Over the last several years, it’s become more and more difficult for small and mid-sized companies to obtain a bank loan — even for businesses with strong financials and a track record of success. That’s because banks often require prospective lenders to show consistent cash flow, substantial available collateral or a strong debt-to-income ratio in order to qualify for a loan.
That’s already highly limiting, and with more companies than ever going virtual, it’s no surprise so few small and medium businesses are able to meet such requirements.
Instead, alternative lending has become a far more appealing — and realistic — option for middle market businesses who may be looking to drive growth, expand their operations, or pursue an acquisition. In fact, alternative lending is on the rise; the United States boasts the second-largest alternative finance market in the world, with $61 billion in alternative lending, while the United Kingdom follows with $10.4 billion.
The COVID-19 pandemic has only heightened these trends. As with the 2008-09 financial crisis, uncertainty and economic contraction have once again made banks more hesitant to lend to small and mid-market businesses, making alternative lending companies the obvious choice.
But what exactly is alternative lending? What are the pros and cons?
In this article we’ll dive into how it works, the most common types, and what to look for in an alternative finance company.
What Is Alternative Lending?
Alternative lending refers to any loan that is secured outside of a traditional banking institution.
There are many types of loans that fall under the umbrella of alternative finance — everything from direct lending and equity financing to debt financing. While the lending options vary, what alternative lending companies share in common is their specialization in business lending and financing options, rather than all the other services of a traditional bank.
Alternative lenders are also more readily accessible than banks, and often offer a streamlined lending process owing to their use of online tools that facilitate the underwriting process.
Moreover, alternative lenders provide greater flexibility surrounding certain loan requirements like credit score and annual revenue. And while alternative loans typically require higher interest rates than their conventional counterparts, alternative lenders are also more responsive to changes in repayment schedules.
How Does It Work?
As mentioned, alternative lending surged into prominence as they filled the void left by banks, offering middle-market businesses speedier and more accessible loan processing via online platforms.
This is particularly crucial when a small or medium-sized business has an urgent need, as when there is structural emergency or a supply shortage, and time is of the essence. But generally speaking, such loans further the growth initiatives of these enterprises, whether that be opening another location, adding staff, or pursuing an acquisition. Whatever the case, alternative lenders have become a viable option for these small and middle-market businesses.
The loans they offer tend to range anywhere from $5,000 to $5 million, and are usually three to five years in duration. And many of these lenders focus on market sectors that are often spurned by the big banks, such as Software as a Service (SaaS). As a result, alternative lenders have become an important source of financing for small businesses around the world, promoting innovation.
Pros & Cons
As with any type of lending, there are pros and cons to pursuing alternative finance.
Advantages of alternative lending include the easy application process and speed of approval, as well as the flexible underwriting terms and the diverse types of funding that may be available. In fact, some businesses may move from application to funding in a matter of days, and this can be significant for businesses that need a cash infusion quickly or have a short-term opportunity that could help them to grow in the future.
While some types of alternative lending — like SBA loans — may offer single digit interest rates in line with traditional bank loans, others can be more expensive. Medium-term loans or business lines of credit, for example, may incur APRs varying from 7-30 percent, while others like short-term loans or merchant cash advances can be even more costly.
However, most traditional bank loans are not available to small and middle-market businesses in the first place, so the comparative cost savings from traditional loans may not be accessible to the average business owner.
Some types of alternative lending have higher costs and risks than others while others offer smaller loans with shorter repayment terms. The options available vary from business to business. In general, faster loans that are easier to qualify for also have higher interest rates, while those requiring the strictest, slowest process also have the most affordable rates.
Another significant advantage of alternative lending companies is their approval rate. While in 2018 the approval rate for bank loans hovered around 26 percent, that same rate reached 56.6 percent for alternative lenders.
Common Types of Alternative Lending
Alternative lending comes in many forms, and there are a variety of options to explore for small and mid-sized businesses. Here are some of the most common types of alternative lending to consider.
Type 1: Direct Lending
Put simply, direct lending provides bank-type loans without a bank. The cutback in business lending from traditional banks has led to a flourishing market for alternative lending companies that offer direct loans, like a bank, but without the surrounding bank structure.
Direct lenders, including business development companies, raise capital from investors to fund leveraged loans to borrowers. Their borrowers could include small and mid-sized businesses, entrepreneurs or even other investors — exactly the type of borrower banks have shied away from in recent years. Therefore, it could be said that direct lending bridges a major gap in the market. It provides both businesses and investors with significant growth opportunities that may be otherwise unavailable to them.
Investors want to enjoy predictable success — i.e., high yields and strong returns — while businesses are looking for capital to grow. While direct lending is not regulated in the same way as bank loans (therefore involving some risk for investors), it often serves clients with a high level of dedication and commitment to success. Direct lending funds often show strong yields and consistent returns for investors, encouraging the market to grow further and opening up new streams of funding for previously excluded businesses.
