Introduction to Financing that Fits
When it comes to finding financing for your business—you’re looking for a “yes!” During the hard economic times brought on by COVID-19, finding that “yes” can feel like searching for a needle in a haystack. While it may be disheartening, it’s important to keep two things in mind:
- You aren’t alone. There are thousands of small business owners who were hit just as hard—or even harder—by the pandemic. They have felt the impacts not only in revenue and income, but also in the way they access funding.
- When you’re unable to qualify with a bank or credit union, you still have small business funding options available.
Just because your business is unable to qualify for traditional financing at this time—whether due to COVID or something else—doesn’t mean you should give up on your pursuit for capital.
In this guide, we’ll explore various alternative financing options so you can pursue the right one for your business.
Traditional Lending Requirements
While terms can vary by lender, the majority of traditional lending institutions require businesses to meet certain criteria to receive funding.
The first is collateral. If you’ve ever applied for a business loan through your bank, you know the importance of collateral. Banks and other traditional lenders require business owners to put up a certain amount of collateral—or tangible assets—as a guarantee that the loan will be repaid in case of default.
Most traditional lenders will require you to have a minimum of one dollar in collateral for every one dollar you request to borrow. If this seems impossible for your business, you should know you aren’t alone. Many business loan applicants lack the required amount of collateral, also known as collateral deficiency. If you’re unable to secure your business loan with the proper amount of tangible assets, alternative financing products can provide you with viable solutions.
The second common requirement for a traditional business loan is a proven track record. If your business is well-established, this won’t be an issue. For startups and businesses exploring new areas of opportunity, on the other hand, this can seem like a challenge.
If you fall into the latter category especially, then you need access to capital that’s as dynamic and entrepreneurial as you are—which means finding alternative financing solutions outside of your bank or credit union.
Alternative Financing Options
While bank loans are a great source of funding for businesses with a proven track record of profitability and collateral, new and growing businesses are often unable to qualify for conventional small business funding. If your business is in this stage and in need of financing, alternative forms of funding like an SBA loan, financing from a Community Development Financial Institution (CDFI), or a business loan from fintech lender may be available.
The Small Business Administration (SBA) partners with banks and other lenders to offer guaranteed business loans to those who are not yet able to qualify for traditional financing.
The SBA does not provide loans, but establishes guidelines for partnering lenders, micro-lending institutions, and CDFIs to grant loans to small businesses. By assuming a large portion of the risk, the SBA is able to reduce risk for lenders while making capital more accessible for business owners.
The SBA 7(a) loan program is the organization’s most common financing option for small businesses.
Terms & Conditions
The Standard 7(a) term loan is guaranteed by the SBA for up to 85% of the loan and interest rates are determined by the lender (but cannot exceed the SBA maximum of Prime + 4.75%). The maximum loan amount is $5 million, with terms up to 25 years for real estate and 5-10 years for equipment, machinery, and working capital. The 7(a) loan can be used for new construction, land or building purchase, fixtures, working capital, refinancing existing debt, inventory, and starting a business.
SBA 7(a) loans are more accessible than conventional loans, but borrowers are required to meet certain criteria for approval. For your business to qualify, you must:
- Be a for-profit business
- Meet SBA size standards
- Demonstrate good character
- Have good credit and management skills
Along with more flexible approval requirements, there are several benefits to the SBA 7(a) loan program:
- Long-term financing
- Fixed maturity
- No balloons
- No prepayment penalty under 15 years
SBA Community Advantage
The Community Advantage Loan Program is a mission-focused pilot program introduced by the SBA. It was introduced to make funding more accessible to women, veteran, and minority business owners, and improve the overall economy throughout underserved markets.
Terms & Conditions
Aside from providing education and critical resources to borrowers, loans granted through the Community Advantage (CA) program feature low-interest financing with reasonable terms. CA loans are capped at $250,000, and have maximum interest rates of Prime plus 6%.
