Access to loans or credit has always been critical to the success of small business. Yet banks are continuing to reduce both the dollar value and proportion of loans they make to small business in favor of big business. Getting small business loans is more difficult than ever.
A Harvard Business School working paper on “The State of Small Business Lending” finds that banks were already ramping down their small business loans prior to 2008. The situation worsened during the recession. By 2012, only 30% of bank loans were going to small businesses, down from 50% in 1995.
The trend continues. In terms of absolute value, the 10 largest banks loaned small businesses $44.7 billion in 2014, as opposed to the $72.5 billion they loaned to them in 2006.
There are many reasons for banks reducing their small business loan footprint. Just a few:
• Poor or no track record of operations
• Many small businesses are considered to be in high risk industries, such as restaurants
• Owners have bad credit
Fortunately, small businesses have options to access loans or credit outside of banks. I don’t mean asking your family and friends. As a CEO of a start-up seeking to disrupt the cosmetics industry recently put it, “the market ALWAYS wins.” And there’s a robust market of alternative lenders for business loans for people with bad credit.
Here are six alternative funding options, followed by a few tips to keep in mind when deciding what option may be best for your small business.
BAD CREDIT BUSINESS LOAN OR UNSECURED BUSINESS LOAN
These are business loans that will feel similar to a bank business loan, but are designed for businesses with credit challenges.
These lenders have their own underwriting criteria, just as banks do. They differ from banks in that their underwriting criteria are more focused on cash flow, understanding the owner’s and/or business’s credit history, and appreciating the quirks of various industries’ revenue cycles.
They may also look at your credit history and annual revenue, but generally accept lower numbers than do banks. They rarely require collateral to secure the business loan.
Alternative lenders are also more open to working with new business that don’t have an established operations history. These lenders will want to see that the operations history a new business does have is strong and shows promise, as they’re taking a bet on the small business’s future operations.
The flipside to making business loans to small businesses with bad credit is that the SMB will have to pay a higher interest than on a bank loan. It makes sense since the alternative lender is taking on more risk to make a bad credit business loan; the higher interest rates offset the lender’s risk, making such loans possible.
The loan application process is another way these alternative lenders differ from banks. As online entities, these lenders operate on internet time. Meaning, the time to process applications and receive access to cash is much quicker than a bank loan.
Some of them even require that a business applicant use certain online accounting software that integrates with their application process. They’ll plug into the business’s account, which reduces the paperwork the business has to put together to apply.
LINE OF CREDIT OR BUSINESS CREDIT CARD
Having a business line of credit provides the most flexibility of all the cash/loan access options. The credit is there for you to use as needed, but you don’t need to pay interest on the credit you’re not using. With a business loan, you start paying interest on the entire amount, which can make it more expensive than credit.
Like any other kind of credit card, you make a monthly payment, which can vary based on what your cash flow permits for a given month.
Another great benefit of using a business credit card or line of credit is that it can help you repair your business’s bad credit rating. Or, if your business is new enough, that it’s been operating on the basis of your personal credit rating – a business credit card is a good way to create some separation between your business and personal credit. Having that distinction also reduces your potential personal liability for business debts.
Just as with unsecured business loans, you can get an unsecured business credit card. You don’t need to put up any collateral, which is another way these cards protect your personal assets.
MERCHANT CASH ADVANCE OR LOAN (MCA)
An MCA is an option for small businesses that have a customer base making a high volume of credit card purchases, like restaurants or salons. You’re taking an advance, or loan, against future credit card sales. Not far away in the future credit card sales, but tomorrow’s sales.
The funder advances you the loan, which you pay back a little each day, as a percentage of that day’s credit card sales, plus a transaction fee.
Why would you want to pay back a loan every day?
Well, the daily payment amount is tied directly to your actual credit card sales. It protects your cash flow in that you don’t have a fixed monthly loan payment due regardless of that month’s revenue. Your lender takes the hit for revenue ups and downs with you.
These are unsecured business loans that shield you from strangling monthly payments.
An MCA helps small business sidestep bad credit since it’s not the business’s credit history that matters. What matters is your customers’ credit.
