Alternative bank financing has increased significantly since 2008. Unlike bank lenders, alternative lenders typically place more importance on a company’s growth potential, future earnings and asset values than on its historical profitability, balance sheet strength or creditworthiness.
Alternative loan rates can be higher than traditional bank loans. However, the higher financing costs can often be an acceptable or only alternative in the absence of traditional financing. What follows is a rough sketch of the alternative loan landscape.
Factoring is the financing of debtors.
Factors are more focused on receivables and collateral than on the strength of the balance sheet. Factors lend money up to a maximum of 80% of the value to be received. Foreign claims are generally excluded, as are old claims. Claims that are more than 30 days old, as well as any concentrations, are usually discounted by more than 80%. Factors typically manage accounting and collection. Factors usually charge a fee plus interest.
Asset-Based Lending is the financing of assets such as inventory, equipment, machinery, real estate and certain intangible assets. Asset-based lenders will generally lend no more than 70% of the value of the assets. Asset-based loans can be term or bridge loans. Asset-based lenders usually charge an initial commission and interest. Valuation costs are necessary to determine the value of the assets.
Sale and Lease Back Financing. This financing method involves the simultaneous sale of real estate or equipment at a market value, usually determined by an appraisal, and leasing the asset back at a market rate for 10 to 25 years. The financing is offset by a lease payment. In addition, a tax liability may need to be recognized on the sale transaction.
Purchase Order Trade Finance is a fee-based short-term loan. If the manufacturer’s credit is acceptable, the purchase order borrower (PO) issues a letter of credit to the manufacturer, guaranteeing payment for products that meet predetermined standards. After the products are inspected, they are shipped to the customer (often the production facilities are abroad) and an invoice is generated. At this point, the bank or other source of money pays the PO lender for the money advanced. Once the PO lender receives payment, it deducts its fee and transfers the balance to the company. Inventory tracking can be a cost-effective alternative to PO financing.
Cash flow financing is generally accessible to very small businesses that do not accept credit cards. The lenders use software to view online sales, banking transactions, bid histories, shipping information, customer comments and ratings on social media, and even restaurant health scores, if applicable. These metrics provide data that demonstrates consistent sales volume, revenue, and quality. Loans are usually short-term and for small amounts. The annual effective interest rate can be quite high. However, loans can be financed in a day or two.
Merchant cash advances are based on revenue streams associated with credit/debit cards and electronic payments. Advances can be secured against cash or future credit card sales and typically require no personal guarantees, liens, or collateral. Advances have no fixed payment schedule and no restrictions for business use. Funds can be used for the purchase of new equipment, inventory, expansion, renovation, debt or tax repayment, and emergency financing. In general, restaurants and other retailers that do not have sales invoices use this form of financing. Annual interest rates can be onerous.
Non-bank loans can be offered by finance companies or private lenders. The repayment terms may be based on a fixed amount and a percentage of the cash flows, in addition to a share of equity in the form of warrants. In principle, all conditions are negotiated. Annual rates are usually significantly higher than traditional bank financing.
Community development financial institutions (CDFIs) commonly lend to micro and other creditworthy companies. CDFIs can be compared to small community banks. CDFI financing is usually for small amounts and the rates are higher than traditional loans.
Peer-to-peer lending and investment, also known as social lending, is direct investor financing that often new businesses have access to. This form of lending and investment has grown as a direct result of the 2008 financial crisis and the resulting tightening of bank credit. Advances in online technology have facilitated its growth. In the absence of a financial intermediary, interest rates for peer-to-peer lending and investments are generally lower than traditional sources of financing. Peer-to-peer lending and investing can be direct (a company receives funding from one lender) or indirectly (several lenders pool funds).
Borrowing directly has the advantage that the lender and the investor can build a relationship. The investment decision is generally based on a company’s creditworthiness and business plan. Indirect lending is generally based on a company’s creditworthiness. Indirect lending distributes the risk among the lenders in the pool.
Non-bank lenders offer more flexibility in evaluating collateral and cash flow. They may have a greater appetite for risk and inherently riskier lending. Typically, non-bank lenders do not have deposit accounts. Non-bank lenders may not be as well known as their counterparts at the major banks. To make sure you are dealing with a reputable lender, research the lender thoroughly.
Despite the advantage that banks and credit unions have in the form of a low cost of capital (nearly 0% of customer deposits), alternative forms of financing have grown in recent years to meet the demand of small and medium-sized businesses. This growth is sure to continue as alternative finance becomes more competitive, given the declining trend in the cost of capital for these lenders.
Patricia McMillan of McMillan Consulting LLC can help your business with financial, leadership and coaching issues.