Learn about the advantages of alternative lending for small businesses, including term loans, merchant cash advances, business lines of credit,Advantages of Alternative Lending
Approximately 80 percent of small businesses that apply for a loan from a traditional bank are rejected. Small businesses are commonly hindered by constraints such as insufficient assets to pledge, smaller loan sizes not being profitable enough for banks to entertain, and inconsistent cash flows, among many other reasons. Historically, small businesses have had more success securing capital from a local bank or credit unit than a big bank. Unfortunately, for small business owners, the number of community banks with assets less than $500 million have declined by about 70 percent from 1990 through 2018; while the number of independent commercial banks have shrunk by about 14 percent during that time. If a bank denies a small business’ loan application, the business owner’s natural reaction is to wonder where they can turn in order to secure financing in the event that they have identified a working capital need such as purchasing new equipment, expanding its existing facility or purchasing a new one, relieve cash flow issues, or investing in the growth of the business. For small business owners there are three paths towards obtaining capital:
- Friends & Family
- Traditional Banks
- Alternative Lending Sources
If those first two paths have been unsuccessful, small business owners may consider alternative lending sources. Alternative lending refers to the process of securing funds through sources outside of traditional banks. These sources offer a wide range of options with differing conditions to choose from. There are hundreds of alternative lending sources operating in the United States that offer various forms of lending, including:
- Term Loans
- Merchant Cash Advances
- Revolving Lines-of-Credit
- Factoring (AR/Invoice)
Each of these options have their own unique advantages and could all be beneficial dependent upon the specific circumstances of a business.
Term loans
Term loans include a fixed amount and a fixed repayment schedule, along with either a fixed or variable rate of interest. Term loans are similar to a mortgage or student loan where an applicant is provided with cash up front and then they pay it back in fixed installments (such as daily, weekly, bi-weekly or monthly) over a set period of time. The advantages of term loans include speed of processing as an online term loan can be approved within a few days, whereas a traditional bank can take several weeks or even months. In addition, a term loan allows small business owners to maintain all of their ownership in their company and it does not require them to sell a portion of it to acquire funds.
Cash Advance
Another option is a merchant cash advance. By definition, a merchant cash advance is not a loan; rather a business to business transaction predicated upon the company’s daily deposit activity. Merchant cash advances provide a short-term funding option for small business owners who were unable to secure financing through a traditional bank. The funds are borrowed against future sales and typically need to be repaid within six months to 18 months. Merchant cash advances provide quick access to financing, typically within 24 to 48 hours. There are also no minimum payments, and repayments are taken out of the small business owner’s account automatically, which eliminates the chance for late charges.
Business Line of Credit
A third option is a business line of credit. This is a loan that provides the small business owner with access to a fixed amount of capital in order to help pay for expenses of the business such as inventory, equipment repairs, a new facility, shoring up a gap in cash flow, or to finance a marketing campaign, among many other uses. A business line of credit provides the business owner with quick and convenient access to funds, along with flexible payments and terms. With a line of credit, the business owner is only charged interest on the funds once they are used and interest is only charged on the funds that are used, not the entire amount of the line of credit. There is also a revolving line of credit option, which is where the credit replenishes up to the agreed upon amount as the small business owner pays off the existing debt. This means that as soon as the debt is repaid, the business owner can borrow up to the credit limit again without having to go through the loan approval process for a second time.
It should be noted that there are two types of lines of credit, secured and unsecured lines of credit. A secured line of credit requires business assets (such as accounts receivables or inventory) to be provided as collateral to secure the line. If the small business owner does not repay the line of credit, the collateral will be collected by the lending source and liquidated to pay off the line.
Unsecured lines of credit, on the other hand, do not require collateral; however, a strong credit score and a strong track record of the small business will be needed to qualify. It should be noted that interest rates may be higher for unsecured lines of credit. Both secured and unsecured lines of credit can be used flexibly and repeatedly, with low minimum payments and there are no demands to pay it back in full.
Factoring
Another available option a small business owner can consider is factoring. A factor is a funding source that pays the small business the value of an invoice in exchange for a fee, which is typically a percentage of the invoice total. The process of factoring includes the small business selling its invoices to the factoring company in return for a lump sum, which can be utilized as working capital for the business.
The advantages of factoring are that the factoring company collects the small business’ outstanding invoice totals from their clients, thus eliminating the need for the small business owners to take the time to collect it themselves. This option also provides small business owners with immediate access to funds (with no definitive expiration date) in order to cover cash flow shortages commonly resulting from their customers paying slowly or making late payments.
In addition to factoring providing almost instant cash flow, it can also be utilized on a continuous basis, which could eliminate any future cash flow issues the small business owner faces as a result of having to wait for invoice payments from customers since the funds will be disbursed regularly. In addition, collateral is not needed for this service, as the invoices themselves serve as collateral. If a small business owner was denied on a bank loan application and does not know where to go next in order to secure additional financing to cover important business expenses or to make improvements to their business, alternative lending may be the much needed solution.
