After the credit crunch and subsequent housing meltdown in 2008, the banking industry made a much publicized move to reign in small business lending. What had once been a moderate flow of small business finance to the nation’s smallest companies, then almost completely dried up. In it’s wake, various alternative lenders and other loan arrangements have all been clamoring for a slice of the business financing pie.
Though today, bank loans to small businesses seem to be making a come back, the truth is traditional financial institutions are still refusing to service countless small business owners- especially newer companies, companies with poor or little credit history, or those that operate in industries considered to be high-risk, such as food services or retail.
Thus, it’s no surprise that alternative lending among small businesses continues to surge. But even as alternative lending gets airtime the definition of just who qualifies as an “alternative lender” can get murky. The reasons: any non-bank lender technically qualifies for that description, and the alternative financing industry keeps expanding. Small business owners now can choose from a whole crop of new (yet similar-sounding) financing products that have only emerged in recent years.
So how can you as a small business owner looking for non-bank financing make sense of it all? The following are 10 explanations of the most popular forms of alternative financing available to small business owners:
Non-Bank Financial Institutions:
1. Credit Unions
Though they may look like banks from the outside, credit unions are non-profit cooperatives owned by their members. In order to maintain their non-profit status, credit unions have to restrict membership to a particular group of people, such as those attending or working at an educational institution, or residents of a particular community. The tax advantage associated with being a non-profit typically allows credit unions to offer lower interest rates on loans, and higher rates on savings accounts and other savings products.
Lately credit unions have been more aggressive in soliciting new accounts. The National Association of Federal Credit Unions (NAFCU) provides a list of its members online.
2. Community Development Financial Institutions (CDFI)
CDFIs are financial institutions that offer credit and financial services to economically disadvantaged and under-served communities within the US. These institutions may take on many forms including: a community development bank, a community development credit union, a community development loan fund, a community development venture capital fund, a micro-enterprise development loan fund, or a community development corporation. CDFIs are certified by the Community Development Financial Institutions Fund (CDFI Fund) at the U.S. Department of the Treasury, which provides funds to CDFIs through a variety of programs, yet they themselves are not government entities. The CDFIs were established by the Reigle Community Development and Regulatory Improvement Act of 1994.
To locate a CDFI near you, you can use this CDFI locator.
3. Micro Lenders
Microloans are short-term loans of small amounts, typically no more than $25,000 spread out over 5 years. There is a network of commercial microlenders and non-profits that offer these loans to small business owners. If you are a minority, have a low-income, or are seeking to start a business in an economically challenged area then your chances for being accepted for funding increase dramatically.
4. Accounts Receivable (AR) Lenders
Accounts Receivable (AR) financiers (also known as “factors”) purchase a company’s accounts receivable at a discount and in return provide the company with fast working capital. The financing comes in the form of a cash advance, often at 70-85% of the purchase price of the accounts. Interest rates generally are higher with factoring since the lender is assuming a higher level of risk. Many times, small business owners who have little or no credit history or who need a lot of money quickly will turn to AR financiers.
5. Business Cash Advance Companies
A business cash advance is a form of receivables financing typically based on future credit card sales. In this setup, the cash advance provider purchases some of the transactions from the business at a discount, which generally ranges between 20%-30% of the amount funded. In exchange, the business receives a predetermined amount of instant cash usually used as working capital. The cash advance company then collects a set daily percentage of future credit card sales until the full loan is paid off.
Cash advance companies usually require that a company be in operation between 3 and 6 months, and some financing companies may also require a minimum sales volume.
6. Revenue Based Financing
Similar to business cash advances above, revenue-based financing allows borrowers to pay off their loans based on a monthly allocation of the revenue their business generates. Though, unlike the cash advance, a business’ whole revenue stream is considered. While interest rates are again on the higher side, this financing setup allows business owners to maintain ownership of their companies while not being forced to borrow against their homes and possessions.
7. Purchase Order Financing
Also called inventory financing or PO funding, purchase order financing is a short-term commercial finance option that provides capital to pay suppliers upfront for products or inventory so the borrowing company doesn’t have to deplete its available working capital. The products or inventory then serve as collateral for the loan if the business does not sell its products or otherwise cannot repay the obligation. Inventory financing is especially useful for businesses that must pay their suppliers within a short payment cycle or a longer period of time than it takes them to sell off their inventory. It also provides a solution to seasonal fluctuations in cash flow and can help a business support a higher sales volume by, for example, allowing a business to purchase bulk orders of inventory to sell later on.
8. Lease-Back Programs
Also known as a “sale and leaseback,” lease-back programs allow the owner of a property or other valuable asset, such as equipment or vehicles, to “sell” it to a lender and then lease it back during a set period of time. Under this arrangement, the original property owner can quickly free up working capital while retaining possession and use of the property.
Some leaseback arrangements allow the lessee the option to buy back the property at a future date. During the life of the leaseback, however, the buyer derives tax benefits from the arrangement, such as being credited for depreciation of the property.
Peer-Based Alternative Financing Arrangements:
9. Peer-to-Peer Lenders
Peer-to-peer, or P2P lending is a form of financing that occurs directly between individuals or “peers” without the involvement of a traditional financial institution. Loan amounts are typically small, up to $25,000 and have loan terms typically lasting anywhere from 1 to 5 years.
Much of the success of P2P lending is a result of the social networking power and infrastructure of the Internet. P2P lending sites, such as Lending Club and Prosper, offer an online marketplace where borrowers and lenders can come together. Often, there will be several private lenders per borrower who each share in partially funding a a given loan amount.
These sites typically provide identification and verification services as well as an assessment of the borrowers’ creditworthiness and the risk involved in lending to them. Clear, precise documentation covers the loan’s terms and conditions as well as the repayment schedule and tax payments as determined by both parties.
10. Crowd Funding
With crowd funding, business owners and entrepreneurs can raise the funds they need by requesting a small amount of money from a large number of people online. By tapping into the power of the internet, entrepreneurs can pitch their ideas to a large group of people, who, if interested will respond by donating a small portion of the money they need to help them reach their target.
Unlike more traditional forms of business capital, the money raised through crowd funding is not directly repaid. Recipients may instead offer their investors some specified item or service in return for their financial support, such as a free sample of their product. In some, crowd funding models, such as the one supported by Sellaband, investors also get a cut of the recipients’ future sales revenues.
So there you have. Any one of these ten alternative financing models can help you access the money you need to start, run, or grow your business. But not every model is suitable for everyone. So be sure to do a little research and exercise your due diligence before signing any dotted lines.