In the first article of Demystifying Alternative Lending, we discussed how online alternative lenders are leveraging technology to simplify and accelerate the small business loan process. As a result of these innovations, we have seen a new alternative lending market emerge, growing at compounded annual growth rate of 145% since 2009 and originating close to $9 billion in loans in 2014 (Liberum: volumes of Lending Club, Prosper, Funding Circle, Zopa and RateSetter). And yet, the alternative loans market is still confusing for business owners – for good reason. There are many different alternative capital products in the market – Camino Financial offers 8 products. Not all loan products are made equal for every company or use of capital. The following article takes a modest attempt to (over)simply the options available in the market.
Type #1: Short Term Loan
The short-term loan is typically for small businesses owners that have immediate cash demand (e.g., working capital, inventory purchase, growth capital) and require 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%+. The pros of these products involve a quick turnaround on cash with a relatively hassle free application process. The cons include high interest rates and daily automated payments. Short-term lenders tend to be more flexible on borrowers with suboptimal credit. For many emerging businesses or owners with FICO scores below 640, these loans can be an effective way to (re)establish business credit. However, these loans are cost prohibitive over the long-term.
Type #2: Intermediate Term Loan
The intermediate term loans are for established businesses with at least 2 years in operation and positive cash flows. These loans are used for medium to long term cash investments in the business (e.g. equipment purchases, store expansion). The terms of these loans vary between 6 months to 5 years with bi-monthly payments and interest rates in the range of 8-25%. Alternative lenders process these loans at a fraction of the time relative to traditional banks and lend up to $500,000. Intermediate term loans are an excellent alternative for established businesses seeking to conveniently access growth capital. Usually credit quality standards for these loans are similar to that a bank loan. So if the prospective borrower has time (2-3 months), it makes sense to check with a bank first before pursuing the alternative route. Another positive feature of these loans is they typically do not have prepayment penalties.
Type #3: Line of Credit
Lines of credit are similar to a credit card. It’s a pool of credit available to business owners to pay for daily or monthly working capital requirements. The big difference between a line of credit from a bank/credit card vs. an alternative lender is in the payback structure. For alternative lenders, once the cash is drawn from the credit account, the principal and interest payments are automatically paid back on a daily basis for a predetermined period. With bi-monthly fees starting around 5%, the APRs are 30%+. While APRs are high, these open lines of credit are easily accessible to businesses owners, even with suboptimal credit history. The approval of open lines of credit are measured by the frequency and size of transactions flowing through a business’ bank account. Another benefit is the relatively high credit balance available to business owners ($100,000) relative to traditional open lines of credit / credit cards.
Type #4: Merchant Cash Advance
Merchant cash advances (“MCAs”) are the most flexible, but also the most expensive alternative financing product in the market. MCAs are not loans. These are cash advances against the credit card receivables of a business. Once the cash is disbursed to the business owner, a daily percentage of credit or debit card sales are remitted to the MCA provider until the agreed upon amount is paid in full. There are limited 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 – ideal for seasonal businesses. The cons are MCAs are very expensive with APRs exceeding 50% and since payments are withdrawn from credit card systems, these could potentially leave business owners with negative income. MCAs could be a good source of capital for high return/short-term investments (e.g., investor purchase), but are a very expensive or risky source of working capital.
Other Asset Based Alternatives
There is a myriad of other forms of alternative capital, usually collateralizing some type of business asset such as invoices, purchase orders and equipment. These types of loans vary in structure and payment schedule but serve as a reasonable alternative for businesses with limited cash flows and/or suboptimal credit history.