For many small and midsize businesses, obtaining traditional bank financing is more difficult than you might think. Old-school banking’s inefficiencies and outdated underwriting processes make it almost as costly for banks to make loans under $250K as it is to make loans of $1 million, and banks are facing increasingly strict capital ratios. The result is that many banks aren’t interested in making smaller loans to SMBs because the economics don’t work.
If you’re bumping up against these constraints in your quest to secure startup capital for your SMB, don’t give up. Alternative lenders have transformed the lending environment for SMB borrowers. New financing products are better structured for SMBs and can deliver capital more quickly, enabling entrepreneurs to stay focused on growing their businesses.
Four common forms of alternative funding
1. Short-term loans
Short-term loans can be useful for SMBs needing to replace equipment, bridge a rough patch in working capital, or invest in their business. However, they typically carry a fairly high all-in cost — short-term loans from some popular online lenders carry effective APRs in the triple digits! SMBs should be careful of any fees and other costs, which can quickly increase the cost of the loan. Due to the short term and, potentially, a daily repayment structure, SMBs should also be sure that their cash flows can support repaying the loan in full; otherwise they may need to refinance and carry debt for longer than intended.
2. Medium-term loans (1-3 years)
These loans generally have a lower interest rate and tend to work for slightly larger, more established SMBs. They are available more quickly than bank loans which often take 60 to 90 days to process. On the downside, they usually require personal guarantees.
3. Revenue-based loans (3+ years)
These are loans that are structured in a more “entrepreneurial-friendly” manner. Revenue-based loans, like those offered by Lighter Capital, offer a medium-term source of funding for SMBs. Because they are repaid based on a fixed percentage of monthly sales rather than on a preset amortization schedule, these loans tend to work well for SMBs that are investing for growth and may have lumpy sales.
4. Merchant cash advances (flexible terms)
Merchant cash advances (MCAs) have a repayment structure that’s tied to an SMB’s future credit card sales. Instead of basing payments on a fixed amortization schedule, SMBs remit a fixed percentage of daily credit card sales to MCA providers. While MCAs tend to be more expensive than term loans (triple digit effective APRs aren’t uncommon), they are not tied to personal assets and payments fluctuate based on sales. Some lenders present MCA loans as revenue-based financing, so make sure you clearly understand the loan terms and structure.
Why costs for alternative lending are coming down
It’s not uncommon for entrepreneurs to be a bit suspicious of alternative online lending sources. After all, why are they able to make loans quicker than a traditional bank? How can they offer alternative repayment structures that traditional banks cannot? And how can they do any of this without charging astronomical rates?
The answer is simple: by leveraging the latest technology. The use of the technology in sourcing, underwriting, and servicing loans has dramatically brought down costs and processing times for alternative lenders. The market has continued to grow and streamline as borrowers become more comfortable applying for loans online—perhaps even without ever speaking with a human.
In fact, technology has permeated every aspect of underwriting, allowing lenders to assess financial and bank statements in real time, directly from the source or trusted third party, to ensure better accuracy. Lenders are also using new sources of data, such as Yelp reviews or Foursquare check-ins to assess the credit-worthiness of a business. In servicing, lenders utilize technology to evaluate the loan performance in real time, and can more quickly intervene when issues arise. They also can create automated systems to take on most of the performance monitoring work that used to require a large, costly staff. Borrowers can also leverage technology to their benefit to evaluate the wide variety of alternative loan products. Several aggregating sources, like Merchant Maverick, show SMB owners their debt financing choices, clearly highlighting product features and disclosing all-in pricing.
There’s never been a better time for SMB owners to pursue alternative sources of debt-based financing to grow their companies.