Even a reasonably healthy business may run short of cash from time to time. Or a borrower may have a sudden need for a loan in order to take advantage of an unexpected opportunity. In both scenarios, traditional lenders, faced with regulatory constraints and other limitations, may not be able to act quickly enough to be helpful.
Enter, “alternative financing” — financing provided by a party other than a bank or credit union. In particular, for borrowers seeking small business financing, pursuing alternative lending options offers viable solutions.
Alternative financing has become more prevalent over the last decade for several reasons. First, and perhaps foremost, bank lending all but dried up for most small businesses in the wake of the 2008 financial crisis. And after the financial crisis receded, banks tightened their requirements for lending, making it more difficult to secure a loan.
In fact, even before the global pandemic hit, small and mid-sized businesses were finding it harder to get traditional loans, even as they increasingly sought capital. In the wake of last year’s economic crisis, many small business owners cited the lack of capital or cash as their top challenge, with 67% unsure how to access funding, according to Goldman Sachs. Banks only approved 13.3% of loan applications in the last quarter of 2020, down from the 28.1% approval rate recorded in November 2019. Needless to say, for small business financing, borrowers may be wasting their time talking to banks.
In the last few years, we’ve seen new entrants move into the space largely abandoned by traditional lenders. Equipped with new technologies, these alternative lending companies are expanding their beachhead. The 2022 market size is expected to hit $2.65B.
Conservatism is in a bank’s DNA. Bank regulatory requirements are due to the fact that they lend from depositors’ funds, as well as the outsized effects banks have on the national economy. Hence, Dodd-Frank rules.
Bank conservatism also aligns with the dominant industry business model of pursuing long-standing relationships with borrowers to whom a bank can cross-sell other services. For banks, then, the financial and operational condition of a borrower’s business is key. Quick and tailored funding of a liquidity-challenged or struggling business is a very different thing, and difficult for banks to accomplish.
Indeed, some banks have started partnering with alternative lending companies. For those seeking small business financing who are unable to meet bank loan criteria, the banks can now refer them to alternative lending solutions. This allows small businesses to pursue more tailored funding opportunities, outside of traditional lending.
For small business financing, one might consider selling equity in the business to meet cash needs. Securities law consideration aside, the fundamental problem with selling equity is that many business owners want to maintain control of their companies.
And while it’s typically more expensive than traditional bank financing, pursuing an alternative lending solution is almost always cheaper than equity. This is especially true at the lower end of the middle market, where there’s little appetite from institutional or private equity investors for minority investments.
Alternative lenders are able to move more quickly and enter into smaller and creative loan structures, in part because their regulatory load is oftentimes lighter than a bank’s.
Unlike banks, alternative lenders do not lend from depositors’ funds, but from the funds of investors, such as hedge funds, family offices, and accredited investors, and from bank lines of credit. Some alternative lenders grew out of large but cyclical businesses (e.g., shipping) that generated a lot of cash.
Alternative lenders charge higher interest rates and fees than traditional lenders. They also tend to insist on other terms that are “harder” than those of traditional lenders, thereby earning them the moniker “hard money lender.”
For example, a hard money lender may require the borrower to grant it a security interest in collateral with a value comfortably exceeding the loan amount, irrespective of the financial and operational health of the borrower. An equity “kicker” is also commonly negotiated.
Indeed, alternative lenders charge a premium for providing quick response, creative financing solutions, and additional liquidity for non-standard situations. However, it can be worth it for borrowers when they need to quickly access capital for small business financing.
Different lenders lend upon different assets or upon the overall assets of an unencumbered business. It’s not uncommon for alternative lending firms to provide short-term financing with a very rapid turnaround, with some loans ranging up to $350,000. In exchange, the firm asks for titles to and possessions of valuable personal property such as jewelry, cars, or boats. These assets are stored by the firm and then returned upon repayment.
“Some companies or high-net-worth persons have access to bank loans, but those loans are not closed quickly enough, and so they borrow from us and pay us back with the proceeds from the eventual bank loan,” said Dan Ambrosino, CFO of White Glove Capital. “Others may have seasonal businesses, and pledge the winter equipment to get start-up capital for the spring business, and vice-versa. We help those who have both assets and an immediate cash need.”
There are a variety of burgeoning internet-based lending platforms for online loans. Some specialize in short-term capital needs for small companies that are unserved or underserved by banks. Such loans are often made on an unsecured basis. Other platforms, commonly referred to as “marketplace lenders” (and sometimes referred to as “peer-to-peer” lenders,” though that term can be a bit of a misnomer) offer term loans that can substitute for bank loans.
A good example of this is a marketplace lender like Funding Circle, which facilitates small businesses by helping owners get access to the finance they need to grow and expand. The lending process with marketplace lenders is oftentimes more transparent than a bank’s process. In addition, this alternative financing option can be more economically friendly than others.
Sometimes merchants who regularly do business with a company will provide cash advances. Oftentimes, with these types of loans, the borrower will receive cash from the merchant in exchange for a promised percentage of future sales. For example, the merchant could provide a loan in exchange for a set percentage of the borrower’s daily credit card receipts. These loans are short-term, usually less than a year, and of small scale. With this type of alternative lending, the average amount borrowed is usually under $100,000.
Another financing option is factoring. In this scenario, a “factor” provides cash to the business in exchange for ownership of the company’s accounts receivable. Accounts receivable may be the only assets a borrower has that are not subject to another lender’s lien. Factors focus on the soundness of the borrower’s customers and not of the borrower, and may thus offer credit to companies to which traditional lenders will not lend.
Factors are extremely agile. They not only provide quick approval of a factoring arrangement, but they can also bring efficiency and discipline to the collection process.
In taking control of accounts receivable, the factor becomes intimately involved with the borrower. A rapidly growing company may benefit, since it may lack the managerial processes to manage its burgeoning invoices. A struggling company may benefit because it may lack the bandwidth to collect efficiently. Of course, giving up control of collection to the factor may affect the company’s relationship with its customers.
An emerging type of alternative financing is financing secured by intellectual property. Intellectual property (e.g., trademark, trade name, patents) may contain substantial value that may not be fully understood by its owner. Of course, valuation of these types of assets can require specialized knowledge. Additionally, start-ups and small businesses may struggle to demonstrate that their intellectual property has a value separate and apart from the company’s general goodwill.
In both traditional and alternative financing, a borrower with a keen understanding of their options enhances the likelihood of a positive outcome. For small business financing, owners must remember to consult their attorneys, accountants, and other advisors before approaching a potential financing source. They should also review relevant data and package it appropriately for presentation in an organized fashion.
Moreover, having a seasoned advisor can make the financing process much less daunting for borrowers who lack the time or resources to explore all of the various alternative financing options. An advisor can present the information in a concise manner and in the language that lenders understand.
In addition, a seasoned advisor will know which segment of the financing market to target based on industry preferences, risk appetite, size of the deal, etc. Careful targeting can foster competition and a sense of urgency among lenders, getting the deal done faster and at terms more advantageous for the borrower.
[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):
This is an updated version of an article originally published on June 2018. It has been updated.]
©?2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Mr. Cahill is partner at Sugar Felsenthal Grais & Helsinger LLP, in Chicago, Illinois. He guides secured lenders, creditors, debtors, creditors’ committees, potential purchasers and others through bankruptcy cases, out-of-court workouts, assignments for the benefit of creditors, and receiverships. Mr. Cahill has substantial mega-case experience representing very large debtors, and counsels and litigates on behalf of manufacturers…
Please log in again. The login page will open in a new tab. After logging in you can close it and return to this page.