U.S. businesses, especially smaller ones, may have a problem.
Increasingly, America’s entrepreneur class is having trouble getting the financing they need to keep the lights on and keep revenues rolling in. Enter alternative lending as—well, an alternative—to traditional loans or self-financing.
What are Alternative Loans?
Alternative loans (also referred to as “FinTech”) cover a broad array of business loan options available to start-ups and existing businesses that fall outside of a traditional bank loan. Alternative loans are in demand for one major reason—increasingly, company decision-makers cannot obtain a traditional bank loan. As larger financial institutions have slowed the lending spigots in the years following the Great Recession, many small businesses are labeled as lending risks.
Into the breach has stepped alternative lenders, who cater directly to small business owners and can consider often-overlooked (by banks, primarily) sources of collateral, like real estate, future revenues, or outstanding client invoices to secure the loan.
To provide a more appealing option to small businesses, alternative lenders are usually more flexible than larger financial institutions on loan repayments (many offer flexible schedules, for example) and often green light loan approvals much faster than banks, often getting business owners within 24-48 hours of the loan application. With speed, convenience and flexibility as selling points, alternative loans are among the fastest-growing financial tools for small businesses available today.
How to Get Started
The first thing you need to know is what options are available and when to best utilize each. Entrepreneur magazine outlines four different situations in which alternative lending might be the right option for your company:
In each of these cases, you should have a clear understanding of your business goals, how the money will be used, and the terms for each of your loan possibilities.
A New York Times article profiled Ivan Rincon, a small business owner looking to diversify his apparel offerings. After being rejected by traditional banks, he looked toward alternative lending. After an initial merchant cash advance, Rincon realized this was not the best option to expand his business. He then began exploring other types of alternative lending that better fit his expansion goals.
Types of Alternative Lending
“Which type of alternative financing may be best for me?” To help answer that query, here’s a look at some of the most popular types of alternative lending below. Find more lending resources and types of loans here.
Primarily, there are two types of online lending that show major signs of stability and growth—peer-to-peer lending and online platform-based business lending.
Peer-to-peer lending rolled out in 2005, as a solution to a vexing problem for business borrowers: “Where can I get a loan if a bank won’t give me one?” A decade later, P2P has really hit its stride, with lending industry analysts estimating the market will grow to $350 billion by 2025. Segment leaders include Lending Club and Prosper at the top of the list, but there are a burgeoning number of competitors looking to satisfy borrower demand for online lending options.
Online Platform-Based Business Lending (OPB)
Online Platform-based Business lending, or “OPB” is defined as loans to businesses that provide a lump sum amount in exchange for a share of future transactions/sales. Much like the structure associated with venture capital deals, the upfront money does come with financial strings attached that go beyond simply paying off a loan—OPB lenders want a cut of a company’s futures revenues, too. The analytical firm Research and Markets calls OPB lending “a purchase and sale of future income” that primarily aims at businesses “having strong credit card sales like retail, restaurant and service industry.”
The sector is humming along, as business borrowers seem more than happy to share future profits for a loan deal now. OnDeck, the current segment leader in OPB small business loans, has delivered $4 billion in loans since 2007, estimating more than 74,000 jobs and $11 billion in U.S. economic impact.
For borrowers, the combination of lower repayment rates (relative to bank loans) and more convenience, both P2P and OPB loans are well worth a look.
Merchant Cash Advance
For business owners who can’t get a traditional loan, and who may have less than stellar credit, a merchant cash advance is another route to alternative financing. MCA’s are not a loan. Instead, this form of funding is deemed as the sale of a company’s future credit sales at a discount. By and large, merchant cash advances are short-term (usually 90 days or so), with regular, even daily payments made by the borrower, usually straight from the company’s bank account, or from a fixed percentage from each company sale after payment is made by the customer. The good news for borrowers is credit can be approved quickly, without the onerous and volume-heavy paperwork associated with traditional bank small business loans. The downside is that interest rates linked to such loans can be heavy, with many MCA rates over 20%.
Small business factoring is cited by many industry observers as the “smart alternative” to bank loans. Just like merchant cash advances, factoring can be a viable option for small business owners as factoring financing approvals aren’t based on the business owner’s credit health, but on the company’s clients’ credit health. Factor financing is also good for small firms facing a cash-flow crunch or slow-paying clients. With factoring, those companies can sell their customer invoices to so-called “factor companies,” that, after approving the deal and weighing the client’s credit, will deliver up-front payments against client invoices and account receivables, of up to 90% of the total amount owed by the customer. After the client makes the total payment owed, the factoring company remits the balance, and tags on a processing fee.
