Alternatives to Bank Lending: 7 Other Options
When a business earns a profit, some or all of that profit can be put back into the business. This helps the business continue to grow.
Sometimes, businesses will require additional financing from a reputable lender. Many business owners turn to banks in order to secure financing. However, banks aren’t the financing solution available to business owners. In this article, we’ll discuss seven alternatives to bank financing, so that you’re aware of all of your options.
- About Alternative Loan Types in Small Business Lending
- Lines of Credit
- Merchant Cash Advances
- Working Capital Loans
- Equipment Loans
- Professional Practice Loans
- Invoice Factoring
- Franchise Startup Loans
- Is Conventional or Alternative Right for You?
- Frequently Asked Questions
About Alternative Loan Types in Small Business Lending
Banks are a common financial platform for small businesses. Yet, banks often have stricter lending policies than larger alternative lenders. Due to this, small businesses find it difficult to obtain crucial financing from banks to operate their businesses.
Luckily, banks aren’t the only financing source that business owners can pursue. This article describes some of the popular alternative financing types.
Lines of Credit
In order to be successful, a business owner must responsibly manage their cash flow. Although cash flow management requires numerous factors, timing is arguably the most important component.
The operating cycle may cause businesses to experience shortfalls for a specific period. There are numerous reasons why this can happen, but one underlying reason is that a business may extend credit to its customers to attract more business. The more credit a business extends, the less cash is available during that time. That’s why a line of credit can help these businesses with their cash flow management.
A line of credit (LOC) is a set amount of money that a business can use when it needs cash. An LOC can be either secured or unsecured.
A secured line of credit requires some collateral, whereas an unsecured loan doesn’t. Once the amount borrowed from the LOC is paid off, It frees up the amount to be used in the future. Usually, the business can use some or all of the cash from the LOC but it must be paid back in a reasonable period. Financial institutions will monitor how the business uses the cash and raise any concerns when extraordinary situations occur.
Pros and Cons of Lines of Credit
- LOCs are flexible and can help businesses experiencing temporary cash flow shortages.
- The use of LOCs will help businesses to predict their future operational cycles.
- The interest charged on LOCs can be high, depending on the situation of the business.
- Businesses may rely on the LOC too much and can cause them to overextend.
Merchant Cash Advances
From a bank’s perspective, small businesses are riskier to lend to than larger companies. Banks’ lending requirements have also become stricter since the banking crisis of 2008. These stringent lending standards have left small business owners with fewer options to obtain the much-needed cash to keep their operations going. However, entrepreneurs still have access to other financing options, such as merchant cash advances.
With a merchant cash advance (MCA), a business owner will receive lump sum financing, in exchange for a percentage of their future credit card sales. If you have a steady stream of credit card payments, you’re likely a great candidate for this product.
Once you receive a cash advance, the provider will take a percentage of your credit card sales until your balance is remitted. When sales are higher, you pay more. Conversely, you’ll pay less during slower periods. This helps your business meet short-term financial obligations without putting excess pressure on your cash flow.
Pros and Cons of Merchant Cash Advances
- Payments aren’t fixed and are based on your business’s credit card sales at the time. This helps you to maintain cash flows based on how much your business is making via credit card.
- It’s one of the quickest ways to obtain funding.
- Payments are taken directly from your account, reducing the chances of late fees.
- The rates can be high.
- Cash advance terms can be restrictive, and it’s crucial for business owners to read them carefully.
Working Capital Loan
A loan that is used to fund a company’s core operations is known as a working capital loan. Day-to-day operations can cause financial hardship if a company doesn’t have the funds to maintain them. This frequently occurs with seasonal businesses or companies that are subject to cyclical sales. Still, businesses in various industries can experience working capital shortfalls at some point during their history.
Companies should understand that working capital loans aren’t meant to be used for long-term capital expenditures. They are not cost-effective for longer-period financing needs. Working capital loans are meant to provide a cushion, helping companies get through periods when cash isn’t readily available, with the cash expected to arrive within a few days or weeks.
A working capital loan isn’t a specific loan type, but more of a category of loans. Any loan that helps a business meet short-term operational obligations could be considered a working capital loan. This includes lines of credit, term loans, and invoice financing, all of which are examples of loans in this category.
Working capital loans can be either secured or unsecured, although many are unsecured. Typically, unsecured loans require excellent credit for approval.
Pros and Cons of Working Capital Loans
- Since this type of financing is a loan, business owners can retain equity in their businesses.
- Working capital loans may not require collateral. However, unsecured loans will require businesses to be creditworthy.
- It is a loan, which could affect the credit rating of your business.
- If collateral is required, it could put your business and even personal assets at risk.
Many businesses require equipment to produce the products they sell. These businesses rely on that equipment to work, and when the equipment fails, it can derail the business. The owners will need to replace the equipment, which is often costly.
Without financing to fix or replace the equipment, business operations can be affected. Unfortunately, many small businesses lack the capital required to maintain equipment. That’s where equipment loans can help.
Equipment loans are amongst the best small business loan options, as they can help companies obtain funding when crucial equipment breaks down. They are a class of loans where the equipment itself serves as the collateral. Owners can often get financing for a large percentage of the cost of the equipment since it is a secured loan.
The type of equipment that qualifies for this type of loan is usually high-end machinery and vehicles. Tractors for farms are an example of equipment that could leave farmers without the ability to till the land or harvest crops. Restaurant equipment, such as ovens and vents, will fall into this category as well.
Both banks and alternative lenders provide this type of loan. These lenders will cater to specific businesses, as is described in our article on Business Equipment Loans.
