Banks Are Failing Entrepreneurs, but Alternative Lenders for Small Businesses Can Help

By Oz Konar

The American Dream, long frayed and tattered, has finally snapped.

Years ago, common cultural knowledge told young entrepreneurs that they could build a thriving business so long as they had a good idea and the willingness to see it through. Success was always just around the corner; if they pushed themselves hard enough, they would find it.

But that long-fabled idea of “pushing on” towards success falls a little flat these days, especially when many hopeful entrepreneurs can’t even access the capital they need to start moving. Approval rates at small banks and credit unions—which small businesses often rely on for financial support—dropped to new lows amid the pandemic.

At the end of 2019, small banks boasted an approval rate of just over half (50.6%), according to the Biz2Credit Small Business Lending Index; today the lending rate is 18.2%. Matters are even worse at credit unions. Even before Covid-19, approval rates were about 40%; today the rate is 20.3%. The situation, to put it mildly, is not reassuring for business owners who need cash now, and badly.

Small business owners desperate for cash

In this context, it’s unsurprising that loan refusals come with very real, and often very emotional, consequences. Being barred from traditional small business loans can push entrepreneurs to take extreme and even dangerous measures to save their businesses. Last year, researchers for the Federal Reserve’s 2020 Small Business Credit Survey found that the most common owner response to cash flow lapses was to dip into personal funds. Over half of respondents reported they had withdrawn money from their personal savings accounts or asked friends and family for financial support within the past five years.

This trend towards taking personal responsibility for business debts has continued through the pandemic; in July 2020 a survey commissioned by CreditCards.com found that nearly a quarter (24%) of small business owners turned to personal credit cards and one-fifth (21%) tapped personal savings to cover Covid-prompted funding shortfalls. And 10% of small business owners, researchers found, did both.

These last-ditch tactics are both risky and unsustainable. Without proper financing, entrepreneurs can lose their businesses and shoulder a crushing amount of personal debt. What’s more, this weight is often disproportionately borne by entrepreneurs of color and female founders.

According to Small Business Majority research, founders who are Black, Latino, or AAPI (Asian American or Pacific Islander) are more likely to be rejected when applying for a loan compared to their white counterparts—and those who do obtain financing tend to receive significantly less funding than they hoped. A similar pattern affects women; a study from Biz2Credit reports that women-owned businesses received 33% less in loans than male-owned companies.

Traditional banks aren’t just failing entrepreneurs—their rejection patterns actively hinder certain groups as they struggle to build their version of the American Dream. The SME Finance Forum reports a funding gap of no less than $5 trillion between small business owners’ funding needs and available banked financing options.

Entrepreneurs can no longer rely solely on traditional banks to get their businesses off the ground. They need other financing options—and luckily for them, alternative lenders are ready and willing to lend a supportive hand.

What is alternative lending?

As the name suggests, alternative lenders provide additional options to small businesses that conventional financial institutions have rejected. These financers are small, private, and usually based entirely online; most use algorithms and financial software to underwrite loan applications and process applications quickly—usually within a few days, instead of the weeks or months it might take a bank to do the same.

But what alternative lenders are most well-known for is their flexibility and accessibility. Because private financial providers don’t need to pay for overhead, they have more leeway to invest in businesses that conventional players would reject as being too “high risk.”

While specific requirements vary between alternative lenders, a small business owner generally only needs to be in business for a year, have a personal credit score of 600, and document $100,000 in annual revenue to qualify for a loan. These guidelines stand in stark contrast to traditional banks' strict qualifications, which typically only approve entrepreneurs who have been growing their business for several years, have personal credit scores in the 700s, and report hundreds of thousands of dollars in yearly revenue.

Accessible alternative lending options give frustrated, oft-rejected entrepreneurs a chance to prove themselves and their businesses without being summarily judged and shut down by big banks. Moreover, these financers don’t just offer loans; many also provide business lines of credit, equipment financing, invoice financing, and other core financial products.

