B2B companies — i.e., business-to-business companies, which provide goods and services primarily to other enterprises — have always played a prominent role in the American economy. Consider, for example, the auto industry, which requires vendors to deliver various components (tires, batteries, electronics, etc.) in order for a vehicle to be built.
B2B companies, which can be contrasted with B2C (business-to-consumer) enterprises, have in recent years pivoted toward the digital side. Such companies, especially those in the tech and Software-as-a-Service (SaaS) sectors, tend to fall in the sweet spot of business development companies like Saratoga Investment Corp., as traditional lenders such as banks have faced increased regulatory control since the 2008-09 financial crisis. As a result, they shy away from such companies in favor of large corporations with free cash flow and a significant amount of tangible assets.
BDCs and other alternative lenders, meanwhile, favor those companies because of their recurring revenue streams — i.e., they offer their services on a subscription basis — and their growth potential. Nearly every established company is making a digital transformation these days, and requires the assistance of tech and SaaS companies to stay ahead of the technological curve.
Business-to-business lending on the part of BDCs and other alternative lenders can help those companies that provide these services with the capital that will enable them to reach their full market potential.
What Is B2B Financing?
B2B financing is lending that the owner or owners of a business-to-business company might require to help support their expansion efforts. Such capital might be needed for real estate financing, payroll funding, inventory lending, or expansion to new services. B2B lending can also include the refinancing and consolidation of the B2B enterprise’s business debt. In all cases, B2B lending is geared toward enhancing the growth potential of an existing business-to-business venture, a common focal point of BDCs.
Small and medium-sized enterprises (SMEs) are critical to the American economy. They comprise 99.9 percent of all U.S. businesses. They create two-thirds of the jobs and drive almost half of the country’s economic activity. They nonetheless face difficulty obtaining business loans or financing from traditional banks. Between 2006 and 2014, funding from the 10 largest banks for SMEs fell precipitously, from $72.5 billion to $44.7 billion. However, this left a major gap in the market, as SMEs continued to require financing to expand and enhance their services, opening an opportunity for alternative lenders like business development companies.
Advantages for the Borrower
Why choose an alternative lender? For the companies involved, B2B lending with a business development company offers speed and flexibility, often unlike the big banks. The application process for alternative lenders also tends to be much simpler, the capital more accessible. In 2018, the approval rate for bank loans was about 26 percent, while the rate for alternative lenders was 56.6 percent. For SMEs looking for B2B loans, alternative lenders offer greater security and hope to obtain much-needed financing.
Across the country and around the world, alternative sources of business-to-business lending are becoming a trend. Small and medium-sized businesses are increasingly turning to alternative lenders. In 2018, there was a $5 trillion gap between the needs of SMEs and the cash made available to them from traditional lenders. BDCs and other alternative B2B lenders are well-placed to fill the void. In particular, they provide digital B2B companies with a seamless lending process as they seek to meet their needs, as they use technology to good effect themselves.
Marilyn J. Holt, a Seattle-based consultant and author, points out one more advantage of alternative lenders: “Often alternative lenders are savvier than commercial banks which often experience great turnover in their lending officers, many of whom can be inexperienced. Additionally, non-bank lenders sometimes specialize in certain types of loans or in specific industries, and their greater knowledge can translate into more flexible lending policies.”
Different Types Of Business-To-Business Loans
There are several different types of business-to-business loans provided by alternative lenders. Here are some of the main forms of B2B lending.
1. Direct Lending
Direct lending can be likened to a bank loan without a bank. Those who engage in this type of lending raise capital from their investors to fund a leveraged loan to a borrower. These borrowers could be businesses, entrepreneurs, or even other investors — essentially, everyone shut out of the bank lending market since the 2008-09 financial crisis. Therefore, direct lending bridges a major gap in the market for loans, extending opportunities to businesses and investors alike that may otherwise be denied.
In the $850 billion private credit asset class, direct lending is the most popular strategy, accounting for $314 billion in B2B loans in the 12-month period ending December 2019. This kind of direct lending is especially popular among small to medium-sized businesses because of the tremendous upside of such companies combined with banks’ reluctance to provide loans. Some companies that have received loans through alternative direct lending include Bombardier Inc., a manufacturer of planes and trains, which borrowed $1 billion on the alternative market, and the insurance brokerage Ardonagh Group, which borrowed $2.4 billion.
