanations for them. The examiner generally reviews and comments on the overall reasonableness of the client’s inventory tracking methods. Evaluate physical condition. The examiner assesses the general physical condition of the inventory, noting any storage conditions or security lapses that could cause the inventory to deteriorate. Identify obsolescence. The examiner reviews the inventory for DIMENSION 5 - 25 obsolete and unsalable merchandise, noting particularly whether inventory ledger adjustments have been made to reflect the diminished value. NOTES: Review Management Information Systems Adequacy. The examiner reviews the type of accounting systems that support the inventory tracking and reporting. Focus of the review is to determine whether the systems permit accurate and timely assessment of the quantity and value of inventory. ACCOUNTS PAYABLE/TAXES EXAM OBJECTIVES AND PROCEDURES The objective of the examination of payables and taxes is to verify that all trade creditors and taxing authorities are being paid as required. Analysis of payables practices shows the effective leverage of inventory. Verification of tax payments is important because liens for unpaid taxes may have precedence over secured creditor liens. The payables and taxes examination procedures are designed to verify outstanding payables balances and to compare payment practices with agreed-on terms. Examinations differ according to bank policies and procedures. Typical payables/taxes procedures include: Review the A/P aging. The examiner reviews the client’s payables aging to determine if obligations are being met on a timely basis. Note is made of any intercompany payables, and agings are generally compared with similar prior periods. Identify payables concentrations. The examiner looks for any concentration of payables, which may indicate over reliance on a vendor or short supply of needed goods for manufacture or resale. Identify contra accounts. Vendors who are also customers are identified, and their receivable balance compared with the payable balance. The receivable amounts generally will be considered ineligible for financing. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Identify ineligibles. The examiner makes note of any inventory categories that are not eligible for working capital advances and verifies these items have not been included with other eligible inventory on the borrowing certificates. For new or prospective clients, the examiner will formulate specific recommendations for portions of inventory that should not be eligible for financing. DIMENSION 5 - 26 NOTES: Review payment terms. The examiner reviews payment terms for significant vendors to determine if any unusual terms exist and to determine if any trade payables have been converted to notes payable. Verify tax payments. The examiner reviews tax returns and canceled checks to verify the tax amounts due were actually paid, and on time. Federal, state, and local income taxes are checked, as are withholding amounts, payroll taxes, and personal property taxes. PLANT AND EQUIPMENT AS COLLATERAL GENERAL PLANT AND EQUIPMENT QUESTIONS General questions to consider when evaluating plant and equipment include: Are facilities owned or leased? What is the location? What are lease terms, including options and renewals? Is any portion being financed? If so, who has the security interest? In terms of environmental hazard issues, has there been any history of toxic waste disposal or storage on the property? CRC US Body of Knowledge To the borrower’s knowledge, has there been any evidence of environmental hazard or event on any of the surrounding properties within at least five miles? Has the property ever had an environmental assessment? When and who performed it? Would a copy of the assessment be available to the bank? Is the current facility adequate to meet future needs? Has there been a recent appraisal? What value was given to the property and equipment? DIMENSION 5 - 27 EVALUATING EQUIPMENT The value of equipment as a secondary repayment source depends on the following key considerations: NOTES: What is the age of the equipment? Newer equipment obviously provides greater collateral value than older equipment, and its value is generally easier to determine. Of equal importance is to ask how much of the equipment’s useful life has already expired. A two-year old machine that has a service life of only three years may be less valuable as collateral than a five-year old machine with a service life of 20 years. In a similar vein, equipment with remaining (and transferable) warranty protection may have more liquidation value than equipment without warranty protection. Is the equipment portable? Equipment that is permanently or semipermanently affixed to real property presents liquidation problems. There may be legal issues regarding landlord rights if the real property is leased, and there will be costs and practical issues related to securing and transporting the equipment for sale. Is the equipment essential to the customer’s operation? Equipment that is essential to operations is likely to be better maintained than non-essential equipment, preserving collateral value. Also, if the loan is explicitly to finance equipment, loans for essential equipment are less susceptible to default than loans to finance non-essential equipment. Is the equipment uniquely identifiable? If there is a serial number or other characteristic that provides ready identification, the specific equipment serving as collateral will