Qualifications & Benefits
Borrower qualifications and benefits are the same as 7(a) loans, but lenders must be certified as one of the following:
- Community Development Financial Institution (CDFI)
- Community Development Corporation (CDC)
- SBA Intermediary Lender targeting underserved markets
The SBA 504 Loan Program grants businesses access to long-term, fixed-rate financing for the purposes of expansion and modernization. SBA 504 loans are only available through CDC lenders who are certified and regulated by the Small Business Administration. CDCs work with the SBA and partnering lenders (usually banks) to grant loans to businesses with the intent of community economic development. 504 loans can be used for long-term, fixed-assets including owner-occupied commercial real estate.
Terms & Conditions
The maximum amount for a 504 loan ranges from $500,000-$5.5 million with a 10-, 20-, or 25-year fixed interest rate (the exact amount depends on the type of business and scope of the project). 504 loans are structured through three parties: the lender, the CDC, and the borrower. The lender typically finances 50 percent, the CDC finances 40, and the borrower is responsible for the remaining ten percent down payment.
SBA 504 loans are more accessible than traditional options, but borrowers are still required to meet approval criteria. For your business to qualify, you must:
- Be a for-profit business
- Not exceed $15 million in tangible net worth
- Not have an average net income of more than $5 million over two full fiscal years
- Occupy 51% of an existing building; or 60% for a new construction project
SBA 504 loans feature plenty of benefits to borrowers including:
- Low down payments
- Option to finance fees
- Long-term fixed rate
- Full amortization
- No balloon payments
The SBA partners with non-profit lenders throughout the United States to provide small businesses and startups with microloans.
Terms & Conditions
Through the SBA Microloan program, your business may qualify for up to $50,000 with maximum repayment terms of six years. Interest rates are negotiable, but are typically 7.75% or 8.5% above intermediary cost of funds.
Like the 7(a) program, microloans are made through non-profit lending organizations licensed by the SBA. SBA Microloans can only be used for nearly any business need, including:
- Inventory and supplies
- Working capital
- Machinery and equipment
- Furniture and fixtures
Qualifications & Benefits
While borrower qualifications are the same as 7(a) loans, Microloan program benefits include:
- Direct access to capital from non-profit, intermediary lenders
- Fixed-rate financing
- Small loan amounts
- Technical assistance
As the fintech industry continues to evolve and grow, so do online loans offered by fintech lenders.
Online lenders typically promise a streamlined application process, quick approval times, fast funding, and more flexible approval requirements. While this may be the case with some fintech lenders, it’s important to assess each online loan option independently.
Before accepting any business loan—online or otherwise—it’s important that you take the time to assess the entirety of the situation to determine if it’s the right choice for your business. Online fintech lenders tend to be more transactional than CDCs, CDFIs, banks, and credit unions. If building a relationship with your lender is important, an online business loan may not be a good fit.
Be sure to obtain information on the lender’s interest rates, fees, and repayment terms before moving forward to ensure the loan will work for your business now and in the future.
Similar in concept to peer-to-peer lending (P2P), crowdfunding allows multiple investors to lend small amounts of their own money to a business or project. Businesses are able to raise the money they need for either future repayment or in exchange for equity in the company. Platforms typically charge a finders fee for connecting businesses with a large audience of investors.
There are currently dozens of crowdfunding platforms available online, with more cropping up every day. The most reputable options include Kickstarter, Indiegogo, and Crowdfunder.
Understanding Loan Terms & Conditions
Familiarizing yourself with these common loan terms will help you better understand the business lending landscape.
APR vs. APY
Annual percentage rate (APR) and annual percentage yield (APY) are two distinct rates that have an impact on business loans. A main difference is that APR doesn’t take compounding into play, while APY does.
Compounding refers to your loan interest accumulating more interest on top of it, which can happen on a daily, weekly, monthly or annual basis. With that, APY is higher than APR.
