The small business lending market has been primed for disruption ever since the economic downturn began. On one end of the market, you have traditional banks that are conservative in their approach to issuing small-business loans due to risk and profitability concerns. Then, there are merchant cash advance providers that continue to capitalize on small businesses by offering financing at rates as high as 60 to 80 percent on an annualized basis. This bar-bell effect in the market has opened the door for a new segment of online alternative lenders to better serve small businesses.
The current market dynamics require that a borrower thoroughly understand complex lending products and their applications. Far too often, potential borrowers think all lending products serve the same purpose. This is very far from truth. In fact, the market is very fragmented -- from traditional banks to online alternative financing providers. Each offers a different value proposition and serves different applications and customers. For example, getting an inventory loan is far different from applying for financing for, say, employee payroll. That's why it's important for you to understand the difference between loan products and when to use what.
Here are two options for you to consider and what you need to know about each:
Short-term online lending:
Typically, the average short-term loan size is $5,000 to $150,000 with a term of 3 to 24 months. You may be interested in this option because you need cash quickly and have less-than-desirable credit. There's a catch though. Interest rates on these loans can be very high on an annualized basis. For example, a 10 to 15 percent cash advance over a 90 day period will carry up to 10 times the interest rate charged by most banks.
So, why would a small business ever consider this option? There are three key reasons:
- Small loans. Banks typically don't issue micro-loans because it's an unprofitable business for them, so this may be the only game in town.
- Bad Credit. If you have a FICO score below bank standards or with existing tax liens, you might not be eligible for a bank loan but you could still qualify by one of these providers, who are using other measures to determine your risk.
- Speed. These providers can execute a small business loan in a matter of days.
If you're considering this option, the major providers in the market include OnDeck Capital, CapTap, IOU Central and to a lesser extent Kabbage.
Longer-term online lending:
These providers issue longer-term loans with favorable pricing and are most similar to banks. That said, they focus exclusively on $25,000 to $250,000 sized loans with two to four year terms. They also use risk-based pricing to issue loans with rates that are equal or slightly higher than banks. But it's a premium worth paying considering you can receive cash within days as opposed to several weeks if not months when dealing with a traditional bank. The price is also not as high as shorter-term alternatives.
The key player issuing these types of loans is Fundation, which is fairly new to the market. Other lenders such as SoMoLend and Endurance Lending Network are similar but are based on a peer-to-peer business model as opposed to a direct lending platform like a traditional bank. The main risk with these new alternatives is their ability to scale since they don't have a big bank balance sheet and their resources are limited, but the future looks promising.
Regardless of which option you choose, a few things remain clear: Traditional banks remain the cheapest option, yet the slowest to deliver financing. The online alternative lenders are more convenient, but many charge too much. That's why you might be seeing more long-term alternative lenders like Fundation.
The author is an Entrepreneur contributor. The opinions expressed are those of the writer.
Ryan Himmel, CPA and registered securities analyst, is the founder and CEO of BIDaWIZ.com, a professional network for small businesses and entrepreneurs to obtain trusted advice and services from a team of CPAs, Enrolled Agents, Financial Planners & Tax Attorneys. His team provides answers to the many finance and tax questions that small businesses encounter every day. Ryan has been quoted in The Wall Street Journal, Forbes, Fox Business and Crain's New York, among other publications. Ryan also regularly contributes to the community with his finance and tax blog.