It’s not easy to grow a business. Reliable, desirable products and increasing customer demand does not always translate to more revenue. It’s a positive thing when a customer places a new order with you, but this often involves buying more inventory, paying manufacturers to fill orders, and hiring the right people to pack, ship, and deliver the goods.
There is no shortage of reasons why businesses of all sizes will seek additional financing to invest in growth. However, many businesses have difficulty obtaining financing with traditional banks and financial institutions.
Thankfully there are alternative financing solutions available in the modern marketplace that are designed to better serve businesses with limited or imperfect credit histories. Here we explain some common examples of alternative financing and where it is more suitable than a mainstream loan.
Traditional Loans Explained
Traditional lenders are the banks, credit unions, and other mainstream institutions that have long been used by individuals and businesses as the most common sources of finance. These are often the first option considered for individuals and businesses looking to take out a loan.
The size and type of traditional bank loans vary. Personal loans and business term loans are the most common. Term loans are taken out over a fixed, agreed time period, where the borrower (debtor) repays the full amount in the form of regular repayments (plus interest and fees).
Qualifying for conventional loans can be challenging—more than half of all applications are rejected. During the approval process, most traditional banks look for strong business or individual credit scores, credit history, collateral, loan amounts, and proof of the financial health of a business.
The specific criteria will vary between banks but a conventional loan will include a set of agreements agreed to by debtor and creditor outlining the obligations of the borrower.
Secured vs. unsecured loans
One important difference in loan types is whether they are secured or not. Secured loans require borrowers to put forward an asset as a security in case of failure to repay, otherwise known as collateral. A common example is property—the loan is considered less risky for the bank because they can repossess the debtor’s property and sell it in order to repay themselves
Unsecured loans, on the other hand, do not require borrowers to put up assets as security. Since this increases the risk profile in the eyes of the bank, they have stricter approval criteria and incur higher interest rates. This option is suitable for businesses with no assets to offer, but they are harder and more expensive to obtain as a result.
The Pros and Cons of Bank Loans
The benefits and drawbacks of each loan will depend on the terms and conditions of the lending institution in question. Here are the most commonly cited reasons why businesses may or may not seek a conventional loan:
- Longer, fixed repayment terms
- Lower interest rates
- Access to larger loans
- Consumer protection
- Relationship with credible, reputable lender
- Strict eligibility criteria
- Long application process
- Limited flexibility
- Collateral requirements for secured loans
Alternative Financing Explained
Alternative financing, as the name suggests, is any funding available outside of traditional banks and lending institutions. These financial products from alternative lenders and others help solve problems that arise with traditional bank loans—such as eligibility, lengthy application, and approval process.
For example, startups and small businesses particularly struggle with having limited credit history, making it harder to instill the bank with confidence in their ability to repay. Alternative lenders often focus on flexibility, for example, by enabling faster approval processes, financing specific stages in the supply chain, and other bespoke solutions.
Some common examples of alternative financing include invoice factoring, peer-to-peer lending, working capital loans, and purchase order financing.
Examples of Alternative Financing
Invoice Factoring: The business sells unpaid invoices to an alternative lender—a ‘factor’—at a discounted rate. The seller uses this transaction to reduce the customer terms and obtain working capital in an expedient manner. This allows the supplier to agree to the end-buyer payment terms, while accelerating the cash flow by selling the receivable upon invoicing.
Revenue-based financing: This method raises capital for a business by offering investors a percentage of the business’s ongoing revenue in exchange for financial investment.
Lines of credit: Although they resemble conventional bank loans, lines of credit are flexible loans that are available from alternative finance providers such as online lending platforms. The main difference from major banks and traditional lenders is that the funding criteria is less strict.
Working capital loans: A working capital loan is taken out to finance a business’s day to day operations. The alternative lender provides funding for small or medium-sized businesses to keep things running. Often this will be when demand is low, or the total cost of doing business has suddenly increased.
Purchase order (PO) financing: A business uses a third-party to meet customer demand by covering supply costs of a specific purchase order. When a customer submits a purchase order but the business does not have enough working capital to complete the order, a PO financer pays the supplier directly to make and deliver products and goods, receiving payment once the end-buyer has paid.
The Pros and Cons of Alternative Financing
The benefits and drawbacks of alternative financing will depend on the specific method used, and some will have more advantages than others. Some businesses will use a number of alternative financing tools together.
- Flexible terms
- Faster access to capital
- No/limited collateral
- More accessible credit terms
- Shorter repayment periods
- Higher interest rates
- Limited availability
Bank Loans vs. Alternative Financing
Business owners know better than anyone that the right financing choice for them is what best supports their business’s needs. Reasons can vary, but common goals include maintaining cash flow and purchasing new equipment while pursuing growth. The right financing method ultimately depends on the specific business situation.
A bank loan will suit businesses who have strong credit and who can afford to wait for funding. They will be harder to obtain for a startup or small business with a limited credit history, but often for these types of businesses, capital requirements are too urgent to wait through a lengthy approval process.
An example of this is with financing open purchase orders. Businesses in retail, wholesale, distribution, and others often need to pay suppliers to complete a customer order, even though it may cause an immediate strain on their working capital. In this scenario, a purchase order business loan makes little sense, as meeting customer demand is a time-sensitive process with a much shorter deadline than a loan application.