Every business needs capital to get off the ground or invest in growth. The more important question is where that capital comes from.
The established history is that capital comes from investors or traditional banks, but both have their drawbacks.
Turning to investors means giving away precious equity and say in decision-making.
And with traditional lending, newer businesses may not qualify without an established credit history. If they do qualify, they’re locked into long-term monthly payments disrupting their cash flow.
With alternative financing, the options available for all businesses to obtain capital are wider than ever. Here’s what you need to know to start exploring these new options.
What is alternative financing?
Alternative financing is a way for businesses to raise money without relying on traditional bank loans or equity funding. It includes options like crowdfunding, peer-to-peer lending, invoice financing, and revenue-based financing. These methods are especially helpful for startups and small businesses that need flexible funding or don’t qualify for conventional financing.
Why you should consider alternative financing?
Even for businesses that qualify for traditional lending, alternative financing has its benefits to consider.
Accessibility
Alternative financing has opened up access to capital for businesses that don’t qualify for traditional lending. For underserved businesses that are high risk, operating in emerging markets, or have had unfortunate blips in their financial history, they can still access the capital they need with alternative financing.
Speed and efficiency
Traditional lending has lengthy review processes requiring different financial reports, including bank statements, income statements, balance sheets, cash flow statements, and more. Plus, credit checks could negatively impact credit scores.
Many alternative financing offerings are based on singular aspects of a business’s operations, cutting down the review process and getting you access to capital faster.
Wider variety of offerings
The costs of traditional lending options make them suited for specific situations. For example, the long-term costs and impact of monthly payments on cash flow make a loan an imperfect fit for a business that needs a short-term cash injection to cover bills.
The wide variety of alternative financing options means you have a greater chance of finding something with a funding and cost structure suitable for your needs.
Types of alternative financing
While alternative financing is a broad term encompassing many types of lending, these are seven of the most common types.
Invoice factoring
Invoice factoring involves selling unpaid invoices to a third-party company (called a factor) at a discount in exchange for cash upfront. The factor then takes the responsibility of collecting on the unpaid invoices and keeps any payments in full.
Factoring is done either with or without recourse. In factoring with recourse, the business takes the risk of non-payment as the factor can demand repayment on the advance if any of the customer default on their debts.
Pros:
- Turns stagnant accounts receivable into upfront cash
- No traditional credit history or check is required
- Factor handles the collections process
Cons:
- Costs can be higher than traditional loans, based on a flat fee, a percentage of the invoice amount, or an interest rate for days the invoice goes uncollected
- Factor’s collection process could sour relationships with customers
- Impacts the profit margins on your sales revenue
Invoice discounting
Invoice discounting is another type of invoice financing, using unpaid invoices to access capital. The key difference is that invoice discounting operates as a loan based on an amount of unpaid invoices, with the business retaining the invoice and collections responsibility.
For example, if you have $10,000 in unpaid invoices, you could obtain a loan based on that amount. Then, as you collect payment for the invoices, you repay the loan, including a percentage fee based on the invoice amount.
Pros:
- Easy to plan for if you expect invoice payments to be made within the payment terms
- Turns your accounts receivable into cash now
- Your customers don’t know you’re using invoice discounting, as you control the collections process
Cons:
- The fee structure is typically 1% to 3% of the invoice amount which could be an unnecessary cost if you expect fast payment
- You’re still on the hook if invoices go unpaid
- Most invoice discounting requires a minimum total invoice amount for businesses to be eligible
Peer-to-peer lending
Peer-to-peer lending (P2P) are platforms that connect businesses directly with individual financiers who collect gains on loans offered to businesses. Instead of working with a bank, you’re working with one or many people who are fronting the cash.
The structure of the loan is similar to what you’d get from a bank, with a monthly payment schedule and interest rate. However, some financiers are willing to take on more risk, potentially working with businesses that traditional banks would avoid.
Pros:
- More flexible qualification criteria than banks
- Can build relationships with individual investors
- Greater diversity of offerings than those from banks
Cons:
- Offerings to those with poor credit scores come with a substantial cost
- Platform fees could add to the overall cost
- Getting matched with individuals could take longer than traditional lending
Merchant cash advances
Merchant cash advances (MCA) are offered by point of sale (POS), payment processor companies, or specialty lenders. Typically, repayment is automatically deducted from daily credit card sales until the advance plus any fees are fully repaid.
Many payment processors offer merchant cash advances based on your historical transaction data. This makes getting approved quick and easy.
Pros:
- Fast approval and funding
- No fixed monthly payments disrupting cash flow
- Minimal paperwork and administrative burden
Cons:
- Tend to have the highest costs of the alternative financing options
- Other financing options may not work with businesses that have an active merchant cash advance
- The percentage taken off of sales makes slow sales periods even tighter
Revenue-based financing
Revenue-based financing (or royalty-based financing) is a broader version of merchant cash advances, offering capital in exchange for a percentage of future revenue until a predetermined amount is repaid.
This option is typically offered by investors as an alternative to debt or equity financing. It’s a suitable option for businesses with recurring revenue that don’t want to impact their balance sheet.
Pros:
- No equity dilution or loss of control
- Faster process than traditional equity funding
- Repayment scales with business performance
Cons:
- Requires consistent revenue streams
- Cash flow is impacted for the entire payment period, which is based on when the agreed-upon amount is paid
- It can be expensive depending on what the investors expect as a return
Equipment loans
The most niche offering on the list, equipment loans are specifically designed for businesses purchasing equipment. In this type of loan, the purchased equipment acts as the collateral, meaning the lender can repossess it in the case of defaulting on the debt.
