Alternative bank financing has significantly increased since 2008. In contrast to bank lenders, alternative lenders typically place greater importance on a business’s growth potential, future revenues, and asset values rather than its historic profitability, balance sheet strength, or creditworthiness.
Alternative lending rates can be higher than traditional bank loans. However, the higher cost of funding may often be an acceptable or sole alternative in the absence of conventional financing. What follows is a rough sketch of the alternative lending landscape.
Factoring is the financing of account receivables. Factors are more focused on the receivables/collateral rather than the strength of the balance sheet. Characteristics lend funds up to a maximum of 80% of receivable value. Foreign receivables are generally excluded, as are stale receivables. Receivables older than 30 days and any receivable concentrations are usually discounted over 80%. Factors manage generally the bookkeeping and collections of receivables. Factors typically charge a fee plus interest.
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Asset-based lLending is financing assets such as inventory, equipment, machinery, real estate, and certain intangibles. Asset-based lenders generally lend no greater than 70% of the assets’ value. Asset-based loans may be term or bridge loans. Asset-based lenders usually charge a closing fee and interest. Appraisal fees are required to establish the value of the asset(s).
Sale and lease-back Financing. This method of financing involves simultaneously selling real estate or equipment at a market value usually established by an appraisal and leasing the asset back at a market rate for 10 to 25 years. A lease payment offsets financing. Additionally, a tax liability may have to be recognized on the sale transaction.
Purchase Order Trade Financing is a fee-based, short-term loan. If the manufacturer’s credit is acceptable, the purchase order (PO) lender issues a Letter of Credit to the manufacturer, guaranteeing payment for products meeting pre-established standards. Once the products are inspected, they are shipped to the customer (often manufacturing facilities are overseas), and an invoice is generated. At this point, the bank or other source of funds pays the PO lender for advanced funds. Once the PO lender receives payment, it subtracts its fee and remits the balance to the business. PO financing can be a cost-effective alternative to maintaining inventory.
Non-Bank Financing
Tiny businesses that do not accept credit cards generally access cash flow financing. When applicable, the lenders utilize software to review online sales, banking transactions, bidding histories, shipping information, customer social media comments/ratings, and restaurant health scores. These metrics provide data evidencing consistent sale quantities, revenues, and quality. Loans are usually short-term and for small amounts. Annual effective interest rates can be hefty. However, loans can be funded within a day or two.
Merchant Cash Advances are based on credit/debit card and electronic payment-related revenue streams. Advances may be secured against cash or future credit card sales and typically do not require personal guarantees, liens, or collateral. Advances have no fixed payment schedule and no business-use restrictions. Funds can be used to purchase new equipment, inventory, expansion, remodeling, the payoff of debt or taxes, and emergency funding. Generally, restaurants and other retailers that do not have sales invoices utilize this form of financing. Annual interest rates can be onerous.
Finance companies or private lenders may offer nonbank Loans. Repayment terms may be based on a fixed amount, a percentage of cash flows, and a share of equity in the form of warrants. Generally, all times are negotiated. Annual rates are usually significantly higher than traditional bank financing.
Community Development Financial Institutions (CDFIs) usually lend to micro and non-creditworthy businesses. CDFIs can be likened to small community banks. CDFI financing is generally for small amounts, with higher rates than traditional loans.
Peer-to-Peer Lending/Investing, or social Lending, is direct investor financing, often accessed by new businesses. This form of lending/investing has grown due to the 2008 financial crisis and the tightening of bank credit. Advances in online technology have facilitated its growth. Due to the absence of a financial intermediary, peer-to-peer lending/investing rates are generally lower than traditional financing sources. Peer-to-peer lending/investing can be direct (a business receives funding from one lender) or indirect (several lenders pool funds).
Direct Lending has the advantage of allowing the lender and investor to develop a relationship. The investment decision is generally based on a business’s credit rating and business plan. Indirect Lending is also usually based on a business’s credit rating. Indirect Lending distributes risk among lenders in the pool.
Non-bank lenders offer greater flexibility in evaluating collateral and cash flow. They may have a greater risk appetite and facilitate inherently riskier loans. Typically, non-bank lenders do not hold depository accounts. Non-bank lenders may not be as well known as their big-bank counterparts. Research the lender thoroughly to ensure that you are dealing with a reputable lender.
Despite the advantage that banks and credit unions have in the low cost of capital – almost 0% from customer deposits – alternative forms of financing have grown to fill the demand of small and mid-sized businesses in the last several years. This growth will continue as alternative funding becomes more competitive, given the decreasing trend in these lenders’ cost of capital.
