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 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 most significant impact:

• Timing
• Situation
• Precise needs of the business

For the 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. Especially during uncertain economic times or when a recession looms, as banks may pull back on lending, ABL loans might offer more options and flexibility for a business in times of need.

Business owners should educate themselves on non-bank capital alternatives because most businesses face adversity at some point. Understanding available alternative loan options 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 price 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 capital costs and only have one way of generating income: making profitable loans. They must seek higher returns to make a profit.

Most Business Owners Miss Alternative Lending Opportunities

Most business owners spend their entire careers 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. A business owner often doesn’t think of what to do in an emergency, except ask their bank for help. Sometimes banks help, but not always.

Banks face intense regulatory pressure and have to reserve against troubled credits. Many companies are asked to leave banks even if no payment default has occurred.

This is where the rubber meets the road. A business owner can 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’s assets support and what it needs to get financed from a bank. People misunderstand this capital because it is completely subordinated to a bank and is usually not long-term.

Returns for this capital can range from mid-teens to high-twenties, sometimes higher, depending on interest rates. That type of pricing causes major heartburn among business owners. After all, most business owners might go decades without ever having an issue. When a problem 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 specializing in subordinated debt or troubled credits, but they should.

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

Business Owners Have More Lending 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 whether 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. It typically 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, offer an amortizing term loan subordinated to a bank.

High-Interest Debt Loan: When To Use It

The term ‘high interest’ is relative and often misconstrued. Companies with access to institutional capital or public markets pay a very different price than those without. There is a disconnect between what business owners think debt should cost and what it actually costs when you need capital from an alternative lender.

The smaller the company, the fewer options it has to raise capital. It doesn’t matter if you’re talking about debt or equity; fewer products are available to them. It is not uncommon to see specific lenders obtain higher pricing to provide 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 difficult to evaluate. This is because they are very rarely apples-to-apples.

That said, business owners have many options in today’s marketplace. The necessary 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.

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[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):

1. Handling the Arbitration
2. Digital Assets and Bankruptcy
3. What Kind of Loan?

This article was originally published on May 9, 2017 and updated on November 13, 2023. This article was most recently updated by the Financial Poise Editors.] 

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