Guide to alternative lending for small businesses
Learn all about the different options for funding your business in this guide to alternative business loans.
Learn all about the different options for funding your business in this guide to alternative business loans.
As a small business owner, you’re more likely to get approved for a loan by alternative lenders than banks. While the approval rate for banks ranges between 14.3% and 20.1%, that of alternative lenders stands at 26.1%.
And that’s only because the coronavirus pandemic forced non-bank lenders to ease up on loan approvals. Pre-pandemic numbers show that alternative lenders granted 56.3% of small business loan applications.
This is a contrast to banks, which continue to pose strict requirements on small businesses trying to access financing. You’ll typically need a substantial annual revenue, consistent cash flow, high credit score, asset ownership (for collateral), strong debt-to-income ratio, and longer time in business before your company qualifies for a traditional bank loan.
Because of these high eligibility requirements, many prospective borrowers are often turned away by banks and credit unions. It’s no surprise that alternative lenders for small business have become the go-to option for many entrepreneurs.
Because of its accessibility, flexibility and speediness, alternative lending has quickly become a more appealing option than traditional banks. In the U.S. alone, the alternative finance market accounts for $61 billion of all lending, making it a viable option for small business owners who are looking to access financing and drive growth.
But how do you choose the best alternative lenders for small business loans? How do these alternative loans work? Are they right for your business? This article answers these and more questions to help you vet alternative lending companies and qualify for the most suitable non-bank loans and credit facilities.
Alternative lending refers to loans and credit facilities that can be secured outside of traditional banking institutions. The term encompasses a wide range of financing options, including business lines of credit, term loans, equipment financing, and other forms of tradelines.
Alternative lenders for small business loans differ from banks primarily in the underwriting process. Traditionally, getting a bank loan requires an extensive application process, strict eligibility requirements and prolonged time to funding.
On the other hand, alternative lending companies focus on easy access. They typically have relaxed qualification criteria, especially around personal credit scores, annual revenue and time in business. You may qualify for a small business loan even with a new startup, bad credit, and half-decent cash flow.
Additionally, alternative lenders offer a speedy and flexible underwriting process, thus increasing small business access to credit. Many of these firms leverage on fintech to provide streamlined lending procedures, allowing the entire process to happen online. You can apply for a small business loan, get approved in a few hours, and have the cash in your business account in one or few days.
That said, alternative loans typically carry higher interest rates compared to their conventional counterparts. That’s something to keep in mind as you compare alternative lending companies with traditional banks.
Alternative lending companies work in different ways. However, many of them do not actually originate loans. Instead, they partner with funders who are willing to extend loans. Those funders, then, originate loans to individuals and businesses through the alternative lender. This makes the alternative lender essentially a matchmaker in the credit market.
A good example is Fundera. While it does not originate loans, Fundera matches you up with financiers who may be willing to lend to your small business. The company currently works with funders who offer a variety of products, including lines of credit, short-term loans, medium-term loans etc.
The same goes for Funding Circle. Although it’s Better Business Bureau (BBB) credited, it doesn’t originate loans. Instead, the company acts as a marketplace for connecting business owners with financial products from funders. For instance, as an approved Small Business Administration (SBA) lending partner, Funding Circle links small business owners with SBA loans.
Other alternative lenders work differently. Rather than linking borrowers with multiple fanciers, they choose to work with one financial institution that has a full banking license. This institution can then originate loans to small business owners through the alternative lender. A good example of this is Kabbage, which is now owned by American Express, but operates independently. However, all Kabbage loans are originated by American Express. So, you’re essentially getting an American Express loan, but through Kabbage.
That said, alternative business lenders can engage in typical banking services like operating checking accounts, issuing credit and debit cards, and extending lines of credit. The difference comes in how they manage their operations. By leveraging technology, alternative lending companies are able to streamlines their services, including the business lending process. They quickly underwrite borrowers’ credit risk to determine the amount of loan to offer, interest rate, and lending terms. This streamlined process speeds up small business access to credit.
Many alternative lenders operate online only and don’t have the expenses that come with brick-and-motor operation. This cost-saving model is what allows them to focus on businesses that traditional banks – which typically have high operation costs – deem too risky. They are able to give loans to small business owners who don’t have stellar credit scores, cash flows, or annual revenues. That’s primarily why alternative lending is growing into an important source of business funding for small businesses in the U.S. and around the world.
The loans offered by alternative lenders tend to range between $5,000 and $5 million, with a repayment period of anywhere from three to five years2.
A good number of top alternative lending companies have diverse loan options for small business owners. Here’s a look at the alternative lending options to consider when looking for financing:
Business term loans are credit products that give you a lump sum amount, which you typically repay over a set period of time and in regular installments. Term loans from alternative lenders are a lot like term loans offered by traditional lenders. However, online loans often have higher interest rates and shorter repayment periods compared to bank loans. The upside is that alternative term loans are easier to qualify for.
Alternative lenders generally offer short-term loans, but some companies like Funding Circle have long-term options as well. Short-term alternative financing typically lasts anywhere from one to two years. They are easy to qualify for and will usually be disbursed in one or few days. This makes them great for funding business emergencies and immediate expenses like cash flow gaps.