be easily determined. This is particularly important if there is a mix of lenders, or if some of the customer’s equipment is leased from other financing sources. Is the equipment easy to maintain? If maintenance is simple and maintenance costs are low, it is more likely the equipment will remain in good condition and thus retain its collateral value. What is the current condition of the equipment? Equipment in good condition has greater value, and it is also suggestive of the customer’s operational management practices. Similarly, it is important to find out in what setting the equipment is being used. Equipment being used in a very dusty or corrosive environment will not retain value as well as equipment used in a clean, climate-controlled building. Equipment used by companies that do not commit adequate maintenance training and resources will not hold its value. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Is the equipment general purpose or specialized? General purpose equipment has broad application inside and outside the customer’s industry, where special purpose equipment has a very narrow market. DIMENSION 5 - 28 NOTES: Is the equipment comprised of a few significant pieces of equipment or are there many smaller units? Handling and disposal costs are less if the equipment is concentrated, and costs can be significantly higher to liquidate a large number of small-value items. Does the equipment have a low rate of obsolescence? Equipment subject to little obsolescence has a higher value as collateral than equipment that will rapidly lose value in favor of newer technology. Also find out if there is any regulatory legislation existing or pending that will require expensive modification or even phase-out of the equipment. Is there an active secondary market for the equipment? The liquidation value of equipment may be readily estimated if there is an active secondary market in the equipment, and less time will be needed to market the equipment in liquidation. Is there a shortage or a surplus of this type of equipment in the customer’s industry? A shortage suggests easier disposal at higher values; a surplus may suggest the equipment is no longer desirable, or is being phased out in favor of newer or alternate technology. In either of the latter circumstances, liquidation value is impaired. How do current industry trends impact the value of the equipment? For example, if an industry is in distress and there are consolidations, bankruptcies or downsizings in process, value of equipment used in production or manufactured as products by the industry may experience value loss as surplus equipment enters the market. REVIEWING AN EQUIPMENT APPRAISAL When reviewing an equipment appraisal, key questions to consider include: CRC US Body of Knowledge What are the appraiser’s credentials? There are several certifying bodies for equipment appraisers, including: –– Association of Machinery and Equipment Appraisers. –– American Society of Appraisers. –– North American Association of Equipment Appraisers. DIMENSION 5 - 29 In addition, there are appraisal bodies that specialize in particular types of equipment, such as the American Association of Farm Equipment Appraisers. In a formal equipment appraisal, the appraiser should identify his or her professional certification and memberships. Some of the certifying bodies provide multiple levels of certification (i.e., Certified Appraiser I, II, etc.). Several bodies subscribe to The Appraisal Foundation’s Uniform Standards of Professional Appraisal Practice (USPAP), which also governs real estate appraisal practices. NOTES: What is the purpose of valuation provided in the appraisal? The most common values specified are: –– Fair market value. The price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts in the open market. –– Orderly liquidation value. The amount of gross proceeds that could be expected from the sale of appraised assets under orderly conditions given a period of time in which to find a purchaser considering a complete sale of all assets, as is, where is and all sales made free of all liens and encumbrances. –– Forced liquidation value. The estimated gross dollar amount that could typically be realized by a properly conducted public auction held under forced conditions under present day economic trends. –– The valuation most commonly requested by financial institutions for collateral assessment is an orderly liquidation value. Has the appraiser certified that he/she: –– Performed a personal inspection of the equipment? –– Engaged in appropriate investigation and research, including evaluation of comparable equipment being offered for sale and actual previous sale data? –– Charged an appraisal fee that was not contingent upon any value estimate, and has no present or contemplated future interest in the property or the appraisal client that might tend to prevent making a fair and unbiased appraisal Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral The appraiser’s statement of credentials should also include educational credentials and a brief description of professional experience, with any specialized knowledge and experience with relevant types of equipment noted. DIMENSION 5 - 30 NOTES: Has the appraiser provided definitions to explain what is meant by descriptive terms such as excellent, very good, good, fair, poor, and scrap when describing the condition of appraised equipment? Has the appraiser commented on the collateral considerations noted under “Evaluating Collateral” prior? The