When Is it Appropriate to Take on a High Interest Rate Debt Loan?

Utilizing the Alternative Lender for Your Business

High interest debt gets a lot of bad press. That is one reason why a high interest debt loan, whether senior or subordinated, remains largely misunderstood (this is especially true when there is a quick need for capital). In these instances, most business owners are under too much pressure to think about the cost of debt in relative terms and in a static environment.

That’s a problem, because the cost of capital for debt often varies significantly. Here are some of the factors that have the biggest impact:

• Timing
• Situation
• Precise needs of the business

For purposes of this article, all non-bank lenders are considered “alternative lenders.” Because business owners rarely use them, they tend not to understand the underlying costs of alternative lenders’ businesses. That’s a mistake. Business owners should educate themselves on non-bank capital alternatives, because most businesses face adversity at some point. Understanding what alternative loan options are available can be the difference between success and failure.

Why Are Non-Bank Loans So Expensive?

Anything seems expensive compared to bank or bank-owned asset-based lending (ABL). Banks lend at a low cost, because they also borrow at a low cost from federal funds or customer deposits. Because banks maintain several revenue line items, such as treasury and payments and processing (in addition to their interest income), they can pass these lower rates on to borrowers.

That’s why alternative lenders must treat borrowers as short-term clients who will return to bank lending when circumstances permit. Most non-bank lenders deal with higher costs of capital, and only have one form of generating income: making profitable loans. They must seek higher returns to make a profit.

Most Business Owners Miss Other Opportunities

Most business owners spend their entire career dealing with one bank. This makes them ill-prepared to navigate the world of alternative lending.

Most business owners limit themselves to one bank, and this practice drives many misconceptions and negative connotations in the marketplace. No business owner thinks of what to do in an emergency situation, except to ask their bank to help. Sometimes banks help, but not always. Banks face intense regulatory pressure, and have to reserve against troubled credits. Many companies end up being asked to leave banks even if no payment default has occurred.

This is where the rubber meets the road. A business owner might be able to go to another bank, or they might have to transition to an asset-based lender. That could trigger a need for extra capital. This capital – termed “airball” or “stretch capital” – is the difference between what a business’ assets support and what it needs to get financed out of a bank. People misunderstand this capital, because it is completely subordinated to a bank (and usually not long-term).

Returns for this capital can range from mid-teens to high-twenties – sometimes higher. That type of pricing causes major heartburn with business owners. After all, most business owners might go decades without ever having an issue. When one arises, though, they’re left like a deer in headlights. Most professional business service providers (accountants, lawyers, etc.) develop strong relationships with a limited number of banks (sometimes just one). They don’t often keep a list of firms who specialize in subordinated debt or troubled credits. They should.

All a business owner needs is one wrench thrown in their business, bad season, vendor issue or lawsuit to create a cash crunch.

Business Owners Have More Options than Ever

Never before have there been more options for business owners seeking capital. A slew of internet-based companies cropped up for companies that need less than $250,000. Non-bank ABL service companies or alternate lenders are forced to leave banks. Subordinated capital providers can finance any shortfall. Rates and structures may vary. This depends on if a company raises senior or subordinated debt (and whether equity might be part of the equation).

Traditional mezzanine capital is the most patient form of mezzanine capital. Typically, it comes with warrants. Most non-private equity-backed companies cannot obtain this type of capital.

Instead, firms that provide second lien capital (a second lien behind the senior lender, which provides an amortizing term loan subordinated to a bank). That is less patient capital and contains no equity, but it is considered high interest rate debt.

High Interest Debt Loan: When to Use It

The term “high interest” is relative and often misconstrued. Companies that have access to institutional capital or public markets pay a very different price than companies who don’t. There is a disconnect between what business owners think debt should cost versus what it actually costs when you need capital from an alternative lender.

The smaller the company, the fewer options to raise capital. It doesn’t matter if you’re talking about debt or equity; there are fewer products available to them. It is not uncommon to see certain lenders obtain pricing in the mid-teens for providing more availability and flexibility than a traditional bank.

When it comes to subordinated capital, business owners can see these potential structures:

• Straight fixed fee
• Cash-on-cash returns
• Lower interest rates plus warrants
• “Royalty lending” (a lender gets a percentage of sales until they obtain a certain dollar threshold)

Many of these alternatives, especially junior debt alternatives, are not always easy to evaluate. This is because they are very rarely apples-to-apples.

That said, business owners have many options in today’s marketplace. The need and decision to incur high interest rate debt products does not come often. But, when it does, it typically comes quickly. The fact remains that, in most situations, debt is cheaper than equity.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: What Kind of Loan? and Borrower or Lender Be 2019. This is an updated version of an article originally published on May 9, 2017.]