One in seven. Those are the chances of getting approved for a bank loan in the USA today, so little wonder that more small-to-medium enterprises (SMEs) than ever are turning to alternative small business loans.
A once-in-a-lifetime pandemic, spiraling inflation and a cost-of-living crisis have all had a dramatic impact on traditional lenders’ willingness to approve.
This is no good for business owners who need to borrow funds not just to grow, but to cover purchases, expenses, and other business needs in order to survive.
It leaves the financial industry with an increasing problem: small businesses are growing in number quickly – totalling 33.2 million, they make up 99.9% of the business industry in the USA today – yet government and banking restrictions are failing to satisfy their lending demands.
The rising number of small businesses
Source: Oberlo
This leaves a chasm between what SMEs need and what they’re actually receiving.
Known as the ‘MacMillan Gap’, it reached a global figure of $1.5 trillion in trade finance alone in 2019, prompting SMEs to seek other funding options that alternative lenders for small business have been only too happy to provide.
Small business dependence on large banks seems to be coming to an end.
Alternative loans with more flexible conditions, lower interest rates and a quicker approval turnaround than their traditional predecessors are coming to the fore. According to research, almost a third of SMEs now apply to non-bank lenders, up from 19% in 2016.
But what qualifies as an alternative loan and how do we separate it from traditional business funding?
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To get to the crux of what separates alternative lending from traditional funding arrangements, we should first focus on what each represents.
In summary, alternative finance involves any type of small business financing from a nonbank lender. This could be from a fellow business, an angel investor, or even members of the general public.
Traditional lenders, meanwhile, are banks, credit unions or other conventional financial institutions that have typically been around for many years.
They normally base approval on an applicant’s credit history, and often charge higher interest rates to those they deem to have inadequate ratings.
That’s if they lend at all.
Alternative lenders tend to be more accessible to small businesses thanks to fewer lending restrictions brought about by their ability to leverage technology.
Like old-fashioned business lenders, they offer various types of loans, so it’s useful for small business owners to understand the differences between them. Asset-based vs cashflow lending, for example, is a good place to start.
In the next section, we’re going to jump in and look at the different types of alternative business lending out there for SMEs, along with a real-world example of each one which tells us why it might be useful for a small firm entrepreneur.
Flexible, varied and user-friendly, there are now more alternative financing options for small businesses than ever before.
Improving technology means that these are likely to grow in number, making it easier and quicker for SMEs to get fast funding for start-up costs and working capital.
Here are nine modern loan options that today’s small companies can call on.
A classic example of traditional bank loans, term loans suffered due to tight lending restrictions following the 2008 financial crash, but it’s since led to an online industry full of alternative lenders ready to offer more flexible, customer-friendly terms.
Put simply, an online term loan is a lump sum repayable over a set period of time, normally three to five years, that follows the annual percentage rate (APR).
Sometimes this amount is secured with a guarantor or collateral, but many unsecured term loans are available without these. Instead, they come with higher related costs, which might be worthwhile for a small firm if it means getting them out of trouble.
Mr L. Gallagher has set up a small farm but needs finance to pay for equipment.
He finds an online fintech lender willing to lend him $8,000 at an APR of 15%, a higher rate than usual due to his low credit score.
He accepts, knowing that his expected annual revenue is more than enough to cover the repayments over the term of three years.
Similar to traditional term loans, the idea of a business line of credit comes from the traditional finance world and acts as a type of overdraft, which a business can call on should they need it.
And like online term loans, digital lines of credit tend to be more flexible, more user-friendly and quicker to process than their old-world alternatives. They work well for SMEs who don’t have a specific loan amount in mind, but would like the option of extra funding should they need it: a kind of safety net, in other words.
Mr Brewer is a crafts beer producer looking to expand into new markets after success in his native California. He’d like finance to fall back on should he spend more than he expects, but doesn’t want to commit to a loan, knowing he’ll pay back more after interest and fees.
A digital LOC, then, suits him perfectly as he can dip into it when he wants, knowing he’ll be able to pay the amount back shortly after.
He starts one with an online lender for a period of three years, in return for a small annual charge and the payment of a fixed fee.
Banks have never been that interested in lending small sums to businesses.
All the better, then, for the microloan industry, which is set to grow at a rate of 12.8% per year between 2022 and 2030.
Microloans open up funding to groups who would otherwise struggle to obtain it, including minority-owned businesses. Because they typically cover amounts between just $5,000 and $10,000, they also include companies with poor credit within their eligibility criteria.
In the US, the Small Business Administration (SBA) is the chief microfinancing provider, a government-run institution that lent almost $45 billion in SBA loans to companies in 2021.
While microloans normally come with lower interest rates, they’re often subject to a shorter repayment term, which may cause problems for some small businesses.
Mrs Hass runs an avocado farm but is having cash flow problems. She’s just paid for expensive farming equipment but her customers are slow in paying.
Frustrated, she contacts the SBA and puts in a loan application for a $5,000 lump sum. She gets accepted thanks to her business’s sound proposal and ability to repay. The repayment term is three years and the loan carries an interest rate of 4.25% plus the base rate.
Crowdfunding is a great example of the power of the web when it comes to collective fundraising.
While various famous examples have grabbed the headlines over the years, like when Oculus founder Palmer Luckey raised $2.4 million to make VR headsets that you may have heard of (10 times his target), the concept has also spawned a loan-based industry built along similar lines.
Instead of receiving donations, businesses raise funds via loans, which they pay back to the lenders with interest over a short-term period.
This model has advantages over other types of crowdfunding in that they don’t need to offer perks or shares of the company, like with rewards-based and equity-based initiatives, respectively.