Pros:
- Collateral lowers lender risk meaning costs are lower, and it’s easier to qualify
- Terms can be matched with the equipment’s useful life
- Equipment purchases can save you money on taxes as depreciation is tax-deductible, thus offsetting some of the cost
Cons:
- Limited to equipment purchases only
- May require a down payment
- Risk of repossession if payments are missed
Crowdfunding platforms
Crowdfunding allows businesses to raise money directly from their audiences. Using online platforms, a large number of people contribute relatively small amounts in exchange for donation-based rewards.
The business has no monetary debt to pay back. Instead, they are responsible for providing the rewards promised in exchange for the funding.
Pros:
- Raises funds without traditional qualification requirements
- No debt obligations or repayments
- Validates customer demand for the business initiative
Cons:
- Success largely hinges on the business’s audience and marketing
- Managing the funding campaign takes a large amount of time and effort
- Some models are all-or-nothing, meaning the business gets no money if their goal isn’t met
How to choose the right alternative financing for you
Each of the options listed offers businesses new and unique ways to access capital beyond the traditional lending environment, but each is suitable for different businesses or situations.
If you’re considering any of the above alternative financing options, work through the following framework to help decide what is best for you:
- Assess your funding needs: Determine how much money you need and what the intended purpose is. A short injection of cash flow could be better served with invoice factoring or discounting, whereas a large sum may require something like peer-to-peer lending.
- Evaluate your timeline: How quickly are you needing access to capital? You may be restricted for options based on your expected turnaround time.
- Eliminate options you’re ineligible for: Some options have unique applications that may not pertain to your business, such as invoice factoring for a business that doesn’t use invoices or equipment loans if that’s not your intended purpose for the capital.
- Consider your risk tolerance: Alternative funding sometimes operates outside of the same practices and regulations that protect borrowers, and you should be aware of the potential recourse that can be taken if a debt is unpaid.
- Analyze your cash flow and revenue patterns: Look at what your payment turnaround times are for invoices, the seasonality of sales, and determine your ability to cover debt payments.
- Compare the true costs: Alternative financing options have costs beyond simple interest rates. There may be platform fees or admin costs with an application to consider before committing to what seems like a good option.
Risks and considerations of alternative financing
Alternative funding isn’t all upsides and benefits. There are potential risks and downsides to consider before committing to this path.
Higher costs
The convenience and accessibility of alternative financing often come with higher fees than traditional bank loans. Options like invoice discounting, merchant cash advances, and revenue-based financing make repayment easier by tying it to revenue, but the cost of borrowing is significantly higher.
Shorter repayment terms
Traditional loans spread out the costs over a long period of time, but alternative financing does not offer the same luxury. Many are short-term debts expected to be paid within a year, potentially straining cash flow and limiting financial flexibility.
Less regulation
The rules and regulations of traditional lending exist to protect both the lender and the borrower. Many alternative financing options operate outside of this system, which means less consumer protection and potentially predatory practices.
Restrictions on future financing
Having an active alternative financing option may restrict your eligibility for traditional and additional alternative financing options. If you intend to explore traditional lending, you should do so before committing to any alternative financing.
Complex fee structures
A loan agreement shows you exactly how much interest you’ll pay and when. But alternative financing hides some of this information to make the option seem better than it actually is. In particular, you should carefully read the terms of merchant cash advances and invoice factoring so you know precisely how much cost you’re committing to.
Debt trap potential
High-cost, short-term financing can create a dependency on lending as repayment strains cash flow. A short-term fix may create a long-term problem that can only be continuously served by alternative financing. Carefully plan the amounts and payment terms you’re comfortable with, such that the business isn’t strained too far.
How to get started with alternative financing
If alternative financing is right for your business, take the following steps to find and commit to the option that’s best for you:
- Prepare financial documentation: Collect bank statements, financial statements, cash flow statements, and other financial reports. While they may not be requested in the application process, they’ll help you determine the best option.
- Research multiple options and providers: Even if you have an idea in mind for what alternative financing option you want, look into the terms and costs of different providers.
- Calculate the true costs: Consider all fees and interest associated with the financing before you make any formal applications.
- Understand the terms: Take time to ask questions and get the clarification you need so you understand exactly what you’re agreeing to.
- Don’t overcommit: Choose an amount that’s reasonable and manageable, knowing that you could explore traditional financing down the line.
- Plan for repayment: Adjust any budgets or cash flow forecasts to account for the repayment amounts.
- Maintain good records: Save copies of any agreements or payment records for tax purposes and in case of any disputes.
- Monitor the impact on your business: Regularly check in on the impact of repayment on your cash flow or profit margins to ensure the agreement is sustainable.
- Consider consulting with a professional: For financing large amounts, you may want to talk to an accountant, advisor, or attorney to understand the costs and implications of the agreement.
While alternative financing has increased access to funding, creating a more equitable environment for businesses of all types and sizes, it’s ultimately not for everyone. Be prepared for the risks and costs of every option mentioned here so you don’t end up in a situation that does more harm than good.
Automated reporting that helps you get approved
Whether it’s traditional lending or alternative funding, you’ll need updated reporting that shows your revenue and expense history. And when you leverage automation, you’ll have access to up-to-date reporting without having to lift a finger. That means no last minute rush and panic trying to update your numbers for an application.
With BILL, all of your revenue and expenses are tracked and seamlessly imported to the top accounting platforms. Plus, your finance team saves time on menial tasks meaning more time to spend on applications.
Reach out for a demo to see how BILL’s platform saves you time with automation and can keep you prepared for financing applications.
