Should You Consider Alternative Business Funding? Let’s Find Out
Prospective borrowers basically have two ways to go when seeking financing for their businesses: banks and nonbanks.
We’re all familiar with banks, of course, but the concept of a nonbank might be a bit fuzzy by comparison. Very simply put, a full-scale bank is a for-profit financial institution that accepts deposits and offers checking and savings account services in addition to providing loans. Nonbanks, with the exception of credit unions, cannot do both. Nonbanks range from pawnshops to payday loan operations, but here we’ll be exclusively concerned with online-based lenders.
The alternative lending industry has thrived around the world and in the U.S., where it grew 22 percent from 2015 to 2017, reaching a market volume of $34.5 billion according to a 2017 study by the University of Chicago Polsky Center for Entrepreneurship and Innovation.
Alternative lenders achieved their first major growth during the financial crisis when borrowers found it extremely difficult to get loans through traditional banks. They have continued to prosper because their flexibility and the variety of their lending options often allows them to extend credit, and do it quickly, to customers who might be turned down by a bank. For many borrowers, these advantages outweigh the fact that alternative loans typically cost more.
Alternative funding advantages and disadvantages
Traditional banks have always been quite particular about the borrowers they approve for long-term business loans. They minimize their risk by lending only to business owners with good credit, a substantial and successful track record, and by making collateral a requirement for most loans. They also require potential borrowers to go through a rigorous application process than can take months to approve.
The great appeal of alternative lenders has been their willingness to offer loans to businesses that would have little chance of success at a traditional bank. This includes businesses that have been open for less time, for example, and those with fair or even poor credit.
Typically, banks have favored borrowers who have been in business a minimum of two years, whose businesses have proven profitable, and who have personal credit scores of 680 or more. In comparison, alternative lenders often approve loans to borrowers who have been in business just a year, even if those businesses are not yet profitable (if the annual revenue is $100,000 or more), with a personal credit score as low as 620 for some loans, and even as low as 500 for other types of financing.
It’s worth noting, however, that banks are beginning to show greater willingness to fund small businesses than in the past. According to the latest Biz2Credit Small Business Lending Index, as of December 2017, business loan approval rates for big banks (more than $10 billion in assets) had risen to 25.2 percent, while other large institutional lenders approved 64.3 percent. At the same time, small banks approved roughly 49 percent. The same study places alternative lender business loan approvals at 56.7 percent.
According to that study, government-backed Small Business Administration bank loans were approved more often in 2017 than ever before.
These new developments could mean business borrowers who are not in a hurry and feel confident about their creditworthiness might be wise to consider a traditional bank.
Alternative lenders maintain a great advantage because of their ability to process and approve loans in days or sometimes hours — a major plus for businesses that need quick access to funds. Part of the reason for their speediness is that alternative lenders are not subject to the same federal regulations as traditional banks (which use funds from depositors as the basis for their loans). The real reason they are able to make approval decisions so quickly, however, is that they bring cutting edge technology to the table. In addition to employing complicated underwriting algorithms, they use software that allows them to quickly scan financials and even social media before approving or disapproving an application.
This is one area where banks have a clear advantage over alternative lenders, though the reason for this is the same exclusivity that has enabled alternative lenders to attract businesses with little chance of meeting bank loan requirements. Because banks favor businesses with proven long-term profitability and stellar credit histories plus ready collateral, they can afford to offer small business loans on comparatively affordable terms.
The fact that alternative lenders are more accessible to businesses that have been open a shorter time and with less well-established revenues and problematic credit ratings means they are also more vulnerable to risk. This is risk they attempt to balance by charging higher rates, or by often offering shorter term lengths and smaller loan amounts.
Interest rates from alternative lenders mostly depend on the usual factors (time in business, creditworthiness, profitability, etc.). The cost can vary considerably, however, depending on the type of funding business owners seek.
Types of alternative business funding
It’s important for borrowers to understand their options, especially since alternative lenders offer a variety of relatively new loan products in addition to the traditional products offered by banks.