Asset managers in the alternative lending industry raise capital from interested investors, review applications from debt advisors and investigate companies to determine how to best deploy their funding. Unlike other types of alternative finance, direct lenders may offer long-term loans with significant repayment periods.
Business development companies (BDCs) offer support and advice to the companies that borrow from them and often pursue multiple funding rounds for their borrowers. Direct lending may be offered at different priority levels: A direct loan may be offered as a first lien, or senior debt, which enjoys priority in case of a bankruptcy or default. Other direct loans may be offered as a second lien or junior/subordinated debt, typically if a first lien is already in place.
Direct lenders also offer unitranche debt options, making use of a hybrid model that combines both senior and subordinated debt into one loan, which may lower costs and allow for greater financing in one round. These diverse options mean that direct lenders may be able to craft alternative lending options that work for a wide range of borrowers.
And for investors, the appeal continues to grow. As an example, the Arizona State Retirement System announced in 2019 that it was increasing the fund’s investment in direct lending to 17 percent of the $41 billion pension fund. Managers touted direct lending’s ability to “replicate what we could do in the public markets but in the private world.”
Type 2: Venture Debt
Venture debt is another type of alternative lending, often conceived of as an alternative to venture capital, especially for businesses that do not want to lose any more equity to investors. Business development companies, along with private equity firms, hedge funds and even some banks, may provide venture debt options. This alternative funding option is typically pursued to obtain capital for a specific project or opportunity, much like the type of initiative that might prompt a typical venture capital investment.
Many founders do not want to give up an even greater equity share in their companies by seeking another round of venture capital financing, even if they have raised multiple successive rounds. Venture debt offers an attractive alternative to many promising startups, with even major players in the field like Airbnb and Uber opting for venture debt to fund new projects.
Venture debt can be an excellent counterpart to equity financing rounds. It can provide valuable capital for growth, with a significantly lower long-term cost in terms of equity than successive equity financing rounds.
At the same time, it is important to carefully consider the decision to pursue venture debt. This is not necessarily the best choice for a company with uncertain or questionable finances, as venture debt is typically a form of first lien or senior debt. If a company is unable to pay back a venture loan, it could face bankruptcy or repossession. Nevertheless, for entrepreneurs with a strong basis for success, venture debt can provide a lower-cost, more accessible financing option that opens new doors to opportunity.
Type 3: Structured Equity Products
Structured equity products come in many forms. Designed for small and mid-sized businesses that want new funding for growth, these options are offered by alternative funding companies such as business development companies or individual investors. These may offer flexible funding that does not affect business owners’ equity stake while at the same time providing access to capital.
A structured equity product created by a business development company is a pre-packaged investment option that typically involves the issuance of bonds or other debt securities by the borrowing company. They may involve an array of investment products alongside debt securities, including stocks, currencies, commodities or derivatives. In essence, these investments are bonds intertwined with long-term equity indexes. Because they are linked to equity indexes over the long term, they are not subject to immediate market fluctuations. However, there is always a concern with this type of product about the potential to fall prey to market trends over the term of the structured product.
Type 4: Debt Financing
There are multiple forms of debt financing offered by alternative lending companies. Here are some of the most common forms that small and mid-sized businesses may turn to for capital.
Non-Bank Cash Flow Lending
Cash flow loans are also referred to as enterprise value lending. For businesses with a significant upside in terms of growth but limited physical property, this form of alternative lending may offer great potential. Business development companies (BDCs) that offer cash flow lending rely on the potential growth of a business to underwrite and secure a loan, rather than relying on tangible assets like the value of equipment or real estate.
In essence, a cash flow loan is borrowing based on the money you expect to make in the future. Alternative finance companies like business development companies have advanced software and algorithms to analyze business cash flow potential, reviewing data like transaction volume, expenses, seasonality and customer loyalty in order to determine the potential for future growth. Cash flow loans do not focus on a business’ tangible assets but rather its growth potential.
This type of loan may require a personal guarantee from the business owner, but it can offer substantial access to debt financing for businesses with a strong upside. In addition, alternative lenders like BDCs work with their borrowers to make these loans a success, offering professional guidance and flexibility that banks do not.
Recurring Revenue Lending
Another intriguing type of debt financing is recurring revenue lending, particularly for companies with subscription-style services or other products with high levels of customer loyalty. For example, recurring revenue lending based on annual recurring revenue (ARR) or monthly recurring revenue (MRR) may be an excellent choice for a software-as-a-service (SaaS) company.
This type of company may have few tangible assets but very strong and predictable recurring revenue to come in the future. Their clients may schedule months and years of payments in advance to continue to rely on a valuable software system, and changing SaaS providers can be an extensive and costly undertaking.
