Alternative loans for small businesses can accelerate growth or confuse your finances. Here are the basics when looking for funding.
The biggest obstacle most small business owners face is cash flow, with 86% of businesses requiring supplemental funding if they lose two months of revenue. But reliable and accessible funding options (e.g., bank loans, alternative loans) often seem few and far between.
Traditional bank loans offer lower interest rates and reasonable repayment terms, but they can take weeks to process without the guarantee of approval. Business credit cards are easily accessible, but high interest and low limits make them useful only for specific use cases, such as employee travel and one-time expenses. Startups often seek venture capital funding, but less than 1% actually get the money they need.
Traditional loans can take weeks to process, which is why business owners turn to alternative loans.
As a result, small business owners look for another financing option—online lenders and alternative business loans. Unfortunately, while faster than traditional bank loans, alternative forms of small business lending tend to elicit images of shady loan sharks. But that couldn’t be further from the truth.
Before we get into why and how business owners strategically use alternative lenders, let’s go over the different types of lending options.
What are alternative loans and financing?
Alternative loans are essentially any kind of business financing other than a traditional bank or Small Business Administration (SBA) loan or other forms of credit, like a credit card. Generally, small business owners turn towards alternative lending because they cannot tap into traditional funding, whether that be a loan or venture capital. Business credit can take several forms.
Other types of loans
- Short-Term Loans – A short-term loan is a form of credit that should be paid back within a year or less. This is normal for alternative lending and is usually used when a business needs a fast influx of working capital.
- Installment Loans – In this instance, the business owner is given a lump sum of cash, which is repaid with interest over an agreed-upon period. Buy Now, Pay Later (BNPL) is one recent example of this kind of financing—you pay for an item in monthly installments.
- Marketplace Loans – Peer-to-peer lending is the most challenging type of business financing to pin down, as loan terms largely depend on the individual lender.
- Equipment Financing – As a type of short-term business financing, this loan is for purchasing equipment. The equipment itself acts as collateral.
- Merchant Cash Advances – A small business owner turns to a merchant cash advance for immediate access to working capital. But this form of funding is usually a last resort due to high-interest fees and fast repayment demands. Borrowers often pay back this loan through a percentage of their revenue.
- Invoice Financing – A type of cash advance, invoice financing involves business owners receiving working capital immediately based on a percentage of their invoice—usually 70-80%. There is typically a processing fee and a high-interest rate for repayment.
- Invoiced Factoring – Similar to invoice financing, factoring involves taking an advance on an invoice. However, the loan company “buys” the invoice directly and follows up with your clients for repayment.
Loans from family and friends
As a last resort, some business owners seek out friends, family members, and community investors to help with funding. Generally, this can become difficult to manage if contracts and repayment plans aren’t in place. Some platforms, like Ned, have sprung up to help with this form of borrowing.
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Why use alternative financing?
An unethical lender can result in more financial stress than you had before.Many small business owners are wary of alternative business loans—and for a good reason. Partnering with an unethical lender can result in exorbitant interest fees, an unreasonable repayment term, and even more financial stress than before. However, when used correctly and with a flexible, ethical lender, you can use these financing options strategically.
Some reasons businesses turn to lenders are:
- Stabilize cash flow due to late payments
- Buy inventory
- Purchase new, necessary equipment
- Expand to a new location
- Upgrade technology
Ultimately, alternative loans can help a business grow or stay afloat during difficult times. And unlike traditional bank loans, they require less paperwork and a lower credit score. Additionally, business owners typically get funded in days rather than weeks.
Despite the many benefits, business owners should still be cautious when taking out any type of credit.
4 pitfalls to avoid in business financing
1. Failure to accurately calculate interest rates
Loan interest rates can often be tricky to pin down. Ideal rates are fixed and don’t change, but variable rates are often common. But even if the loan rates are straightforward, such as a 14% fixed-rate loan for new equipment, the repayment period can affect the actual calculations.
For example, when you consider the time when reviewing interest rates, short-term loans can be several times higher than the stated interest rate. The shorter the time period, the more interest you are actually paying.
If you take out a $5,000 equipment financing loan at 14% over six months with a repayment plan of $867.69 every month, you will end up paying $5,206.14. If you know you will have additional invoices worth $20,000 coming in after you purchase the equipment, the interest rate may not matter as much as the opportunity. However, your actual APR is closer to 318% because of the short repayment period.
2. Not reading the fine print
A common issue many business owners run into is simply not understanding all of the terms. Generally speaking, an alternative lender who offers a lengthy, convoluted contract may not be the best lender for you. The more complicated the terms, the more red flags the lender raises. For example, the last thing you want is to believe you are paying a fixed interest rate, only to discover it’s hiked up within three months.
Always read the fine print or have a professional look over it for you.
Pick apart any document provided by your lender. This is critical to ensure that your alternative business loans will help your business, not sink it.
3. Choosing the wrong financing option
There are several financing options to choose from, and selecting the right one for your needs can reduce headaches and ensure more favorable repayment terms. For example, invoice factoring is great if you know that your clients will pay and you need money immediately. Since your clients will pay, perhaps the higher interest rates and fees are easier to manage.
However, if you need the funding for new equipment, an equipment financing loan is likely more favorable. This is because the interest rates tend to be lower.
4. Overly relying on financing
Financing is a great tool, and having creditors you trust on hand during a crisis is essential. However, overreliance on borrowed capital can devastate credit and overwhelm your finance team. Keep track of your cash flow and understand general payment patterns. This should make it easier to accurately depict when you might need capital and which lender you can turn to.
You’ve got funds—now what?
While alternative loans can be suitable for small businesses, business financing is just part of the equation. Cash flow isn’t just about finding new sources of revenue – but also how to save money in your budget. You can directly cut expenses from the balance sheet or find ways to optimize processes and boost retention.
Healthcare plans and payroll are two areas that offer high visibility and value to both you and your employees. Check out our healthcare benchmarks or payroll guide to find out how to balance cost with value.