For business owners, the big difference with factors is payment times—instead of waiting 30-to-60 days to get paid by customers, small business owners get access to cash within 48 hours, by opting for the factoring route. As with MCA’s, interest rates linked to factoring are generally higher than bank loans. Still, factoring is proving popular with businesses. The Wall Street Journal estimates the size of the factoring market is in the billions, although much of those assets are tied to specific industries, like trucking, retail, construction, and health care.
Going the crowdfunding route is another increasingly viable and popular option for small business owners seeking alternative forms of financing. With crowdfunding, business owners shouldn’t expect big chunks of money coming via crowdfunding – the average “donation” is only $88. But if you get enough donations of $50, $100, or $150, the funds can add up. Unlike peer-to-peer lending, you don’t have to pay the money back in a literal sense in a crowdfunding campaign (companies reward donors with perks and company swag, in many instances). Donors who give are passionate about the business idea and want to see it get off the ground for myriad reasons. But with some platforms, if the crowdfunding campaign doesn’t reach a predetermined financial goal, all bets are off, and the monies are returned to the original donors, a result that about 50% of crowdfunding participants experience.
The most successful crowdfunding timelines are between 30 and 39 days. Any less, and you’re not reaching maximum asset volume potential. Any more, and you’re risking oversaturating the market and running, fairly or unfairly, a stale funding campaign. Kickstarter (almost $2 billion raised since 2009) and Indiegogo (over $500 billion) are two popular crowdfunding sites used by entrepreneurs, but for a complete list, check here.
As of May 16, 2016, equity crowdfunding is open to the public, as opposed to just accredited investors. Learn more about equity crowdfunding or check out sites like Crowdfunder to get started. For more information, Crowdfunder’s CEO, Chance Barnett, helped explain the relatively new funding source in this podcast.
What if small business owners could raise capital by promising investors a future, set percentage of revenues? That’s the promise behind revenue-based loans. Basically, revenue-based financing (RBF) is a hybrid financing method that fills a need in the growth capital market for companies with approximately $1 to $10 million in revenue and a proven plan for growth, according to Lighter Capital (formerly RevenueLoan), a leading funding provider in the RBF sector. How does it work? Here’s how Lighter Capital describes it on Startup Owl:
“Instead of requiring a business to pay a fixed amount and over a fixed amount of time (i.e. think of your typical bank loan), an RBF investment receives a fixed percentage of gross revenues, up to some negotiated “cap” (anywhere from 1.25x for a short term, on up, depending on the needs of the company, and the timeframe and risk factors).”
Does your small business qualify? RBF investors usually look for companies with revenue run rate of $1 million or more; gross margins of 50% or higher; a solid plan for use of funds with a near-term return, and who are seeking $100k to $500k in funding immediately.
Which Alternative Lending Option Seems Right for You?
There is no single standard for determining the best alternative lending for your small business.
In general, the lending option you select depends on where you stand on the small business spectrum. If you’re just opening a new company, you probably won’t qualify for a big chunk of money from any lender, traditional or alternative. But for $25,000 or even $50,000, a peer-to-peer lending option could make the most sense.
Conversely, if your business is up and running, and has a good track record of revenue performance, a merchant funding platform would likely meet your needs. If you’re experiencing slow payment cycles from clients and customers, then a factoring or revenue-based deal makes good sense.
To protect yourself no matter what type of ending platform you use, make sure it adheres to the Responsible Business Lending Coalition’s Bill of Rights, which calls for greater transparency and accountability from all business lenders and financing platforms, giving small business owners, as the RBLC puts it, “fundamental financing rights that we believe all small businesses deserve.”
Below is the complete set of rights embraced by the Responsible Business Lending Coalition—use it to shape your best choice for small business lending options:
- The Right to Transparent Pricing and Terms, including a right to see an annualized interest rate and all fees
- The Right to Non-Abusive Products, so borrowers don’t get trapped in a vicious cycle of expensive re-borrowing
- The Right to Responsible Underwriting, so borrowers are not placed in loans they are unable to repay
- The Right to Fair Treatment from Brokers, so borrowers are not steered into the most expensive loans
- The Right to Inclusive Credit Access, without discrimination
- The Right to Fair Collection Practices, to prevent harassment and unfair treatment
What You Can Expect to Pay in Alternative Loan Rates
While there is no single number indicating interest loan repayment rates linked to alternative loans, data from both Lending Club and Prosper shed some light on the issue:
*Note that rates for merchant cash advances, factoring deals, and other alternative lending platforms are more volatile, and can be significantly higher than for traditional bank loans.