Here, a business development company can assess ARR or MRR rather than more traditional methods of evaluation like past-year profitability. With predictable revenue to come, recurring revenue lending can be an excellent option for businesses to grow into profitability with strong customer loyalty, planned revenue projections and a positive customer renewal rate.
In addition, recurring revenue lending can also serve as a line of credit for ongoing financing for a small or midsize enterprise, and the borrowing limit can grow along with the business’ success.
Home Equity Loans/Lines of Credit
Home equity loans are familiar to many consumers, not only small business owners. Because small businesses are often deeply tied to their founders, some entrepreneurs may be willing to explore a small business home equity loan.
If you already own a home and have significant equity on it, you can borrow against that equity to finance your business rather than other typical uses for a home equity loan such as debt consolidation or home improvements.
Home equity loans and home equity lines of credit (HELOCs) are often easily accessible and relatively affordable, with attractive interest rates. At the same time, there is a high level of risk involved in taking a home equity loan to fund a business. The debt lies with the owner, not with the business itself, and your home could be at risk in the event of a loan default. Other options offered by alternative lending companies may provide similar advantages with fewer personal risks.
Debenture
A debenture is a type of bond or debt instrument backed not by collateral but by the company’s performance and reputation. Does it, for instance, boast solid credit? For this reason, the more well-known and reputable companies — ironically, the ones who can probably gain access to other types of funding — may benefit the most from debenture.
Because it is an unsecured loan certificate, many investors may hesitate to opt for a debenture issued by a startup, while they may find those issued by major corporations or national governments to be a solid investment.
These, unlike other forms of alternative lending, are largely based on your company’s credit rating. Some small and mid-sized businesses may be able to secure financing through these types of bonds, but other types of alternative lending may be much more accessible and affordable.
Type 5: Mezzanine Financing
Any business owner can only offer so much equity to investors in exchange for capital. At the same time, lenders may have a cap on the amount of capital they want to invest, leaving a business owner to make up the difference.
Mezzanine financing is a way of bridging that gap and completing the transaction, with advantages for both parties. That aspect is even reflected in the name of this type of product. Mezzanine debt draws its name from architecture, as a mezzanine is an intermediate story between two floors.
Mezzanine financing is typically subordinate to a pure equity stake held by the same investor, but it is also a senior form of debt and takes priority over a typical loan. In many ways, mezzanine financing can be more like a form of stock than traditional debt, because it can typically be converted into stock depending on the options embedded in the financing deal.
Mezzanine debt has grown as an attractive financing option from its origins in the 1980s when it was initially offered by insurance companies and savings and loan institutions. Later, limited partnerships, pension funds, hedge funds, leveraged public funds, insurance companies and other alternative lending companies entered this growing space.
Type 6: Non-Dilutive Funding
Non-dilutive funding, also known as non-dilutive financing or non-intrusive capital, does not require the business owner to give up an ownership share. This doesn’t mean that non-dilutive funding is “free” — most forms of non-intrusive capital need to be paid back, and requirements and restrictions may be attached to a grant.
These options may be particularly beneficial to smaller, newer companies with an interest in research and development, and various types of non-dilutive funding may be backed by the government in order to encourage business growth.
One recent example of a non-dilutive fund is the Paycheck Protection Program, which was instituted by the federal government in response to the coronavirus pandemic. No fees were charged, and the loans were fully forgiven if at least 60% of the forgiven amount was used on payroll. For those businesses that fell short of that threshold, the loans had a maturity of at least two years and an interest rate of 1 percent.
The advantages of this type of funding, where available, are obvious, but options may be limited in scope or restricted to certain types of businesses, at least absent a major national initiative like the PPP.
What To Look For In An Alternative Lending Company
You know that your business could benefit from an alternative lending company’s approach to small or mid-sized business financing. How do you decide what to look for when choosing a business development company? There are several key factors to keep in mind.
The top points to look for include:
- Simplicity: Is this lender easy to work with and understand?
- Speed: How long does it take for approval and disbursement?
- Flexibility: What options are offered for repayment and financing?
- Approval rate: How likely are you to get the loan you need?
Other factors to consider are lending options and requirements, transparency about fees and interest rates and whether the staff is willing to go the extra mile. A dedicated business development company (BDC), for example, can offer more than just a loan; these alternative lending companies often offer business advice, multiple rounds of funding and other tools and resources for success.
Remember, flexibility matters. So too does the reputation of a given lender. “You want to understand who your lender is before you become wed to them in a credit facility that is going to last five to ten years,” said Mike Bielby, a finance lawyer.
While banks have grown increasingly leery of lending to small and medium-sized businesses — especially due to increased regulatory burdens — middle market businesses still have access to significant funding opportunities thanks to these alternative finance companies. With a streamlined loan process and easy access to capital, alternative lenders are a far more appealing option, presenting a feasible ladder to growth and future profitability.