If you’re a small business, you don’t need to be told that small businesses were hit harder than large ones during the financial crisis. Bank loans, especially those for less than $350,000, dried up. Small businesses—especially Main Street firms—couldn’t get the money they needed to maintain cash flow, hire new employees or purchase new inventory or equipment to grow their businesses.
But, as the saying goes, one man’s trash is another man’s treasure. “Emerging online players are filling the void left by many banks, and pushing innovation within the banking sector in the same ways in which other online upstarts such as Amazon.com changed retail and Square has changed the small business payments business,” wrote Karen Gordon Mills and Brayden McCarthy in The State of Small Business Lending: Credit Access During the Recovery and How Technology May Change the Game (PDF), a Harvard Business School working paper.
Whether online or offline, alternative lending caters to customers who need cash but might not qualify for traditional bank loans. It’s even attracting some small businesses that would otherwise qualify for a cheaper traditional bank loan but don’t want to deal with the traditional hassle. In these cases, some businesses determine that the flexibility that comes with alternative lending is worth the extra cost.
Online alternative lending sources have grown dramatically over the past few years, doubling every year compared to a decline of about 3% in traditional banking sector lending. Though growing rapidly, online alternative lending is only a $10 billion industry, accounting for only about 1% of all lending.
In addition to new pools of capital, alternative lenders also provide simplicity and convenience in the application process, quicker access to capital and a greater focus on customer service, according toThe State of Small Business Lending.
Many offer both online and mobile applications that borrowers can complete in fewer than 30 minutes, compared to the 25-hour average completion time typical for the traditional bank application process. In exchange for that ease of access, alternative lenders take more risk, and thus charge you for doing so. Big banks’ approval rate for small business loans was 21.7% compared to 61.0% for alternative lenders, according to Biz2Credit Small Business Lending Index for April 2015.
As a small business, you can benefit from theses streamlined processes and higher approval rates, provided that you understand your options.
Online marketplaces work like exchanges, centralizing and streamlining the loan application process. By filling out a single application through a marketplace, small businesses can connect with a range of traditional and alternative lenders, allowing them to choose the loan that is best suited for the business. Companies in the space include Biz2Credit, Fundera and Lendio.
Small businesses can comparison shop for a range of loan products, from term loans and lines of credit to merchant cash advances and factoring products (advancing cash on the basis of accounts receivable). Each option is offered by a variety of sources, including alternative lenders, conventional banks and everything in between.
Direct lenders, such OnDeck, Kabbage and Fundation, use proprietary risk-scoring models to determine the health of a business. They base their decisions on non‐traditional data like cash flow information from bank accounts and QuickBooks entries, merchant account information and more. Loans are usually short‐term (i.e. shorter than nine months) and come with high interest rates.
Peer‐to‐Peer (P2P) Lending
P2P lenders connect capital from institutional and retail investors with small businesses via platforms such as Lending Club, Prosper and Funding Circle. The platforms make loan decisions based on a proprietary credit model. P2P lending is a proven model for lending to consumers that has only recently been extended to small businesses.
Also known as “invoice financing,” this type of financing provides small businesses with growth capital in exchange for paying the financing company a small percentage of future revenues. It’s technically a loan, but there are no fixed payments, no set time period for repayment and no set interest rate.
Small businesses pay a fixed percentage of their revenue, so payments are directly related to how much revenue the company makes. Companies like Lighter Capital use a tech-enabled application to offer this type of financing.
Not to be forgotten are other forms of funding such as crowdfunding, which pools money from a group of people via online platforms using social and traditional media. Two types of crowdfunding, rewards- and equity-based, are both relevant to small businesses.
- Rewards-based crowdfunding: Funders receive a tangible item or service in return for their money. Some businesses collect the cost of the item from customers before the product is manufactured. Some use funders to beta test products, while others raise money in exchange for a token gift. Websites, such as Indiegogo and Kickstarter, coordinate the transactions.
- Equity-based crowdfunding: Investors receive a stake in the company. Currently, only friends, family and accredited investors in the United States can invest in a company for equity via crowdfunding platforms. They can do so through websites such as AngelList, CircleUp and Crowdfunder. So far, the SEC has only approved the rules and regulations regarding raising money from accredited investors, which is covered by Title II of the JOBS Act. This may change in October, when the SEC is scheduled to release the rules and regulations regarding Title III, which allows non-accredited investors to invest in small businesses.
Finally, there is an array of offline funding sources that includes credit unions, Community Development Financial Institutions (CDFIs), merchant cash advances, equipment leasing and factoring products.
Technology plays a minor role in funding small businesses today. But as more and more small businesses discover the ease of use and speed of transaction technology brings to lending, it is likely it will disrupt the way traditional banking is done in much the same way it has disrupted other economic sectors.
For more information on funding sources for your small business, read our article on understanding equity financing.
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