appraisal narrative should discuss the value implication of many of the considerations we noted as having an impact on the value of equipment as collateral. PROTECTING YOUR ACCESS TO EQUIPMENT COLLATERAL You must order lien searches and obtain copies of all filings to determine whether you have or will have senior liens on collateral. Searches must be ordered from all locations in all states where financing statement filings are required at the time the loan is made. See Dimension 6 for a discussion of how to perfect a security interest in many types of property. Information about environmental assessments is also included in Dimension 6. In addition, it is important to verify that adequate insurance is in place to protect the lender’s interest in the assets. Insurance questions to ask include: What kinds of coverage are maintained? What is the extent of coverage? Are all premiums current? Who is the company’s agent or broker? CRC US Body of Knowledge What is the nature and extent of claims filed in recent years? Are there any pending settlements? Many factors that could negatively affect the value of your collateral and the ability of the borrower to repay its loan are unavoidable and cannot be insured against. For those factors that can be insured against, require proof that such insurance has been obtained and that your institution is an included insured party. Generally you should prefer that your bank be named as loss payee under a New York Standard Mortgagee clause. It provides that your right to coverage under the policy would not be affected or defeated by any act, neglect, or default of the borrower. DIMENSION 5 - 31 INTANGIBLE ASSETS AS COLLATERAL NOTES: Marketing-related intangible assets. Typically these are trademarks and trade names that provide value through the owner’s ability to attract customers and/or charge a premium based on perceived benefits associated with the name. Customer-related intangible assets, such as customer lists and sales contracts. This type of intangible is most valuable in industries for which obtaining customers is a significant barrier to entry. For example, major grocery stores frequently buy their produce only from established brokers. Once established, the broker’s customer list is very valuable. Another example of customer-related intangible assets is the customer maintenance contracts commonly owned by software companies. Covenants not to compete are also customer-related intangible assets. Artistic-related intangible assets, such as copyrights that provide value by establishing exclusive right to sell or license a work. Contract-based intangible assets, such as intellectual property licensed from another entity. One example would be a clothing retailer that owned the rights to use the Olympic rings in its clothing. A franchise agreement or a company’s internet domain name might also be considered contract-based intangible assets. Technology-based intangible assets, more commonly referred to as patented technology, and including software. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Intangible assets, like all assets, are claims to future values. Tangible assets represent either physical value claims (such as equipment or real estate) or financial claims (such as an account receivable, which represents a claim to future cash). Intangible assets represent nonphysical claims to future values and are generally recognized to fall into four categories: DIMENSION 5 - 32 NOTES: There is great variation in terminology used to define intangible assets. For example: General intangibles as defined in Article 9 of the Uniform Commercial Code means “any personal property, including things in action, other than accounts, chattel paper, commercial tort claims, deposit accounts, documents, goods, instruments, investment property, letter-of-credit rights, letters of credit, money, and oil, gas, or other minerals before extraction. The term includes payment intangibles and software.” Payment intangible is defined by Article 9 as “a general intangible under which the account debtor’s principal obligation is a monetary obligation.” Accounting rules distinguish between intangible assets with finite (such as patents) or indefinite lives (such as goodwill). Lenders often add to the list of intangibles balance sheet accounts of dubious value, such as notes receivable from or investments in affiliated entities, when adjusting reported net worth to what we call tangible net worth. Assets such as those named above—trademarks, trade names, customer lists, sales contracts, copyrights, licenses, and patents—are commonly referred to as intellectual property (IP). CRC US Body of Knowledge For the purposes of this collateral analysis discussion, we will limit the topic to the intellectual property intangibles defined earlier. Most other assets included in the broader definitions, such as payment intangibles, have readily identifiable values. Others, such as goodwill, have values that are identifiable, but not separable from the owning entity, and thus do not typically provide collateral value. DIMENSION 5 - 33 IDENTIFYING INTANGIBLES SUITABLE AS COLLATERAL NOTES: Does the asset have value independent of the owning entity? Patents, trademarks, copyrights, trade secrets, customer lists, and software are examples of intangibles that typically can be separated from the owning entity, i.e., can be sold. Goodwill generally does not have independent value, although for legal reasons it is advisable to take a security interest in