FACTORING/ACCOUNTS RECEIVABLE LOAN
An AR loan works on the same concept as an MCA, as it’s based on your customers’ credit, not the business. It differs from an MCA in that it takes into account all sales, not credit card sales. Factoring also looks backward at what customers owe you on current invoices, whereas an MCA looks forward to future credit sales.
These differences matter as to what kind of business is a good candidate for an MCA or an AR loan. An MCA can make great sense for a business-to-consumer (B2C) operation with high volume of credit card sales. An AR loan works better for a business-to-business (B2B) company that has fewer receivables, but each with a higher value and longer payment terms than a simple credit card transaction. In this case, perhaps a construction contractor or professional services firm.
When you take an AR loan, you’re selling your current receivables to a collector at a discounted rate. Let’s say you have $100,000 in open receivables. You can sell them for $75-90,000 cash now, instead of having to wait for your customers to pay you. You’ll get most of this upfront, but the funder holds a bit back until the receivables are paid. This spreads the risk a bit.
Now, the lender to whom you sold these accounts has the responsibility to collect them. The lender also takes a fee for everything collected. This can range anywhere between 2-15%. Once the receivables are paid, you get the difference between what was advanced to you and the amount you sold the receivables for, minus the fees.
I’ve been writing “AR loan,” but this isn’t really a business loan. It doesn’t create a liability on your balance sheet, which can be helpful. However, since it isn’t a business loan, it won’t help you repair any credit challenges.
Even so, for an SMB faced with a long receivables’ cycle, an AR loan can be a great way to bridge that cash flow gap.
Supplier credit is the other side of the coin to factoring. Supplier credit looks at your accounts payable instead of receivable. It’s the approach of negotiating better terms with a supplier. Better terms may mean discounts, extended payment terms, or other benefits accruing to your business.
Improving your cash access via supplier credit is a challenging option. It moves the supplier from a vendor to a lender, which is a different sort of relationship. This type of arrangement depends on a strong, trusting relationship with a supplier – and that they feel the same trust and commitment to you and your business.
It also requires some diplomacy and negotiating skills. You don’t want to give a supplier a sense that your business has some financial instability. This option is marked “proceed with caution.”
Ah, crowdfunding – the sexy sister of alternative funding options. It gets all the press and just sounds fun. Post your business’s story on a crowdfunding site, go social viral, and people in Norway (and beyond) will give you money.
Crowdfunding is a creature of our social networked world.
The upside to crowdfunding is that it isn’t a loan that needs to be paid back. Although some sites let businesses sell equity shares.
In most cases, businesses offer different tiers of giving on their crowdfunding page. Each tier entitles the giver to a growing set of perks. Perhaps a t-shirt, maybe being part of a beta test. In some cases, a new business may use crowdfunding to pre-sell their product before it exists.
Crowdfunding literally opens you up to an unlimited source of funders. This could be great PR. Or going public with your business’s financial need may not be such a good idea. Only you can tell.
Often you need to set a minimum goal amount. If you don’t reach that minimum, you don’t get any of the money. In fact, most crowdfunding campaigns fail. They’re a bit of a popularity contest. Posting a solid business plan on your crowdfunding page may not be as valuable as having a talking cat host your promo video.
If you do want to test the crowdfunding waters, keep in mind that each site has its own guidelines. Some are strictly for consumers or fundraising. Others for business, but perhaps only certain types of businesses.
WHAT OPTION MAKES SENSE FOR YOU?
When considering what option makes the most sense for your business, consider your business challenge and how your operation is set up.
Do you need fast access to cash to manage a cash flow problem? If you have a large amount of outstanding receivables, then an AR loan may be right. Is your cash flow problem due to the fact that you’re in your business’s low season? Then a line of credit may provide the flexibility you need. If your business is based on credit card sales, an MCA will keep your payments commensurate with your actual revenue.
Maybe your challenge is that you want to expand or make a capital improvement. A bad credit business loan may make more sense. If you’re trying to repair bad business credit, then make sure to select a lending option that reports to business credit agencies.
Whichever option you select, research it thoroughly. Since these are funding options designed for higher risk businesses, the costs are higher than a traditional bank. The costs will also vary widely among different alternate lenders offering the same type of option. Before you make a commitment to any option or funder, understand what you’ll be paying for your cash.