Ever since the credit crisis began three and a half years ago, small businesses have found it tough to get loans from traditional banks.
Although many of the larger banks claim to be expanding their small business lending programs, the reality is that nine out of 10 loan applications are typically rejected, according to Biz2Credit, and the total number of bank loans to small businesses have fallen 17 percent since October 2011, according to Pepperdine University.
Why aren’t banks lending? It’s a complicated issue, but it generally comes down to the fact that banks haven’t fully recovered since the 2008 financial crisis and many of them wouldn’t be around today were it not for the Troubled Asset Relief Program (TARP). Many of these banks are still exposed to bad U.S. mortgages and risky investments in Europe, which have prevented them from taking on new lending risks.
The big banks know they can’t rely on a second TARP if they end up in difficult financial circumstances again, so they’ve become extremely risk adverse. Small businesses carry a higher risk of default than their corporate counterparts and they aren’t particularly profitable to begin with; as a result, banks are reluctant to expose their books to this type of lending.
This is one part of the liquidity crisis facing small businesses. The other factor at play here is that accounts receivables are taking longer to be satisfied. According to Experian, larger companies now take 28 percent longer to pay their bills.
Until bank lending steps up, small business growth will remain stagnant due to slower cash flow, and that impacts the whole economy. Many economists believe this is adding to the country’s high unemployment, sluggish recovery and declining household net worth.
Small businesses are the engine that drives our economy; they employ half of all private sector employees, generate 65 percent of all new jobs in the country and pay 44 percent of the nation’s private payroll, according to the U.S. Small Business Administration. But without sufficient financing or liquidity, these smaller companies can’t expand their operations, invest in new equipment or fund new research and development. Often, they can’t hire new employees and in many cases have to lay off existing staff.
In this tough economic environment, when large banks are no longer an option, small businesses need to take advantage of alternative financing. Here are seven alternatives to the traditional large bank loan for small businesses:
1. Credit Unions and SBA loans: Small businesses turned down for a bank loan should turn first to local credit unions or the Small Business Administration. According to BizRate, credit union loan approvals have slightly increased compared to their banking counterparts. SBA-backed loans – for example, 7(a), 504, micro loans - are another healthy option if good business credit exists with at least two years of tax returns.
Best for: Any business at least two years old, with good credit rating.
Pro: Reputable lenders, reasonable terms and interest rates.
Cons: Credit requirements only slightly less than traditional bank loans.
2. Asset-Based Lending: Every company has some type of asset that can be borrowed against. It could be inventory, work orders, equipment, machinery, raw materials, leasebacks, or even securities. By working with a knowledgeable broker, many businesses can leverage these existing assets to secure a much-needed source of cash flow for working capital.
Best for: Businesses in manufacturing, industry, real estate or any company with substantial equipment, products or work orders.
Pros: Loans can be approved regardless of credit rating or track record. And short-term loans can be relatively low-cost.
Cons: Higher interest rates and the lender can legally seize these assets upon default.
3. Factoring: Accounts receivables are another asset that a company can borrow against - and many specialist firms are very interested in doing so. Think of it as a loan against future payments. Lenders pay the money in advance and can also oversee collections.
Best for: Any company to whom monies are owed.
Pros: Same benefits as asset-based lending, and more financial companies are willing to lend this way.
Cons: Interest rates can range from competitive to high.
4. Business Line of Credit: Business owners with good personal credit can take out a business line of credit (BLOC), which is typically for smaller loan amounts in the $25,000 to $100,000 range.
Best for: Individuals/partners with solid credit (700+).
Pros: Good way to provide quick cash flow or start-up seed capital.
Cons: Rigorous approval process to get the line; based on personal credit.
5. Private Equity: Owners can also sell a stake in the business to private investors, similar to what takes place on the reality show ‘Shark Tank.’ Bringing on new investment partners can be an effective way to raise cash and improve liquidity.
Best for: Start-ups or companies that expect high annual growth rates, such as product manufacturing, tech, financial service firms, real estate.
Pros: Bypass banks and other lending institutions and still raise large sum of cash.
Cons: Business gives up autonomy to new partner; can be challenging to find qualified private investors; and requires thorough due diligence on the business.
6. Mezzanine Financing: A short-term high-interest loan that can offer considerable leverage for certain types of businesses. Think of it as a second mortgage on a business. Companies often use this to make real estate purchases or to acquire another business. The holder of the note charges a higher interest rate compared to conventional loans, which it takes out through payments on the debt, added interest to the debt and an ownership stake in the company.
Best for: Companies in the midst of an acquisition or restructuring debt, or real estate development firms.
Pros: Offers considerable leverage.
Cons: High interest rate and may take a stake in company.
7. Hard Money Loans: A high-interest loan that should only be used if a business has run out of options. This also should be considered a short-term (one year or less) option due to the high cost. To get the loan, the business will have to use its real estate as collateral and typically will only receive a maximum of 65 percent loan to value, usually at an interest rate of 15-20 percent, but it can go as high as 29 percent.
Best for: Real estate, manufacturing or any ongoing business that can’t get a loan elsewhere.
Pros: Loan of last resort for companies that can’t get any other type of financing.
Cons: High interest rate and potential low loan to value.
David Sussman is CEO of Valcor and founder of the International Association of Business Mediation Consultants. He is a small business advocate who specializes in small business restructuring, debt mediation and capital acquisitions services.
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Has your business had success or failure with one of these methods? Should small business owners check out another alternative? Please share your experience in the comments below.