As a business owner, it may seem advantageous to pay off your loan early—but doing so can result in fees. Lenders won’t be able to collect as much interest if the loan is paid off early, and will likely charge prepayment penalties to cover the lost income. Be sure to look for these in the contract before signing.
Secured vs. Unsecured Loans
Secured loans use collateral or a business asset to secure it. For example, a car loan is secured by the car, which can be repossessed if the borrower fails to make payments.
Unsecured loans aren’t backed by collateral, and typically have higher interest rates than loans that are secured. The most common example of an unsecured loan is a credit card.
Five Cs of Credit
When deciding whether to approve your business loan, lenders will consider some—if not all—of the “Five Cs of Credit.” These include:
- Character: Determined by your credit score and credit history
- Capacity: Refers to your ability to repay the loan and is based on your income and general financial obligations
- Collateral: Tangible assets that can serve to repay the lender in case of default (secured loans only)
- Capital: Any savings or assets that the bank can claim if you stop making payments
- Conditions: How you intend to use the loan funds
Predatory Lending Red Flags
Choosing to work with an ethical lender with efficient processes may seem like common sense—but unfortunately, some unscrupulous business loan companies have tarnished the industry’s reputation, making it slightly more difficult to find a reputable lender. Be aware of the most common predatory lending red flags, so you’ll be less likely to fall victim.
Here’s what to look out for:
1. High-pressure sales tactics including cold calling
Most legitimate lenders don’t need to cold call hundreds of businesses for approval. Instead, they rely on networks, referrals, online marketing, and other sources. Be cautious of a lender who randomly cold calls you, especially if you haven’t completed their loan application. You should also be wary of anything that seems too good to be true, or comes off as an overpromise—because it probably is.
While it doesn’t happen often, there are lenders who purposely offer exceptional terms and low interest rates up front, only to change them once the paperwork has been signed. This bait and switch technique is illegal, but still happens.
2. Excessively expedited processes
As tempting as it is to work with a lender who promises fast cash, never allow that temptation to rush you through the loan application process. Give yourself plenty of time to read the paperwork, ask questions, and sign the contract. Don’t be fooled by lenders who use false urgency such as a special promotion to rush you into signing before you’re ready.
Instead, here’s what you should do before signing on the dotted line:
- Evaluate multiple lenders
- Slowly analyze contracts
- When in doubt, consult a lawyer
If you’re rushed through the process, you might miss some of the fine print like penalty terms, taxes, cost of insurance policies, and other hidden fees.
3. Unclear or aggressive terms and conditions
If a loan seems too aggressive (i.e. excessive interest rates, fees, and penalties) or unclear, seek guidance from an attorney or another third party resource before singing on the dotted line. Unclear or outrageous terms and conditions are a major red flag and can signify a predatory lender.
Avoid certain types of loans
While it might be tempting to look into other forms of financing like payday and income tax refund loans—these financing packages usually come with high fees, excessive interest rates, and uncommon payment schedules such as daily or weekly payments.
Also, avoid lenders who only work with bad credit applicants or who are willing to lend to anyone. Legitimate lenders have credit and revenue standards in place to protect all parties involved.
Is it a good fit for your business?
Whether you suspect a predatory lending situation or not, it’s important to always ask yourself whether the loan is the right fit for your business. Remember: a “yes” from a lender does not automatically mean a “yes” from you.
As exciting as it is to get approval for a business loan, make sure you can meet the full terms of the debt obligation and have a reliable way to pay back the loan. By taking the time to do your due diligence, you’ll increase your chances for success and decrease the odds of an early default.
Most businesses start from humble backgrounds and will eventually need a business loan to expand. Yet, there are many nuances regarding loan terminology, types of loans, different lending companies and the requirements for each one.
We hope this Business Owner’s Guide to Alternative Financing equipped you with the fundamentals of acquiring business financing like basic terms, predatory lending warning signs, popular alternative financing options, and applicable loan scenarios for your needs.
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