Tom Pickles wants to start a new burger truck business but doesn’t have the funds to cover start-up costs.
He decides to float the idea on crowdfunding platform Crowdspace after being turned down for multiple bank loans. Within hours, he’s received several loan offers ranging from $3,000 to $8,000 from lenders who like his business idea.
He accepts both, totalling $9,000, and enters a short-term agreement in which he must pay back the sum in six monthly payments, plus platform fees.
He’s confident of doing this, as he plans to generate twice this amount from a busy upcoming summer season of birthday events and weddings.
The digitization of the banking sector has led to an explosion in peer-to-peer lending. This works on the simple principle of putting businesses in touch with online lenders via a specialized platform.
According to Precedence Research, this market was worth almost $84 billion in 2021, a figure they believe will double exponentially every three years until 2030 when it will be worth over $700 billion.
The global rise of P2P lending
Source> Precedence Research
The driving force behind such eye-catching figures comes down to three key characteristics that P2P platforms embody, which are:
North America is currently the largest segment for P2P in the world, the US being the central market within that, and with innovative technology it’s continuing to expand.
Mr MacDonald is an agricultural entrepreneur who is looking into how much it costs to run a small farm. He finds that he needs $10,000 more than he budgeted for, leading him to check out alternative forms of lending.
He signs up to a P2P lending platform, where he fills in his personal details and loan requirements and sits tight for a response.
The platform uses several metrics to match MacDonald to lenders in its database, including future financial projections, key performance indicators (KPIs), and even social media activity. It then presents him with a list of lending options to choose from, then charges him a low interest rate.
The platform also takes care of the contract, making sure he pays on time and even has legal insurance in case of disputes.
Upon acceptance, the money lands in MacDonald’s account within days, rather than the weeks it often takes a traditional bank.
A frequent problem for traditional loan applicants is that lenders judge them by their past performance, rather than their potential.
Merchant invoicing takes the opposite approach. Also known as a merchant cash advance (MCA), it’s a way of unlocking finance based on projected sales figures and credit card sales. Once the sale happens, the borrower repays the money, with a fixed fee on top.
The lenders get peace of mind knowing that they’ll get their money at a certain point, especially if the sale is guaranteed. It also removes the need for collateral or a guarantor, making it a great example of a business loan with no guarantee.
One possible negative for the borrower is that the lender might insist on discounts and extra fees, especially if they sense desperation. It’s also easy for small businesses reliant on MCAs to fall into a debt cycle, if they’re not careful.
Miss Fletcher runs an avocado farmer that’s struggling for cash. Even though she’s impressed her bank manager with an excellent business plan, she still can’t raise enough to cover the next three month’s running expenses.
She does have one trick up her sleeve, though: $10,000-worth of purchase orders per month for the next year.
Acting on a recommendation from a friend, she secures a merchant cash advance for $20,000 via an MCA platform, based on this sale. The lender provides funding within 48 hours, and is set to take 15% of her sales amount over the next year until the sum is settled.
Invoice factoring or financing works on a similar principle to merchant invoicing, except the lender buys unpaid invoices from you, then gets the money back when your buyer settles up.
This is particularly useful for small businesses with slow-paying customers who want to free up cash for current expenses. However, like with MCAs, lenders may buy the invoices at a discount and/or charge a fee for their service.
Mr Bennett owns an agricultural production factory but is worried that a delay in payments from his debtors will mean he can’t cover overheads for the next quarter.
He gets in touch with a lender who offers to buy his invoices, worth $15,000, at a 10% discount, allowing him to unlock $13,500 right away. From that, he pays them a $500 fee for the service, but he can now meet his obligations over the next three months.
Equipment financing is any loan or lease provided for the purchase of computers or machinery needed to run a small firm. This could be any tangible asset, including farming equipment, company vehicles, or even office furniture.
The arrangement is convenient for lenders as they have ready-made collateral in the form of the equipment, which they can seize in the event of non-payment.
For small businesses, it’s a quick and convenient way of quickly securing the equipment they need to get up-and-running.
Mr W. Gates wants to break into the agricultural industry using a revolutionary software product but he needs to set up a sophisticated computer system in his office to do so.
After a bank turns him down because of a poor business plan, he finds an online lender willing to lend him $15,000 to purchase the equipment he needs. They agree to a three-year repayment plan at a rate of 8%, with equipment acting as a collateral.
Gates likes this arrangement, because at the end of the three years he’ll own the equipment outright, which wouldn’t happen with a leasing arrangement.
Not all unconventional loans for small businesses are based around fiat currencies.
Despite cryptocurrency’s recent crash, crypto lending is still a viable option for small businesses looking for a short-term influx of cash or crypto funds. It works by lenders loaning out cryptocurrency to borrowers, which can also be converted to cash, in return for regular interest payments.
While it presents a quick, relatively easy way of raising funds, this type of finance does come with inherent risks. The volatile nature of the crypto market can impact the value of the loan hugely, and explains why interest rates are often in excess of 20%. They also normally demand collateral as one of the conditions of the deal.
Security is high, however, with any agreement sealed with a smart contract, and most lenders offer instant loan approval.
George Dawes runs a new beverage start-up and needs to unlock finance very quickly to meet financial obligations.
As a crypto enthusiast, he’s heard about crypto loans before and decides to give them a try. He connects his digital wallet to a decentralized lending platform and sees various crypto loan types there. After selecting the collateral he’ll put up, as well as the type of loan and amount he’d like to borrow, he is accepted by an online lender.
Once he’s deposited the collateral into the wallet, he instantly receives the loan funds, which he can convert into cash and transfer to his company’s bank account.
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