Banks used to be the go-to source for all business loan needs; then the 2008 Great Recession happened. After many of the major financial institutions in America came crashing down, the government intervened and required banks to follow strict guidelines when lending money to people and businesses. This created a gap in the market for businesses that didn’t meet the exacting requirements (see: 700 credit score and up, lots of collateral to offer, and several years in business with strong revenue).
Credit Scores Aren’t Everything Anymore
Working capital is essential for spurring economic growth. After the recession, small businesses and businesses with low credit scores needed working capital from somewhere, so the alternative lending industry emerged to serve that market. Alternative Lending is the purchasing of a business’s future receivables at a determined buy rate in exchange for upfront funding. So many of today’s transactions are based on algorithms and AI, but alternative lending gets to know how the business operates before funding them. Businesses are evaluated on their performance and potential, not a stereotyping credit score.
The deals are typically short term, lasting up to 15 months, where the merchant sells their future account receivables at a discount of up to approximately 10-25%. Rates often reflect the risk level of a deal and health of the business, but even deals with high rates are necessary to provide businesses that couldn’t find funding elsewhere the opportunity for growth.
Many business owners seek bank loans because the interest rates are so low; very rarely will you see an APR over 10%. The same goes for SBA loans. SBA loans are bank loans backed by the Small Business Administration, which covers 85% of these loans if a business defaults. But low interest rates mean competitive qualification and tedious amounts of paperwork. Part of the reason for a low approval rate for such loans is because bank loans are long term – often several years. There’s no guarantee a business will still be around in 5 years. Many businesses have gone under and the owners were left with 10-15 years remaining on a business loan that they never generated revenue to pay back.
Since online lenders offer short term funding options, they can serve higher risk companies. A business will likely still be in business in 5 months, so a low credit score of 520 is more likely to get approved. The industry recognizes that low credit scores aren’t indicative of a failing company and can be caused from a number of harmless reasons such as lingering start up expenses, just like high credit scores can be misleading due to nubile operations.
Where Merchants Are Looking For Cash Flow
Funds provided are typically unsecured and can be wired into the merchant’s bank account in a matter of days, sometimes even hours, which is useful when emergencies arise overnight. For example, a transportation company’s truck breaks down or a restaurant’s freezer decides to quit and spoil everything inside and money to fix the problem is needed immediately. Online funders require minimal paperwork and can get the money to the merchants extremely quickly, compared to banks which often take around 6 months to process the money transfer.
A boost in working capital can be used for a number of other things. Sometimes a merchant needs extra funds to bridge cash flow gaps, while others use online lenders to tide them over until a bank loan is approved. Sometimes a business needs upfront funds for expansion, overhead inventory cost, or additional marketing. The needs are vast but until now, the means were always limited.
Fast forward 10 years to 2018. The alternative lending industry is comprised of thousands of companies with funders and brokers providing small to large businesses with over $50 billion in working capital. As the industry grows, more regulations are being put in place to protect the merchants as well as the funders, making it a safer place for everyone to do business. We as an industry continue to serve the underserved market, helping businesses achieve their goals with the necessary additional cash flow that banks and SBA loans cannot provide.
Alex Shvarts is the CTO of FundKite, one of the fastest growing Fintech companies in New York that provides funding to small businesses across the U.S.