How Businesses Borrow Money when the Bank says “no”Posted On 10/5/2018
When conventional credit markets get tight, individuals and businesses are pushed to seek alternative lenders to obtain financing.
In this article, we’ll uncover the known alternatives (both old and new) and define the benefits, dangers and drawbacks of each.
Factoring (also known as accounts receivable financing) is one of the oldest methods of in-house financing. Factoring, simply put, is when a business sells its accounts receivable to a financial institution or “factor”. The factor will advance funds on a portion of the receivables, usually 75-80% of their face value. The remaining 20-25% is known as the “reserve” and is initially held by the factor. The amount of the reserve will vary with the quality of the receivables and the historical average of the payers. Historical late payers will increase the amount of the required reserve.
The factor handles the transactions, administers the accounts, conducts credit assessments and handles collections. For these services and the funds advance, the factoring costs to the borrower may exceed 20% of the face value of the receivables.
Once the accounts are paid, the borrower receives the difference between the face value and the reserve. The factor usually gets a 2-3% fee for the first 30 days, with late charges ranging from 0.067-0.125% per day thereafter.
The benefits of factoring include quick access to cash (usually within 10 days) and the fact that with a growing business, more accounts receivable will be coming in. There are now some online accounts receivable markets which factor bids for factoring a business’ accounts receivable.
The dangers of factoring can be exacerbated when business owners don’t know whom they’re dealing with. Deal only with well-known, reputable factors. Although it may be convenient, it is inadvisable to factor too many of your accounts receivable as it is expensive and may get in the way of establishing a track record with conventional lenders.
Also, some factors may require that your customers make their payables checks out to the factor. This may give your customers a negative view of the state of your business. Fortunately, this requirement can often be negotiated away if addressed at the outset.
Hedge fund will often loan money into higher risk businesses, such as asset- or technology-concept backed companies. The size of the loan will depend on the quality of the pitch made by the borrower. The decision to lend is usually made after some due diligence, but with greater flexibility than that experienced with conventional lenders.
The benefit of hedge fund loans is that access to funds is usually quick. The dangers include high borrowing costs and prepayment penalties. Some hedge funds have been known to fund risky loans to exploit the internal information gained in the process, which can benefit their other trading.
Peer-to-peer lenders may include family, friends and even strangers who are interested in your success. This can be a formal or informal arrangement. The benefits of this type of loan are quick access to cash and flexibility in the repayment requirements. This financing source may also have a downside — non-business issues and non-financial paybacks can get intertwined with the lending situation. Loans from family and friends may come with expectations of employment or free/discounted products from your business.
Another peer-to-peer credit source is the online social lending marketplace, such as that found at Prosper. The benefits of social online lending sources can include a loan at relatively low rates for high-risk business ventures and more flexible terms than those offered from other lending sources. In this scenario, you place your lending needs online and potential lenders bid on your loan by agreeing to provide the requested loan at a given interest rate. The borrower will usually accept the lowest rate offered with the best repayment terms.
Dangers and drawbacks include not knowing your lender, making your loan requirements public, and not establishing a credit history with one lender.
Borrowing from business customers started in the early 2000s with community supported agricultural loans (CSAs). In CSAs, farmers’ customers loaned money prior to the planting season and took payment in harvested product at discounted prices.
To participate in customer lending, a business must be well-established in the neighbourhood, possess a good list of customers and have earned the trust of those customers.
Dangers and drawbacks include customers wanting uneven amounts of product and/or non-stocked products, and customers dropping out of the repayment-with-product program and demanding cash back.
Credit Card Lenders
Financing from credit cards, often used by owners to start a business, has the benefit of easy and early access to cash if your credit history is good.
It has several dangers and drawbacks, however. Credit card financing is usually limited in the amount available to borrowers based on the borrower’s demonstrated ability to earn and repay the loan. Because this is the only collateral, credit card rates are high and subject to huge rate penalties for delayed or missed payments on any outstanding bills. For example, a delayed payment on a utility bill might send your credit card rate soaring, affecting all other aspects of your credit and financial status.
Convertible Debt Instruments
Convertible debt instruments are essentially asset-backed loans that can require the business owner to give up some future equity in the business if the lender wishes to convert the debt to an equity position in the company. One of the benefits is that the lender incurs less risk in making this type of loan and therefore is more likely to make the loan even with some risk in the situation. It is also less risky for the lender than a straight equity investment if the lender just wants to be paid back with a return and doesn’t want ownership. This may occur if the company’s bottom line growth is not performing as anticipated.
The dangers and drawbacks to the borrower are the potential loss of future equity if the company does well. Conversely, the owner may be required to pay back unconverted debt if the company is performing below budget.