Why Alternative Lending vs Traditional Lending
Consider a few key metrics for small business lending, which all paint a fairly grim picture for companies looking for traditional lending options, through banks, credit unions, and other commercial lenders:
- A small business typically cannot get a traditional bank loan if it has been in business for less than 2 years or is asking for less than $250,000. — Score.org
- Between 2008 and 2013, the value of small business loans had fallen 12% from $327 billion to $289 billion. — Pioneer Capital Group
- Another disturbing number on the traditional small business lending front—50% of small businesses that applied for financing didn’t get it in the first half of 2014. That’s up from 47% in 2013. — CNBC
But where banks see risk, other financing platforms see opportunity.
According to a recent study by Dun & Bradstreet and Pepperdine University’s Graziadio School of Business and Management, more and more small businesses are turning to alternative loans and are finding the experience to be both a positive and sustainable one.
A “Game Changer” in Small Business Lending
Make no mistake, larger banks are already recognizing the risk in turning their backs on small businesses.
In a 2014 letter to shareholders, Jamie Dimon, chief executive officer at J.P. Morgan, admitted that letting small business loan customers go was a mistake:
There are hundreds of startups with a lot of brains and money working on various alternatives to traditional banking. The ones you read about most are in the lending business, whereby the firms can lend to individuals and small businesses very quickly and—these entities believe—effectively by using Big Data to enhance credit underwriting. They are very good at reducing the “pain points” in that they can make loans in minutes, which might take banks weeks. We are going to work hard to make our services as seamless and competitive as theirs. And we also are completely comfortable with partnering where it makes sense.
The Emergence of Alternative Lending
Alternative lending has emerged as a large player in the financial market due to technological advancements online and inelastic operations of traditional banking institutions.
“The future of alternative lending is looking bright in the US. Non-traditional alternative lending has grown rapidly in the last few years. Alternative lending caters to those customers who need cash but might not qualify for traditional bank loans because of poor credit profiles. P2P (Peer-to-Peer lending) and OPB (Online Platform-based Business lending) have emerged to make things easier for people as well as businesses who face difficulty in getting loans only because of their low credit profiles.” — Research and Markets
Banks may be too late in saving their small business customers, many of which are turning to a new financing source—alternative lenders.
While figures for such a new industry vary (alternative lending launched in 2005, economists say), the market is conventionally valued at $500 billion by the end of 2015.
While the past 10 years have demonstrated tremendous growth in the alternative lending market, the next decade should show higher growth. According to Research and Markets, one market segment alone, peer-to-peer lending, is heading to a $350 billion market value, while another, online platform business lending, grew 171% year-over-year by the beginning of 2015.
Alternative lending is on an upward path, and that’s welcome news to businesses looking for a different path to company financing.
A New Period of Growth
Three Quick Facts:
- As of last year, there are an estimated 1,300 companies in the alternative lending space competing for approximately 1% of the total lending market. — Forbes
- Foundation Capital estimates the size of the global non-bank lending market to grow to $1 trillion by 2025. — Foundation Capital
- The peer-to-peer lending market, alone, is expected to reach $350 billion by 2025. — LTP
According to industry data, the next few years should usher in a new period of growth in the alternative lending segment, and in many industry lending categories.
Primarily, those outlets for growth can be broken down into five industry segments:
- Online Lending
- Merchant Cash Advance
- Revenue Based Loans
All fit the disparate needs of alternative borrowers, in three game-changing ways:
- By meeting the demand growth in the need for larger, more complex loans; especially to business-to-business companies.
- By “fitting the bill” as business borrowers focus on “mainstreaming” alternative lending for all businesses.
- By accommodating heightened expectations from business owners on ease and speed of accessing capital, as they continue to sour on traditional lenders.
The question for borrowers now, is, which alternative investment category should they pursue?
Build Your Business Credit Now
Even when seeking alternative funding over traditional, you still may need to have strong business credit. While the alternative loan process generally isn’t as long and doesn’t have as strict of standards, that doesn’t mean lenders won’t look at your business credit report. Regardless of what type of lending you apply for, being able to show that you pay bills on time and manage your finances well can only help you.
It’s important to remember that any credit history takes time and planning. First, start by building your business credit and getting a free D&B® D-U-N-S Number if you don’t already have one. Once you’ve got a solid report, start monitoring your profile so you’re always on top of changes to your scores and ratings.
As your business grows, and you maintain your profile, your business credit will grow too. After you’ve built up a robust and beaming business credit file, you may be able to get traditional funding as well.
A New Era in the Business Lending Sector
Alternative lending represents a legitimate game changer for small businesses frustrated with traditional bank financing options.
Via any channel–peer-to-peer; online platforms, merchant advances, small business grants, or revenue loans—business owners now have a new path for cash that allows them to bypass traditional lenders, thus opening up a robust and revolutionary financing market—just when business owners need it most.
*Dun & Bradstreet does not endorse any of the lenders on this site [http://accesstocapital.com] and is not responsible for the outcome of any loans or contracts.