Three Alternative Lending Sources for Small Businesses
Alternative lenders are growing. These credit providers are not traditional banks, which lend mostly on creditworthiness, and they are not cash advance lenders, who focus on the subprime market. Alternative lenders look at the so-called “mid-prime” market for companies that exist somewhere in between.
These lenders are providing small businesses more options for borrowing. Each opportunity poses unique challenges and financing solutions vary by business needs. Below are three alternative lending options for small businesses. Each offers challenges in addition to huge potential rewards.
Microloans and the need for credit quality
Small businesses looking for a short-term boost of capital are increasingly turning to microloans, which are generally categorized as small, short term loans for small businesses with little collateral or operating history. These small loans may exist for ventures considered too small or too risky by conventional lenders. Nevertheless, microloans grew in popularity in the early 2000s, but declined sharply after 2008, only to make a small comeback in 2012.
Part of the comeback was due to greater automation and loan application processes that involve less friction and more touch points between creditor and debtor. Inherently, automation streamlines due diligence, therefore, lenders use standardized credit measurements to efficiently assess the value of businesses and creditworthiness. Maintaining high credit quality is fundamental, and a company’s credit score is typically an essential component of its access to microloan-based credit. More data leverage is likely to come to the due diligence process as this source of capital becomes larger and more automated in the coming years.
Convertible debt and creative capital raising
As the middle market has grown in size and importance, particularly to yield-hungry lenders, one alternative form of credit that has gained popularity has been the market for convertible debt in the form of preferred stocks and mezzanine loans. These loans, which have become popular among lenders in recent years, provide the option to convert debt into an equity stake in the company. After growing to represent $211 billion in 2013, according to Bank of America Merrill Lynch data reported on by Putnam Investments, the convertible debt market has become an important touch point for both venture capitalists and lenders.
This isn’t to say the convertible debt market ignores credit scores; in fact, creditworthiness and credit history are essential to understanding how well a company has taken advantage of credit and capital access to expand its sector’s baseline. For small businesses, this means having a strong track record in investing and debt payoffs before approaching the convertible debt market.
Crowdfunding and the cost of raising capital
When crowdfunding first burst on the scene, its advocates heralded it as a direct consumer-to-producer pipeline that would allow people to raise funds for new and experimental projects more quickly and easily. Also, it was viewed as a way to green-light projects that gatekeepers would repeatedly reject. To this end, crowdfunding has been incredibly successful.
However, an additional cost is the promotion of the crowdfunding venture. While capital-raising always requires a lot of labor-intensive marketing and presentations to potential investors and creditors, a crowdfunded venture requires a different outreach strategy. Instead of appealing to a few large investors, the entrepreneur may need to attract multiple small investors.
Weigh the challenges versus the rewards
Microloans, convertible debt and crowdfunding are valuable alternative lending tools, but understanding the pros and cons of each alternative is critical in choosing the best option for enabling a business to truly thrive. Maintaining a strong credit profile and staying current with the available financing options can help businesses obtain the capital they need to grow.
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