Three Reasons for the Rise of Alternative Lending

While the credit market for small businesses has been steadily improving, there are still ups and downs. Small banks are approving more than 50% of business loan requests for the first time since the Great Recession, while big banks, though improving, still approve less than one in five applications. Credit unions seem to have reached their peak, according to the most recent Biz2Credit Small Business Lending Index, which tracks loan approvals on a monthly basis.

As banks remain slow in approving expansion loans and business lines of credit to cover short-term cash flow issues, alternative lenders, filled the void for entrepreneurs in need of funding to cover cash flow issues and other capital needs. The category is filled by tech-savvy entrepreneurs who make money available quickly and efficiently to companies that often cannot secure financing from banks, which tend to be more conservative in their lending parameters.  They offer loans for as little as $5,000 and as much as to $2 million, in my experience.

Cash advance companies, accounts receivable financiers, factors, and micro lenders all have become increasingly more attractive funders for three reasons: flexibility, use of technology, and speed.

Flexibility

Banks essentially cut off the flow of small business credit after the financial crisis in 2008. This left the door wide open for other lenders to fill the void for small business owners in need of startup or expansion capital. Big bank lending parameters became increasingly strict. Even today it is very difficult to secure startup funding from a big bank (assets of $10 billion+), in part, because many of them want an entrepreneur to show 2-3 years of revenue in order to approve a loan. Obviously, a startup cannot provide such information.

Alternative lenders, in nature, are more willing to take risks and more forgiving of low credit scores and lack of collateral. Yes, the funding sometimes comes at a premium price, depending on the lender's requirements and how big a risk the prospective borrower is perceived to be. However, when lending markets tightened, it became difficult to launch businesses by "maxing out credit cards." This severely cut down the funding options for startup companies, as well as once thriving small businesses that struggled a bit during the economic turndown. The flexibility that alternative lenders offered enabled many companies to move forward.

Use of technology

The integration of technology allows for rapid decision-making. Small business borrowers can now upload their financial information onto online portals within a matter of minutes. All the necessary documentation that a lender needs is available quickly and in one place so that they can make informed decisions. By automating the entire process, alternative financers can benchmark a prospective borrower's financial status against industry standards and reports from credit ratings agencies. More information is available now than ever before, and the incorporation of Big Data into the small business lending has streamlined the operation forever. Technology has leveled the playing field as modern money lenders have cut into an arena dominated by the banking industry for centuries.

Speed

Often times, small business owners are more interested in getting their hands on cash quickly than they are in getting lower interest rates. For instance, if a restaurant needs significant repairs after Hurricane Sandy, the owner needs to get them done as soon as possible or else risk being closed during the lucrative holiday season when eateries typically book company luncheons and office parties, as well as less formal gatherings of friends.

Some alternative lenders are able to make instantaneous funding decisions, as compared to the weeks and sometimes months it can take a bank to make an approval of a loan. Even a relatively small request for business line of credit can take three weeks.

There are downsides to using alternative lenders. Their reputation for the longest time was that they were just "one step above a loan shark." Some accounts receivable financers charge interest of up to 20%, whereas a bank loan generally rates between 5 and 7%.

However, the entry of reputable companies such as American Express, which offers merchant cash advance funding at rates as low as 6%, has helped lower interest rates for the entire category. Essentially, a merchant cash advance lender provides short-term financing by purchasing future credit card receipts at a discounted price until the amount of the loan has been returned.

Alternative lenders represent a relatively small percentage of the small business lending space.  However, their role has become increasingly valuable -- especially for individuals pursuing their dream of starting their own businesses and for established companies that may have encountered some rocky times in this still tough American economy.

This opinion column was written by Rohit Arora, co-founder and CEO of Biz2Credit, an online resource that connects small business owners with 1,100+ lenders, credit rating agencies, and service providers such as CPAs and attorneys via its Internet platform. Since 2007, Biz2Credit has secured more than $600 million in funding for thousands of small businesses across the U.S.