Small businesses and startups often turn to banks to get funding as the starting capital. However, traditional funding is expensive, and approval rates are low. This may be the direct result of the pandemic, making things worse for companies’ credit histories. As businesses strive to recover and some try to begin their operation at these turbulent times, they look for reliable and accessible working capital options to overcome this economic challenge. To help them and, perhaps, you, our dear reader, we composed a list of funding options that may help you start your business or go on with the existing one, as alternatives to traditional banking. Choose the one that works for your business case!
Top Funding Alternatives to Conventional Loans
Crowdfunding is a type of alternative financing that suggests receiving funding from a small group of investors that finances your product or business. Over the last 20 years, crowdfunding has gained tremendous proliferation, which allowed many SMEs to opt for it. Currently, one can count up to three major crowdfunding models, which are donation-based, equity-based, and reward-based. Donation-based crowdfunding implies giving donations where donors should expect to get nothing in return. Equity-based, on the other hand, is a form of crowdfunding where investors have a share in the business and thus can earn profits from this venture. Finally, in reward-based crowdfunding, donors make donations in exchange for rewards like discounts, gift cards, or entire free products. By its nature, crowdfunding is not a reliable form of funding. There are plenty of cases when crowdfunding campaigns don’t meet their target, meaning that investors don’t earn from them, no matter what type of crowdfunding they chose. Meanwhile, business owners have to look for new sources of funding in that case.
The idea behind p2p loans is dedicated platforms, or marketplaces where investors and business owners meet. The former offer loans to the latter to support their businesses, which business owners must repay within the agreed period.
Typically, investors distribute loans in small portions through p2p lending platforms like Fundable, Upstart, or another one. Some platforms cater to the needs of a specific type of businesses or individual borrower groups. For example, iFundWomen, a platform designed specifically for female entrepreneurs.
Most often, businesses and individuals from developing countries that lack collateral, have poor or no credit history apply for this option since originally, it was created for them. For the last several decades, microfinancing has helped promote business growth for startups and SMEs in many developing countries.
Microfinancing means providing loans in small amounts to borrowers. Its hallmark is that private companies and NGOs often act as investors, offering a loan of up to $35,000 for underserved and underbanked business entities.
Lenders who provide microloans carry more financial risks so they are likely to carefully and comprehensively vet applicants, even more meticulously than banks. But even after you get approved and receive the desired loan, especially when it’s massive, don’t make a mistake by expanding your business too quickly; sometimes, it’s better to ask for a smaller loan, where there will be less temptation to spend them irrationally, thus making every dime count.
Business Term Loans
These loans vary in duration from one to five years, and you can get them in the form of a one-time loan to return in installments with interest and fees during a set period.
Online lenders who offer business term loans offer greater flexibility regarding the number and amount of installments and faster loan provision times than other types of lenders, yet their loans are likely to be more expensive and have shorter repayment terms.
Business term loans can be divided into short-, medium-, and long-term ones. Short-term loans last up to 18 months, provided they are faster than other types, but they are the most expensive ones, respectively. Medium-term ones extend up to five years and have a minimum duration of one year. The lenders that provide these loans have stricter requirements to borrowers, yet they tend to be slower to fund, compared to short-term loans. Finally, long-term loans have a 5+ years’ repayment period. Some of them reach up to 25 years and require top qualifications from the borrower. Long-term loans have lower interest rates and are the slowest to fund.
Medium- and long-term loans work well for large investments such as refinancing debts, purchasing equipment or real estate, hiring staff, and more. On the one hand, they are a good option because they can be applied for multiple business cases and have predictable payment schedules, on the other — they often require collateral and often come with prepayment penalties as fees. In this way, lenders secure themselves against defaults or early repayment as the way to escape fee charges.
Line of Credit
A line of credit is an agreement between a lender and a borrower that defines the maximum loan amount the borrower can take at any time. Lenders also define the size of payments and interest rate which tends to be high as well as penalties for past-due payments.
The distinct feature of this type of alternative funding is its flexibility, meaning that the borrower can request a certain sum but doesn’t have to spend it all. In other words, they can draw a certain amount rather than the whole sum and owe interest only on that amount. In this way, they can adjust their line of credit to their spending habits. In the same fashion, they can adjust their repayments accordingly by repaying the entire balance or, otherwise, making regular small monthly payments.