Direct lending can be provided as a first lien or senior debt, paid off before all other obligations; a second lien or junior/subordinated debt; or as unitranche debt, which combines aspects of both into one B2B loan.
2. Venture Debt
Venture debt is a form of debt-based financing often pursued by B2B companies when they need capital to pursue a specific opportunity. It provides an important alternative to equity investment for many startups, and big companies like Airbnb and Uber have used venture debt to fund their growth rather than pursuing additional rounds of funding. Business development companies are some of the leading players in the venture debt market, along with private equity firms and hedge funds.
Venture debt stands as a worthy complement to equity funding. It provides significant capital for growth and expansion without further diluting the equity stake of the owners of a company. This can be a major advantage to pursuing venture debt rather than equity financing.
At the same time, there are some caveats. It is important that companies are able to repay their venture debt, as lenders are able to take strong action to force the borrower to repay, up to and including bankruptcy. However, for companies that are able to achieve their desired growth, venture debt can preserve precious equity while providing much-needed B2B financing for expansion.
3. Structured Equity Products
There is a wide range of structured equity products, essentially bonds intertwined with long-term equity indexes. These products can provide support to many companies, but they carry a drawback, in that they can fall prey to shifting market trends.
4. Debt Financing
There are many forms of debt financing offered by alternative lenders and BDCs to small and mid-sized enterprises in the B2B space:
Non-Bank Cash Flow Lending
Also known as enterprise value lending, this form of lending relies on the potential growth value of a business to support the underwriting of a loan. Rather than looking at tangible assets like equipment or real estate, this type of loan is based on anticipated cash flow for the future. Business development companies also offer professional guidance and flexibility with this type of B2B lending in order to encourage recipients to reach their goals.
Recurring Revenue Lending
This is another type of B2B financing provided by alternative lenders like business development companies. It is often particularly well-suited to SaaS vendors and other tech companies because it focuses on firms that may not have significant assets but can show ongoing and recurring revenue through the use of subscription-based services. Lenders can predict these companies’ growth into profitability and lend accordingly. These loans are based on annual recurring revenue (ARR) or monthly recurring revenue (MRR) to assess a company’s potential.
Home Equity Loans/Lines of Credit
Small business owners sometimes fall back on home equity loans or lines of credit. If the business owner owns a home, they can borrow against the equity obtained in their home over the years. While these loans offer favorable interest rates, they also put the owner’s personal home at stake, attaching their personal financial future to that of the business.
Debenture
A debenture is a type of debt instrument, like a bond. However, rather than being backed by collateral or direct assets, it is backed by trust in the company, a good credit rating, and performance and reputation. For some small and mid-market companies, debentures provide a mechanism for successful funding.
5. Mezzanine Financing
Mezzanine debt is a form of hybrid debt that takes its name from the mezzanine in architecture, an intermediate story between two floors. It is subordinate to other debt from the same issuer, thereby bridging the gap between debt financing and equity financing.
However, it also comes with high risk, as it comes below pure equity and above pure debt in a ranking of obligations. In many ways, mezzanine B2B financing operates more like a stock than debt, as the options within it make it more attractive to convert the debt into shares of the company. Mezzanine financing addresses a shortfall between the needed funds and the direct loans provided by a borrower, allowing a transaction to be completed.
How To Pick a Good Lender
As a business-to-business company looking for financing, it is important to choose the right lender. Experience matters. Look for a business development company with an established track record, experience in the space, and a simple application process. Your lender should be accessible, offer speed and flexibility as you move through the process, and provide due diligence as part of the process.
A business development company like Saratoga Investment Corp. brings a wide range of benefits to the table. It offers responsive service and excellent communication, with years of experience developing and supporting SMEs. Saratoga provides non-dilutive capital with low costs, flexible financing options, and a quick, secure application process.
To get started finding your B2B lender, review Saratoga’s investment profile to learn more about its comprehensive approach to B2B financing. This will help you determine if your company is a strong fit for Saratoga’s lending approach.