These offerings may come with higher interest rates than those provided at a conventional bank. However, for entrepreneurs who can’t find financial support, assistance with a higher price tag is better than no assistance at all. Data backs this; in 2018, an Oracle retail banking survey found that a whopping 40% of surveyed customers felt that nonbanks could more effectively assist them with their money management and investment needs than traditional banks. Additionally, one-third of participants who haven’t tried alternative financing said they were open to doing so.

More articles from AllBusiness.com:

• Why Millennials Are Flocking to Alternative Funding
• Looking for a Modern Payment Solution? Here Are 10 Cash Alternatives
• 10 Key Steps to Getting a Small Business Loan
• What Lenders Look for Before Granting a Small Business Loan
• Can Crowdfunding Help Save American Small Businesses?

Small businesses’ pressing financial needs, coupled with conventional banking’s increasing selectivity, have catapulted alternative lenders to prominence in the financial sector.

As one writer for Business Insider summarized: “Due to the massive SMB market size, alternative lending companies are positioned to threaten incumbent banks, and unless traditional banking institutions update their lending practices, alt lending technologies could potentially overhaul legacy processes and gain a greater percent of the overall market share.”

It’s worth noting that market forces have already propelled the alternative lending market to lofty heights; just last year, the global alternative credit market topped $291.4 billion.

But what specific assistance can alternative lenders offer to financially-constrained entrepreneurs?

Financial services provided by alternative lenders for small businesses

While particular service items will vary between lenders, many will offer similar financial products. It can be challenging to figure out which to go with when you need funding. Here, a few popular products, their merits, and drawbacks are discussed in detail. Consider each against your business’s needs.

1. Direct lending

Direct lending funds are loans that originate with a single lender and are typically provided to small and middle-market companies. Similar to private equity firms, direct lending funds source capital from external investors. The borrower is generally expected to pay back the original money—as well as associated management and incentive fees—within five to seven years.

Alternative direct lending arrangements are ideal for middle-market companies conducting M&A, as the dollar amount associated with such transactions is often too large for a bank to fund by itself and too small to justify syndication (i.e., splitting the cost across several large investors).

2. Venture debt

As you might expect from the name, venture debt is a financial product typically only used by startups and early-stage companies. Founders often rely on venture debt to complement equity venture financing; it allows them to gain funding without over-diluting their equity stakes and losing their ownership rights.

All this said, venture debt is a very specific lending vehicle that typically only provides benefit to companies that are relatively new and intend to scale quickly. Established or very small businesses may not draw many advantages from a venture debt arrangement.

3. Cash flow lending

Cash flow lending allows companies to borrow against the strength of their projected future earnings. In other words, lenders give companies the cash they need immediately on the assumption that they will earn enough in the future to pay back that loan. Lenders gauge the suitability of this kind of transaction by considering a company’s past and projected cash flows along with its credit rating.

While cash flow lending is ideal for those who are relatively confident in the business’s growth and future earnings potential, this kind of deal may not be the best for a company that is still finding its feet and cannot guarantee strong earnings.

4. Debenture

Debenture lending does not require collateral. In other words, lenders extend bonds or other debt-based products to the borrower on the strength of their reputation. A borrower who wants to rely on debenture will need to have a strong credit score and/or repayment habits.

If your company—or you, personally—don’t have a lofty credit score, debenture may not be for you. Because this method of lending hinges on a business’s reputation and credibility, those who do not have an established track record of repayment may struggle to get approved for a debenture arrangement.

Alternative lenders for small business mean new options, new hope for entrepreneurs

Conventional banks’ increasingly stringent requirements shouldn’t constrain modern entrepreneurs. With alternative lending, small business owners have a chance to finally obtain funding that has long been denied to them and start writing their own American success story.

If you’re looking for an alternative lender to give your business a leg up, you may want to conduct a search into private financers who have an excellent online reputation, ample experience, and often fund initiatives like yours. Look for someone who will be a partner, as well as a source of support. When you need help scaling your business or funding a new growth path, the value of finding an empathetic, understanding, and flexible lender cannot be understated.

RELATED: 8 Important Questions to Ask Before Taking Out a Business Loan