On the other hand, long-term online loans may have a repayment period of up to five years. That’s because they typically carry larger amounts, making them ideal for expansion of operations and increasing your company’s working capital. But keep in mind that the longer the duration, the more the interest payable.
While loan amounts that you can get vary from one lender to another, the average alternative loan amount is $80,000. But you can get up to $1 million or more if you have good financials and are going for a long-term option.
As the name suggests, a microloan is a low-value loan, typically maxing out at $50,000. Alternative business lenders created these loans because many traditional banks consider them too small to originate. But to a small business owner, the amount may be enough to acquire new equipment, pay salaries, add inventory, or expand operations. The thing to keep in mind is that microloans have incredibly short repayment periods – typically a few months.
In business context, a bridge loan is a type of loan that a company gets for current use as it waits to secure permanent financing. If, for example, you’ve just opened a new business location, you can apply for a bridge loan to acquire inventory for that new branch as you wait for a term loan that you can use to hire more employees and probably get new equipment. The bride loan will see you through as you wait for the term loan.
Bridge loans typically take a short time to apply for, get approved and get funding. The tradeoff is that you’re likely to get a high interest rate, large origination fee, and short repayment term of a year or less.
Many top alternative lenders offer small business owners a line of credit that they can use to meet cash flow needs. This is basically a fixed amount of money that you draw upon as needed and then pay back immediately or over a set period of time with interest.
A line of credit works much like a credit card in that both are revolving loans. However, while many credit cards simply avail credit that you can use to pay for purchases, a line of credit give you cash that you can use for any business needs. This makes it a good choice for paying unexpected business expenses, meeting short-term financial needs and generally managing cash flow.
Although traditional banks have business lines of credit, they’re generally hard to qualify for and come with lengthy repayment terms. Alternative lenders, on the other hand, offer lines of credit with short terms and easy qualification criteria.
Equipment financing refers to a loan issued to a business so that it can acquire, upgrade or improve on its machinery and equipment. It’s different from other types of loans because it has only one purpose – financing equipment.
Alternative lenders typically finance up to 100% of the equipment cost, with the equipment itself acting as collateral. Because it’s a self-secured loan, equipment financing is fairly easy to qualify for. Your lender will likely focus on the value of the equipment rather than traditional measures of eligibility (like credit score) when underwriting an equipment loan.
Although equipment loans are available in some banks and credit unions, you’ll typically need a good credit score of at least 600 and possibly a down payment of 5 to 20% before getting approved. Many online lenders scrap such requirements, which makes them more appealing to small business owners.
Also known as invoice factoring, invoice financing is when a business sells outstanding accounts receivable to a factor at a discount. A factor is simply a third-party who takes up the responsibility of chasing down your invoices. They basically give you a loan, and then you transfer your accounts receivable to them.
The lender will typically give you an upfront amount that’s equivalent to 85% - 90% of the total value of your invoices. They then collect those invoices. The 10% - 15% that remains represents the lender’s profit after collection.
One of the biggest advantages of invoice financing is that it’s very easy to qualify for. The lender won’t consider your credit history; they’ll look at your debtor’s credit. Plus, your invoices act as security for the loan, which minimizes risk on the lender’s part. For that reason, they are more likely than not to approve you for an invoice loan.
Banks and credit unions typically don’t offer it. So, you’ll have to get the loan from an alternative lender. Overall, it’s a great credit facility for any business whose cash flow is frequently impacted by unpaid invoices.
A merchant cash advance is a type of funding where your business gets cash advance in exchange for future credit card sales. You, therefore, pay back the money by deducting a percentage of all the payments that your customers make using their credit cards through your card terminal.
The deduction rate of a cash advance varies from one alternative lender to another. But generally, you can expect any rate between 5% and 20%. Also, keep in mind that merchant cash advances come with high interest and a shorter payment frequency.
Depending on your agreement with the lender, you may have to make daily, weekly or bi-weekly payments. These short repayment periods can affect your cash flow, so make sure you have enough income to make the payments.
Having known the types of loans you can get from alternative lenders for small business, the next step is knowing how to choose a good lender. Many of them have well-packaged credit deals that can provide practical solutions to cash flow issues that face the typical small business. But there are others who may offer deals that don’t make a lot of economic sense. Below are the key factors to look at when vetting alternative lending companies:
There have been numerous cases of fake fintech firms luring business owners with credit deals that are too good to be true. Where there’s a fake company, there’s always the risk of losing money; or worse, your entire company. You don’t want to align yourself with an alternative business lender who poses such a risk.
Start by doing some due diligence to establish alternative lenders that are legitimate. Visit their website and check that it’s secure. If they don’t have a website, then you have your first red flag. Look at the fine print on their site. This includes their terms and conditions, privacy policies and other legal disclosures.
Does the fine print match what your business needs? For example, some alternative lenders only extend credit to companies with 50 or fewer employees. If your staff exceeds 50, then you’re automatically locked out.
Proceed to examine the lender’s paper trail. Any good alternative lender will have a decent amount of information about them on the internet. How did they start? Who are the managers? Which banks do they partner with (if any)? Do they have authentic customer reviews on their site? If you can’t find answers to such questions, then probably you should treat that lender with suspicion.
