When conventional credit markets get tight, individuals and businesses are pushed to seek alternative lenders to obtain financing. Some of these alternative financing sources have been around for a long time, but the 2007-2008 credit crunch spawned some new potential financing sources for business owners and individuals, as well as some new ways to access them. Here are seven unconventional ways businesses can borrow money and the benefits, dangers and drawbacks of each.
Factoring (also known as accounts receivable financing) is one of the oldest methods of in-house financing. Simply put, factoring 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. Historically late payers will increase the amount of the required reserve. (For more on factoring, see Taking The Sting Out Of Receivables.)
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 in which factors bid on a business's accounts receivable.
The dangers of factoring can be exacerbated when business owners do not know who they are 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.
2. Hedge-Fund Lenders
According to an August 2008 Businessweek article, hedge fund lenders are being referred to as "the new corporate ATMs." Hedge funds 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. (For related reading, see A Brief History Of The Hedge Fund.)
3. Peer-to-Peer Lenders
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 or discounted products from you or 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. This lending source accounts for a very small volume of business loans, only $200-$300 million per year nationwide. Dangers and drawbacks include not knowing your lender, making your loan requirements public and not establishing a credit history with one lender. (For more on this type of loan, read Peer-To-Peer Lending Opens Doors For Lenders/Borrowers.)
4. Customer Lenders
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.
This model expanded, especially in some retail arenas like local food markets. One Boston neighborhood specialty food market used it successfully in 2008 to pay for store upgrades, according to a May 2005 article in Businessweek. The owner accepted needed cash from a number of customers and agreed to supply them with a given dollar amount of food every week for the coming year at a discount from store retail prices.
To participate in customer lending, a business must be well-established in the neighborhood, 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.
5. Credit Card Lenders
Often used by owners to start a business, financing from credit cards has the benefit of easy and early access to cash if your credit history is good.
This method 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. (For related reading, see Six Major Credit Card Mistakes.)
6. 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. 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 does not 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. (To learn more about this type of financing, read Why Companies Issue Convertible Bonds.)
7. Venture-Capital-Backed Company Loans
Although limited to a small group of qualifying companies (and usually geographically concentrated in California and the Boston area), this bank-based lending source has significant benefits for qualifying companies. This arrangement allows companies with previous backing from venture capital companies that have established relationships with certain banks to access bank lending based primarily on the bank's reliance on the due diligence done by the previous venture capital firms.
With these loans, borrowers have access to bank lenders previously unavailable to the company, quicker access due to the pre-screening by the venture capital firm and access to bank financing with a higher risk threshold than a stand-alone bank loan.
This bank lending comes with a high interest rate and probable future stock warrant coverage requirements, which allows the lender to purchase shares in the borrowing company at a future date at a specified fixed price or a price under current market price at the time of purchase. It is also currently limited to a small percentage of borrowers. (For more on how venture capitalists operate, read Cashing In On The Venture Capital Cycle.)
Availability and choice of alternative lender(s) will be governed by the unique variables inherent in the needs, capacities and credit history of the borrowing business. These will include timing requirements, asset bases, geographic location, risk tolerances and the ability to pitch the soundness and success potential of the business, among others. If thorough and competent credit market shopping and evaluation is done, businesses may still be able to get the financing they need when the bank says "no."