Many entrepreneurs struggle to get access to debt financing. The average loan approval rates for small businesses are as low as 30%. Online alternative lenders like Lending Club, OnDeck, and Funding Circle have emerged in response to this unmet need. They use algorithmic based pricing models and big data to reduce the underwriting process of a loan from 2-3 months to 3-4 days.
Though it sounds simple, borrowers remain with many questions:
- How does the alternative lending process work? What is an algorithm? Big Data what?
- Are all alternative loans the same?
- Does an alternative loan make sense for my business?
What is Online Alternative Lending?
Instead of asking for extensive financial information and paperwork, alternative lenders use technology. They pull business information from big data sources. These sources are often credit bureaus, QuickBooks, and social media (e.g., Yelp, Facebook). The prospective borrower has to fill out a one-page application form. They also have to provide the latest 3 months of banks statements. With this information, online lenders are able to estimate the cash flow of the business. To underwrite a loan, they use the bank statement transaction volume and frequency.
Types of Alternative Lending Loans
There are many alternative capital products on the market. Camino Financial offers 8 products, for example. Not all loan products are equal for every company or use of capital.
Type #1: Short Term Loan
The short-term loan is for small businesses owners that have immediate cash demand. They also need a quick turnaround in funding. The terms of these loans vary between 3 to 18 months, with interest rates as low as 18% and as high as 50%+.
Pros: A quick turnaround on cash with a hassle free application process.
Cons: High interest rates and daily automated payments.
Short-term lenders tend to be more flexible on borrowers with suboptimal credit. These loans can be an effective way to (re)establish business credit. Emerging businesses or owners with FICO scores below 640 could use it for that. Yet, these loans are cost prohibitive over the long-term.
Type #2: Intermediate Term Loan
The intermediate term loans are for established businesses. They should have at least 2 years in operation and positive cash flow. These loans are for medium to long-term cash investments (e.g. equipment, expansion). The terms of these loans vary between 6 months to 5 years. The borrower pays twice a month with interest rates in the range of 8-25%.
Alternative lenders process these loans faster than traditional banks. They can also lend up to $500,000, and they don’t have prepayment penalties. Intermediate term loans are an excellent alternative for established businesses seeking to grow. Usually, credit quality standards for these loans are like bank loans. If the prospective borrower has time to spare (2-3 months), they should check with the bank first.
Type #3: Line of Credit
Lines of credit are like a credit card. It’s a pool of credit available to business owners. They use it to pay for daily or monthly working capital requirements. The big difference is in the payback structure for alternative lending. They first take the cash from the credit account. As soon as that happens there is an automatic payback on the principal and the interest. This happens on a daily basis for a predetermined period. Twice a month you pay fees starting at 5%, and APRs are 30%+.
While APRs are high, these open lines of credit are accessible to businesses owners. Even those with suboptimal credit history. They look at the frequency and size of transactions in a business’ bank account. This helps on the approval of these open lines of credit. Another benefit is the high credit balance available to business owners ($100,000). This is different from traditional open lines of credit/credit cards.
Type #4: Merchant Cash Advance
Merchant Cash Advances (“MCAs”) are the most flexible. They are also the most expensive alternative financing product in the market. MCAs are not loans. They are cash advances against the credit card receivables of a business. The MCA provider gets a daily percentage of the credit or debit card sales, until the agreed amount is paid in full.
There are restrictions on use of proceeds with no personal guarantee required. A key benefit is the simplicity of the application process and the “pay as you go” payment structure. This is ideal for seasonal businesses.
MCAs could be a good source of capital for high return/short-term investments. But they are a very expensive and risky source of working capital. Their APRs exceed 50%. Also, there is a risk of leaving the business owner with negative income due to their payment system.
Other Asset Based Alternatives
There are plenty of other forms of alternative capital. Usually, collateralizing some type of business assets. These types of loans vary in structure and payment schedule. But, they serve as a reasonable alternative for businesses. In particular, those with limited cash flows and/or suboptimal credit history.
Is alternative lending right for your business?
Cons of traditional bank loans
Larger banks have been moving away from lending below $150,000. This is due to high costs to service loans and low collateral value of small businesses. Besides, small business owners find the traditional loan process difficult. They have high credit standards, and entail significant paperwork. The turnaround is also slow, sometimes taking 2-3 months. A banker at a traditional bank targets prospective borrowers with a capital need of at least $150,000. Their ideal personal credit score should also be at least 680.
And here is where alternative lenders come…
Alternative lenders have emerged with a value proposition to addresses these issues. Alternative lending uses a formulaic approach to pre-qualify loans within minutes. Throughout the loan approval process, there is less paperwork. Cash flows receive stronger consideration relative to a business owner’s personal credit score.
A concern about these alternative lending options is the high annual interest rates. These range from 8% to 60%+. At these pricing levels, these loans may be cost prohibitive to small businesses. Especially when compared to SBA loans that are between 6% and 8%. This is why alternative small business funding may not work for everyone.
But alternative small business funding does work for many small businesses. In fact, nonbank lenders loaned about $9 billion in 2015 (source: Liberum). The reality is: the pain points of the traditional lending process are real, and that’s why alternative lending is an attractive option.
At Camino Financial, we come across many businesses that have working capital constraints. Sometimes with cash locked into the business. This impedes investments in growth and/or maintenance. Most of these businesses resort to their credit cards or informal lenders with high interest rates. Much higher than alternative capital options. We also find many businesses with sound cash flows. But also with low credit scores for reasons like short-selling home during the mortgage crisis. We have also found proven businesses that need immediate capital to purchase a large order of inventory to stock for pent-up demand. The examples are endless and the needs vary in nature. In summary, the opportunity costs of not getting an alternative loan could outweigh the cost premium for an alternative loan.
So before you dismiss alternative small business funding due to their high-perceived cost, consider the relative value your business can derive from alternative capital. Without the typical pains and obstacles.