When people think of taking out a loan, whether it’s for business or personal use, a term loan is generally what they envision. Typically, it provides a lump sum to be repaid with regular installments at a fixed rate of interest, anywhere from one year to 25 years. The amount an applicant can borrow for business, as well as the terms of repayment, depend on how long a business has been open, its profitability, and the personal credit score of the owner, among other factors.
Generally speaking, business loans of this sort are most likely to come from a traditional bank, though some alternative lenders offer them as well. Alternative lenders generally charge a higher rate, however, and may offer less advantageous terms of repayment and shorter terms.
Short-term loans are somewhat easier to secure than long-term loans, in part because the amounts are typically smaller, usually $2,500 to $250,000. As the name suggests, the repayment period is much shorter (often three to 18 months) and the interest rates are generally significantly higher. In addition, payments sometimes must be made daily or weekly. Since the profitability and creditworthiness requirements are considerably less stringent, however, more businesses may find short-term loans a viable option.
If a business requires an expensive piece of equipment, or multiple pieces of equipment such as computers or cars, an equipment loan may be the best way to go — especially if the business is relatively new and credit history could pose a problem. Lenders will often accept the equipment as collateral, making an approval easier to secure. The length of the loan is usually determined by the life expectancy of the equipment.
A useful option for businesses with cash flow issues and outstanding invoices. Lenders typically advance from 75 to 90 percent of an unpaid invoice. When the customer pays, the payment goes to the lender, who then sends the balance of the invoice amount to the business minus fees owed to the lender.
Merchant cash advance
On the upside, merchant cash advances can be easy to qualify for because they are essentially cash advances recovered by the lender from a set percent of credit card sales taken out on a daily or weekly basis. Merchant cash advances can provide a quick fix for a cash-strapped business, but repayments can quickly get out of hand and become quite expensive, not unlike consumer payday loans.
One of the major differences between a cash advance of this sort and a loan is that repayment is typically based on a factor rate (usually a range of 1.2 to 1.5) instead of an interest rate. When converted to an APR, the rates for merchant cash advances can range between as high as 70 to 200 percent.
Lines of credit
Business lines of credit are generally considered an extremely useful funding resource, one businesses should secure before the need for emergency funding arises. Lines of credit are similar to credit cards in the sense that the lender has provided the borrower with an amount of credit to be used if needed. And the borrower only pays back what he or she uses — with interest. However, lines of credit have one major advantage over credit cards: access to cash.
Business credit cards
Similar to a line of credit (with the exception of access to cash) and much easier to qualify for, business credit cards are generally considered useful as a ready source of funding. Like a line of credit, they are better to have and not need than to need and not have, despite the fact that they generally come with high interest rates. They should be used responsibly, however, typically for purchases that can be paid off in less than a year, thus avoiding long-term, high-interest debt.
Using credit cards also provides a bonus for newer businesses, namely by helping them build a credit history, which can help them qualify for other types of loans later.
How to apply for alternative business funding
Applying for some alternative forms of funding requires relatively little in terms of formal documentation — invoice financing, for example, or business credit cards, equipment loans, or merchant cash advances. In order to qualify for a traditional long-term loan, however, the business owner should be prepared to provide considerable documentation along with the application — even though alternative lenders have made filling out the application itself a much less painful process compared to banks. Approval decisions are also made much more quickly.
Lenders will be able to assess personal and business credit scores on their own. Aside from that, however, the following documents will be required:
- Three years of business and personal tax returns
- Recent business bank statements
- The business’s most recent profit and loss statement
- A cash flow forecast (ranging from two to 12 months)
- A business debt schedule
- A business plan
Is alternative business funding right for you?
No business owner should take on debt lightly. Emergencies do arise, however. And so do opportunities that could help a business grow and prosper. In the former case, if a business is in the kind of trouble that can only be fixed with a quick infusion of cash, clearly the best course is to secure the most affordable financing available. In the latter, it might be irresponsible not to borrow the necessary funds.
In such a case, if the loan seems justified and if the business has reached a stage where funding can be secured at reasonably affordable rates, the business owner still needs to answer two important questions. Will the loan be used to pay for something that will increase sales and improve profit margins — and is there definitely enough steady income to make regular payments on the loan?
If the business can afford to take on debt and funding will make it more profitable, that might make it well worth the risk.