Avoiding the Alternative Business Loan Trap
How to Avoid Alternative Lending Traps
If you are a small business owner in need of working capital for your business and you have been denied by a bank you are most likely contemplating acquiring a business loan from a secondary source. Considering the small business lending landscape today and the difficulty that comes with acquiring any type of business funding you are likely exploring the alternative lending market. Alternative business loans have become a very common solution for business owners that do not qualify for traditional financing, but there are many inherent risks that come with alternative financing. In order to avoid the potential traps associated with this type of loan there is some basic information that can prepare you as a borrower.
Like any other endeavor in the business world having experience or knowledge can help yield successful results. Although you may be educated about your company and its daily operations, you are not likely as experienced with what alternative business loans are or how they work.
An alternative business loan is a high risk, short term business loan for existing business owners. It is classified as high risk because most of the individuals that receive this type of funding do not qualify for prime business loans from a bank. As with any financial products, the more risk involved the higher the premiums so expect to pay significantly higher rates on the money. The higher level of risk also translates into shorter terms for holding the loan. Most alternative lenders offer funding programs for two years or less, with many programs only lasting for 6 to 12 months.
Alternative business loans are packaged as a business cash advance or a bank revenue business loan. A business cash advance, also known as a merchant cash advance, is an exchange where the borrowing business owner agrees to sell a percentage of future credit card revenue to the lender at a discount; the discount is the actual premium you will pay on top of the funded amount. In order to ensure timely payments, the lender puts in place an electronic process that automatically deducts a percentage of each sale as they are generated until the advance is paid off. The revenue loan works almost the same, except that in place of deducting credit card revenue, an electronic process known as an ACH (Automated Clearing House) is put in place by the lender to deduct a percentage of your revenue deposits from you business bank account. The percentage of revenue allotted for payback of either loan type is discussed and agreed upon before the funding is provided.
The alternative lending industry is not regulated because these financial products are structured as contracts for a purchase and a sale, and not interest based term loans like those acquired with your local bank. There is no set interest rate or term; there is a premium added to the borrowed amount and an estimated time that the lender believes the funding will be paid back based on the payment structure. As there is no regulation and the contract is a purchase and sale, each lender can basically structure a deal as they see fit. This is the reason why there are so many stories of merchant cash advance fraud, or alternative lending traps.
Like any industry, there are unscrupulous individuals or companies that prey on borrowers in desperate situations. The most common trap is outrageous premiums with high payment structures that result in the borrower constantly needing renewals of the contract in order to maintain an adequate cash flow to operate their business. This does not mean that all of the alternative lending companies are going to take advantage of your situation. In fact, there are many great success stories for people that acquired alternative funding with good rates and terms that went on to build a great business. By educating yourself beforehand you exponentially increase your chances of a successful outcome.
In order to avoid many of the mistakes that people make when acquiring an alternative lending product there are some basic guidelines to follow as you go through the process. Like any major financial decision you make in life, doing your due diligence before you get involved with a business deal is always a good idea. The first action you should take is to get a good look at the company you are considering as a source for the loan.
The internet is a great resource for analyzing the background of a potential lender and exploring the following questions can help you establish a basic profile:
Does the company have a social media presence with recently posted content? Any lender doing business for a substantial amount of time is going to have several social media platforms that they use to engage with internet users, and these platforms will have content posted regularly.
Are there any negative reviews on the company? It is hard to find many reviews on lending firms because obtaining business loans is generally a very private matter, but usually borrowers who have a really bad experience with a lender are willing to divulge information in order to make future borrowers aware of their practices.
Is the lender registered with the Better Business Bureau? If a lender is registered with the BBB any claims against the lending company will be made readily available and easy to access on the internet if they do not meet their customer’s expectations and a complaint is posted.
Once you are satisfied with a lender’s profile it is now a good time to have an in-depth look at the loan contract offered to you by answering some very important questions:
Does the premium for the business loan make economic sense for you and your business? Because the cost of the loan will consist of the total amount borrowed plus the premium you need to decide if the cost justifies having the additional working capital. One way to answer this question is by inputting the financial terms of your agreement with the following examples. You should be able to demonstrate that by borrowing $100,000 with a total payback of $125,000 you can make your business more money than the $25,000 it will cost to obtain the funds. If the profit is there than your analysis helps determine that the loan can make sense economically. However, the payments involved are also a critical component to ensuring that the deal in its entirety makes sense.
An equally important factor when determining the viability of the loan is whether or not your business model and current cash flow will be adversely affected by the payments? Even if the overall deal may be profitable based on your projected uses and expected revenue from the loan, not being able to afford the payments will only cause you to make sacrifices along the way that result in additional funds being needed at a later date. When trying to determine if a business loan can yield successful results for your company you must not only calculate the expected overall profit, but you must also account for the payments made throughout the life of the loan.
Handling economic projections can often be too sophisticated or labor intensive for busy small business owners. However, by not taking this step you put your business at risk of constantly needing funding in order to survive. Taking on a business loan requires detailed preparation and analysis in order to achieve a successful outcome so if you are not in a position to handle the task it is advised to speak with financial counselor or someone that understands the economics of borrowing.
If you are an existing business owner that is seeking out funding for your business and you do not meet the requirements for traditional financing, you will likely find yourself considering alternative business loans. Acquiring this type of financing can be risky for business owners that do not thoroughly understand the product or the economic impact it can have on your business. By taking several steps beforehand to improve your knowledge about this type of business loan, background on the lender you are considering, and the economic implications an alternative business loan can have on your company you effectively improve your chances of yielding a profitable and successful financial outcome.