Rachael owns a bakery in New York. The business has grown from what she started in 2010 with personal savings and donations from her family and friends. Rachael needs more financing to open a second store. How does Rachael finance her expansion plans, then?
Due to strict requirements, lengthy application processes, and slow turnaround times, SMBs (small and medium-sized enterprises) such as Rachaels bakery are not eligible for traditional bank loans. Alternative lenders are available that offer quick turnaround times, flexible underwriting, and short applications.
Alternative lending refers to any type of lending that is not offered by a traditional financial institution. These lenders can offer different types loans, such as microloans, lines of credit and equipment financing. They also use technology to quickly process and underwrite requests. They charge higher interest rates because of their flexibility than traditional lenders.
Securitization can be another cost-effective way to raise debt. Lenders have the option to pool their loans and segregate them according to credit risk, principal amount, and time period.
How can these lenders raise funds for SMBs to cover the financing gap?
These firms have two main sources of capital, equity and debt. Alternative lenders often raise equity capital from venture capital, private equity companies or IPOs. Their debt capital is usually raised from traditional asset-based banks lending and corporate debt.
Naren Nayak (SVP and treasurer at Credibly), states that equity typically accounts for 5% to 25% of capital, while debt can range between 75% to 95%. Alternative lenders also have a third source of capital, or funding. This is where whole loan sales are made. The loans (or merchant cash advance receivables), are then sold to institutions on an forward flow basis. He said that this is a balanced-sheet light funding solution, and an efficient method to transfer credit risk to lenders.
Let's take a closer look at each option.
Alternative lenders can access financing through private equity or venture capital. Alternative lending is a great source of venture capital investments. Although it can be difficult for these companies to get credit from traditional banks due to their strict requirements in the early stages, once founders have demonstrated a commitment by investing their own capital, VC or PE firms often step in.
However, PE and VC firms can be costly sources of capital and their investment dilutes ownership and control. Venture capital can be a complicated, lengthy, and competitive process.
Alternative lenders who have experienced high growth rates and scaled up their operations have an alternative option: An IPO allows them to quickly raise large sums of money and provides a lucrative exit opportunity for early investors.
Capital for debt
Banks are more likely to lend money to businesses that are in good financial standing once they have approved revolving credit and loans. Term loans can be provided by banks, credit unions, and small business administration (SBA), lenders. They offer long repayment terms and low interest rates, but they also require certain indicators of security such as collateral and substantial track records, which are not available from nascent lenders.