One of the reasons for choosing alternative lenders over traditional lending is to enjoy a streamlined lending process. Therefore, you’ll want to choose a lender who takes advantage of fintech to circumvent the typically long underwriting process. Many such lenders simplify the process by a fully online application.
Another draw to alternative business loans over traditional bank loans is that you can secure funding faster. Any alternative lender who takes too long to process small business loans waters down this benefit. And considering alternative loans generally have higher interest rates, it would make more sense to go for a bank loan instead if you’ll have to wait equally long.
That said, some alternative lending models – like crowdfunding – generally require a lot of time. But if you go for a direct loan from a lender, then you can get the funds in your bank account in as little as one or few days.
Therefore, make sure to ask how long the lender takes to process loans. This is especially important if you’re looking for a loan facility that can fill cash flow deficiencies on short notice. You’ll need it in your business account as soon as possible.
The approval rate for alternative loans is often higher than that of conventional loans. Even within the alternative finance market, some lenders approve more loans than others.
To increase your chances of getting granted a loan, you can consider applying from a lender whose approval rate is as high as possible. A good example is SBG Funding, which boasts an approval rating of 85%.
When looking for an alternative lender, it’s important to examine their lending terms, fees and charges carefully. You’ll want to pick a funder that discloses all the associated costs of a loan, including interest rates. Conversely, avoid those who have hidden costs in their credit facilities. Such lenders will often be hesitant to disclose the amortization schedule of a loan.
A lack of transparency can lead you to take up a seemingly cheap loan, only for the lender to add costly fees and charges. Plus, some may charge unnecessarily high interest rates that make the loan costlier than it should be. Combined, such things can result in you spending a huge chunk of your business earnings in repaying interest and fees. This may prevent the business from growing.
On the one hand, alternative loans have a lot going for them. They are easier to access and you typically get funding in one or few days. On the other hand, they have a few drawbacks to keep in mind. For example, they generally carry higher interest rates compared to conventional loans.
For these reasons, if you’re looking at alternative lending companies as sources of business finance, you’ll want to weigh their advantages and disadvantages against other forms of funding.
Many alternative business lenders apply fintech in their operations, allowing business owners to apply for loans online in just a few steps. You can complete the entire process from the comfort of your office or home. And that leaves you with more time to focus on growing your business. You can’t say the same for traditional loans, which are typically characterized by lots of paperwork, many steps, and possibly in-person application because you have to deliver documentation in person.
Alternative lenders have a fast loan application process, which is usually followed by quick approval and funding. Depending on the type of loan and amount, you can get the finance in a matter of days – at times one day.
On the other hand, traditional banks take weeks or months. They are not the most ideal for small businesses, especially those that are cash strapped and need immediate financing.
Many alternative lenders offer different types of loans. From term loans to lines of credit, business credit cards and everything in-between. Some even partner with the SBA to provide SBA-backed loans. And if your only need is equipment and machinery, you have the option to apply for an equipment loan.
Traditional banks don’t often avail credit facilities in such many forms. Apart from conventional term loans and SBA loans, you’ll very rarely find other products in a bank.
Alternative lenders typically don’t consider things like annual revenue, credit history and years in business when underwriting loans. This gives credit access to business owners who would have been disqualified for traditional bank loans based on their credit score and the numbers on their business books.
It’s not uncommon for banks and credit unions to place strict restrictions on how you can use the proceeds of a loan. Many of them will ask for a detailed plan for how you plan to spend the money. And they can deny your loan application purely based on it.
Alternative lending companies generally don’t have the same requirements. They give you the free will to use your funding in any way you see fit to grow your business. That said, some types of online loans – such as equipment financing – are meant for specific purposes and cannot be used for anything else.
They may be easier to get, but alternative loans can be more expensive because they carry higher interest rates compared to their conventional counterparts. For example, alternative term loans and lines of credit often incur APR rates that range from 7 to 30%. Cash advances and invoice financing are even costlier.
That said, certain types of alternative loans – like SBA-backed loans – offer single-digit rates that compete with conventional bank loans.
Alternative lenders for small business loans usually – but not always – offer small amounts compared to banks. You’ll generally struggle to find an alternative lender who can offer amounts that reach or exceed $1 million. Many of them cap it at $500,000; with some (like Upstart) having maximum loan amounts of $50,000.
Although this varies depending on the type of alternative loan you take, most of them generally have short repayment periods. This tends to increase the frequency of loan payments and can affect your business cash flow.
At the end of the day, alternative lending fills the gap for small businesses that cannot access conventional financing. It’s flexible, easier to access and has few eligibility requirements. Plus, alternative lending companies have a wide variety of credit facilities to choose from.
The other side of the coin is that alternative loans can be costlier because of their high interest rates. But this boils down to the type of loan. For example, an SBA loan acquired from an alternative lender won’t be significantly more expensive than one acquired from a bank.
Besides, each alternative lender has their own terms – with some offering competitively low rates. Therefore, it all comes down to your ability to identify a good alternative lender and pick a product that works for your business.