associated goodwill when securing certain assets, such as trademarks. Has a value been established for the asset? If so, how was the value established? Accounting rules for intangible assets require annual impairment tests and related value write-downs if an impairment has occurred. However, balance sheet value does not permit recognition of increased market value, which generally can only be reliably established through a formal valuation process. Appraisers of intellectual property and other intangible assets should be credentialed. The Appraisal Foundation’s Uniform Standards of Professional Appraisal Practice (USPAP) apply to intellectual property valuations. Valuation of intangible assets may be based on cost, market, or discounted future cash flow approaches, similar to valuation of other assets. Each approach requires market specialists capable of performing independent research, with specialized knowledge of the borrower’s competitive environment, similar intellectual property in the industry, and recent sales or licensing of similar property. Has the asset been afforded all relevant legal protections, such as registration with the appropriate government agency? Some types of intellectual property, such as patents, need to be registered to protect rights. Other property, such as a copyright, does not require registration but registration is the best means of enforcing a claim of infringement against a third party. Generally, the more legal protections in place, the more likely the asset will provide value in a liquidation. Does the borrower actually own the asset? You should verify that the company has full legal ownership rights in its intellectual property. Licensed intellectual property may not be transferable. Even if a company paid for development of a proprietary copyrighted work, it may not have full ownership rights if the property is considered a work for hire and the company did not secure the appropriate assignments of copyright interest. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Not all intangibles are suitable as collateral, including some intellectual property. To identify intangibles suitable as potential collateral, consider the following questions: DIMENSION 5 - 34 NOTES: Has the asset previously been used as collateral? If your customer provided intellectual property as collateral for an earlier financing, it is possible that the lender’s security agreement was effectively a means to assign the asset to the lender while licensing it back to the borrower. Ownership of the asset may have transferred to the lender in that event. What are the costs to maintain legal protections if the asset is intellectual property? Maintaining and defending legal protections can be very expensive. Patent, trademark and other legal protections have indefinite lives and require additional filings and fees to keep them in force. Defense of intellectual property infringement is expensive, both to protect the borrower’s property and to respond to suits alleging the borrower infringed on similar or pre-existing property. Have contract rights been thoroughly documented, and do they include any restrictions on sale, pledge, or assignment? For both registered intellectual property and intangibles such as non-compete agreements and long-term supplier contracts, you should request information to determine whether there are any express restrictions on your ability to secure and perfect an interest in the asset. In rare cases, financial statement disclosures may provide relevant details, but generally you must request review of the relevant documents. UNDERSTANDING THE REAL ESTATE APPRAISAL APPRAISAL DEFINITION CRC US Body of Knowledge An appraisal of real property provides an estimate of the value of the property as of a defined point in time, based on current market conditions. Regulatory agencies have mandated the use of appraisals in real estate lending decisions and have stipulated the basic information that an appraisal must contain. Regulatory requirements notwithstanding, for the lender the appraisal is one of the more important underwriting tools. It provides very useful information on: Overall market conditions. Characteristics of the particular neighborhood in which the property is located. Current market rental rates and operating expenses. Value of land and any improvements. DIMENSION 5 - 35 This discussion will familiarize you with the critical analytical content of the appraisal, its sequencing and the basic concepts or rationale for each appraisal section. You will normally find conclusions presented at the beginning and end of the report, with the salient supporting data and arguments laid out in the middle. This is a fairly high-level discussion, as the actual content of an appraisal is much more comprehensive than as outlined here. Appraisal content not discussed in this section may include photographs of the site, site/ parcel descriptions, project descriptions, title/lien priority data, surveys, etc. It is easy to see how on larger, complex projects appraisals can be 100 pages or more in length. Regardless of the length, a comprehensive review of the appraisal constitutes essential due diligence on any commercial real estate loan. The major appraisal sections addressed in this section are: Highest and Best Use. Three Approaches to Value. Cost Approach Sales Comparison Approach. Income Capitalization Approach. Final Reconciliation of Value. NOTES: Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral KEY APPRAISAL CONTENT