The majority of lines of credit are unsecured loans where the borrower doesn’t carry any responsibility in the event of nonpayment. It means that there is no collateral from them to back the line of credit. The only exception is home equity credit lines where the deal is collateralized by the borrower’s home, meaning that they are secured loans. Other types of lines of credit, which include a personal line of credit, demand line of credit, securities-backed line of credit, and business line of credit, are unsecured loans.
Overall, secured lines of credit are more convenient for borrowers since they provide higher credit limits with lower interest. At the same time, unsecured lines of credit are more difficult to obtain since they have more severe requirements to the borrower’s credit score and credit rating.
The option suggests that a company sells its outstanding invoices to a third party, or a factoring company. The factoring company pays back 80–90%% of the invoice amount immediately and collects the remaining 10% directly from customers to pay them back to the invoice-issuing company (minus fee).
Invoice factoring is normally used when a business has many invoices, which negatively impacts its cash flow. With invoice factoring, they can take care of short-term expenses, use seasonal opportunities to their advantage, repay loans, or overcome any other hindrances caused by cash flow.
Since the major invoice amount is paid immediately, the cash flow is mostly predictable, which is one of the main benefits of invoice factoring. Also, invoices are cheaper than bank loans. On the other hand, it required much commitment on the invoice issuer’s part and the necessity to pay more if the factoring company’s customers are high-risk or fail to pay in due time.
Merchant Cash Advance (MCA)
This form of alternative funding is widespread among companies that work with credit card payments. You can get upfront from the provider in the form of cash in exchange for a part of your future debit and credit sales. Or, you can repay the upfront through regular remittances from the bank account, plus fees, until you pay the advance.
In merchant cash advance, the provider determines the number of fees in the form of a factor rate. The rate ranges between 1.2 and 1.5 depending on risk assessment. The higher the rate, the higher the fees to pay. To get the total repayment amount you need to pay, you should multiply your cash advance by the factor rate. Thus, if you borrow a cash advance of $40,000 and your factor rate is 1.2, you will have to repay the lender $48,000, including fees. The repayment period starts with three months and may last up to 12 months.
Why do businesses choose merchant cash advances? First, because they are quick; the assessment normally takes a week or so. Also, they don’t require collateral from you to back the MCA in case you fail to repay it in due time. However, the MCA provider may require you to provide a written guarantee that you are personally responsible for repayment.
SBA loans are the ones provided by the Small Business Administration (SBA) hence their name. Here, the SBA itself pays back the most portion of the loan if the borrower defaults. You need to have a good credit history if you want to obtain an SBA loan.
SBA offers three loan programs to choose from:
- 7(a) Loan Program — a group of SBA loans for small businesses with special requirements like purchasing real estate that is typically repaid monthly, including fixed interest.
- 504 loans — long-term fixed loans that suit best when you purchase or repair real estate, machinery, equipment, landscaping, or other assets with repayment terms of 10, 25, and 25 years.
- Microloans — loans of up to $50,000 to help young businesses start and grow. The maximum repayment term is six years, with interest rates varying from 8 to 13%.
Equipment loans are given to purchase, replace, update, or repair tools like office equipment, machinery, furniture, or other items that are essential for your business to run. Here, the items you plan to cover with the loan are your collateral. Also, you need to pay not less than 20% of the item’s price in advance to the lender. To apply successfully, you need to demonstrate an excellent credit history as businesses with poor or bad histories are treated as “very risky.”
As with any type of alternative funding discussed in the article, equipment loans have their benefits. First, they ensure quick business vetting to get approval or denial. Second, this is the versatility of cases for which the equipment loan can be provided; that is, if your equipment breaks down, you can take the loan to repair it rather than purchasing a new one. Third, you have a flexible repayment schedule with a choice to make monthly, quarterly, annual, or even biannual or seasonal payments.
Finally, your equipment lender covers the most of “soft costs,” including fees and different charges. Yet, each lender has their own terms so make sure to clarify what charges apply to your loan.
Eventually, the choice of the funding option depends primarily on your business needs and the loan repayment term. Sure, the pandemic made running a business more difficult and sharpened the need for financing. At this point, consider the options and mind that such things as repayment terms, interest, and even fees can be subjects for negotiation so make sure to discuss them with your lender.
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