Pros and Cons of Equipment Loans
- The financed equipment is the collateral, making this a secured loan. Typically, secured loans are easier for businesses to obtain.
- Rates are usually attractive, although the type of the business and its creditworthiness play a role in determining the rate.
- Many lenders require a significant down payment for this type of loan. It could be difficult for smaller businesses to meet this requirement.
- When equipment becomes obsolete, it may be difficult to receive any tangible value from it. However, the loan still needs to be serviced.
Professional Practice Loan
Professional practice loans are a class of specialty loans for medical, legal, and accounting professionals. The majority of these loans are for medical practitioners as their financing needs are often greater due to the cost of medical equipment. This includes doctors, dentists, and even veterinarians.
The loans could be used for initial equipment purchases or acquiring other professional practices. Refinancing existing debt and expanding operations with real estate are other possible uses for this type of funding. For medical practitioners, it may even include malpractice insurance costs.
Professional services companies must spread the word about their offerings in order to attract customers, and a professional practice loan can help them do this. For example, they can use this funding to start marketing and advertising campaigns. If the business owner isn’t skilled in marketing, the funding could be used to hire a marketing firm. This frees up the owner to work with clients without worrying about marketing efforts.
Pros and Cons of Professional Practice Loans
- The rates for these types of loans are attractive as professional services businesses have low default rates.
- Lenders specializing in professional practice loans tend to understand the risks associated with them.
- Practitioners may spend too much of the capital from the loan on non-core functions such as marketing and advertising. This could cause the core business to suffer when it needs a capital infusion.
- As techniques and technology improve, past equipment becomes obsolete. Practitioners may find themselves upgrading too frequently, requiring more funding.
Invoice factoring is one of the oldest forms of business financing. In fact, it existed during the Roman empire and possibly even before. Ironically, many business owners aren’t aware of this type of financing, despite its long history.
A factoring company will agree to buy the receivables generated by invoices. In this way, factoring isn’t considered a loan; it’s a transfer of assets. The factor pays a discounted cash amount based on the value of the receivables, and often takes a role in the collection on behalf of the company. This frees up the business owners, allowing them to focus on their operations.
Factoring is different than asset-based lending, where a loan is generated. With asset-based lending, the receivables are used as collateral for a loan. This affects the credit profile of the business. With factoring, as no loan is generated, the credit profile of the company remains intact.
The two main types of factoring are recourse and non-recourse. With recourse factoring, the business owner continues to assume the risk of a customer defaulting. With non-recourse factoring, the factor assumes most of the risk. Due to this provision, non-recourse factoring is often more expensive than recourse factoring.
Pros and Cons of Invoice Factoring
- The processing time for factoring is quick. Business owners can often get funding in a week or less.
- Business owners with bad credit can receive funding as the factor analyzes the risk of the business owners’ customers.
- Factors often take on the role of the creditor on behalf of the business.
- It’s one of the more expensive options for funding.
- Factors will be involved with the day-to-day operations of the business.
Franchise Startup Loan
A franchise is a business form that helps people who want to go into business, but don’t want to start from scratch. A franchise helps by allowing these people to piggyback on the success of a well-known brand. A company whose operating model is primarily a franchise (franchisor), lends support to those accepted into the franchise (franchisee).
The franchisee will often be required to raise capital to cover the cost of the franchise fee. However, the franchisor may have financing options available to help the franchisee with this requirement. Even with this help, however, a potential franchisee may need to put up some capital in the process.
Alternative lenders and traditional banks will review a franchisor’s disclosure document (FDD). This is a crucial document that potential franchisees should read carefully. A lending institution will want to know the success rate for a franchisor. This rate can be found in the FDD.
Lenders tend to be more open to lending to franchisees as the brand for the franchise carries weight. However, this doesn’t guarantee funding. Potential owners will need to evaluate their break-even point and the potential for profit. The types of franchises will play a role in the decision to fund. A capital-intensive franchise may require interim funding that will be a consideration.
Pros and Cons of Franchise Startup Loans
- The franchise is often an established brand, which helps in the funding decision.
- Franchises are often based on proven formulas, which put the odds of success higher than starting a business from scratch.
- Initial funding can be out of reach for many, especially the more established brands.
- Capital-intensive operations will require interim funding for the replacement of critical components of the business.
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Is Conventional or Alternative Right For You?
Choosing the right financing option is challenging, but several options are available to help you with the decision. Established small businesses with pristine credit will have more options than companies with less-than-stellar credit. However, there are lenders who will provide bad credit small business loans. These small business owners may not receive the best rates, and the terms may not be as attractive as ones for businesses with good credit. The options are available, though.
Capital is the lifeblood of a business, and as long as your small business has the potential to generate a profit, you can access the capital you need to keep the business running.
At Fora Financial, we offer business owners tips to help manage their businesses. We work with many businesses to help them find the right funding options, and we are confident we can help your business. Sign up for our newsletter to start receiving tips to help your business succeed.
Frequently Asked Questions
Do alternative lenders require excellent credit when considering funding for my business?
It depends on the circumstances. Some lenders are stricter than others. Traditional bank loans will likely be your toughest route if your business has suffered from credit problems. This is one of the reasons why alternative lenders emerged to help with funding businesses that find it difficult to secure traditional bank loans.
Will obtaining capital affect my credit rating?
In most cases, the more debt you take on as a business owner, the higher the risk in the eyes of lenders. However, short-term loans that get paid off quickly and funding options that aren’t considered debt may not have as big an impact on the credit rating of your business. At Fora Financial, we can help you find the perfect loan for your unique situations.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.