Having regular access to working capital is essential to the success of any organization. Which is why all startup and small business owners often find themselves in a situation where they need to secure additional capital.
Typically, bank lending is the most common form of raising money (from external sources) for entrepreneurs and small- and medium-sized business owners, who rely on traditional debt to fulfill their cash flow needs. Unfortunately, they frequently get turned down by big banks when they need capital.
Over the last few years, banks have become notoriously selective when it comes to giving companies the money they need — even those with a solid track record and strong financials. This is because banks require prospective lenders to present sizable collateral, consistent cash flow or a strong debt-to-income ratio (percentage of a company’s gross monthly income that goes into paying monthly debt payments) in order to qualify for a bank loan.
In such situations, considering the difficulty of securing a bank loan, startup and small business owners often turn to nonbank and alternative lending solutions. Nonbanks are financial institutions that despite not having a full banking license offer different lending options to entrepreneurs and small business owners. Whereas, alternative lending is a lending practice where funds are provided outside of the traditional banking system.
Alternative lending has become a far more attractive option for startups and small businesses who may be looking to raise capital in order to expand their operations, drive growth or acquire a company. In fact, the alternative lending market has grown tremendously since the 2008-09 financial crisis. In fact, according to research by the University of Cambridge’s The Global Alternative Finance Market Benchmarking Report, the U.S. is the second-largest alternative finance market in the world (only after China) with $61 billion in alternative lending, while the U.K is the third with $10.4 billion. And now, the coronavirus pandemic has only given a boost to the growing alternative lending market.
In this article, we discuss the four main types of alternative lending options, namely, direct lending, venture debt, cash flow lending and debenture lending.
In simple words, direct lending is a type of credit provision that provides bank-type loans without a bank — it cuts out all sorts of middlemen such as brokers, investment banks and private equity firms. Just like private equity firms, direct lenders raise capital from external investors to fund leveraged loans to borrowers. The borrowers are usually expected to pay back the principal amount along with the related incentive and management fees within a few years.
Considered an alternative to venture capital, venture debt is a financial product used mostly by startups and early-stage businesses, especially those that do not want to over-dilute their equity stakes and lose their ownership rights to investors.
Private equity firms, business development companies and hedge funds are some institutions that provide venture debt to borrowers. This type of alternative funding is typically used to raise funds for a specific project.
Cash flow lending
Also called enterprise value lending, cash flow lending or loans allow businesses to raise capital against their projected earnings. Essentially, lenders that offer this type of loan usually rely on the potential growth of a company in order to underwrite and secure a loan, instead of relying on tangible assets that the company owns, including the value of equipment or real estate.
A debenture is a type of bond or debt instrument that is backed by the business’ performance and reputation, instead of collateral. In order to raise money through this type of alternative lending, the borrower is required to furnish a strong credit score and/or repayment history.
For a lot of small- and medium-sized businesses, alternative lending solutions are some of the only viable options available for raising capital. Fortunately, these options are not only accessible, flexible and can be acquired quickly, they sometimes work out better for a small business than traditional bank loans.