Business opportunities and crises do not always wait for a cash reserve. When a large purchase order comes in, or a prime location you’ve been coveting opens up, you need to be ready. If the timeline or a short credit history prevents you from obtaining a traditional loan or pursuing venture capital, there are several alternative finance options. Among them, invoice factoring and merchant cash advances (MCAs) are two of the most common avenues. 

What is Alternative Finance? 

Financing alternatives provide money to businesses without using traditional banks or capital markets. While the term is often associated with internet-supported technologies, alternative ways of financing businesses have always existed. However, alternative lenders often take on more risk, and in turn, you may pay a higher interest rate or take on more risk as well. 

When Would a Business Need Alternative Financing? 

Any business should keep abreast of alternative finance. A need for one could come quickly in the form of a working capital shortage or arrive more deliberately as a way to finance a new initiative.

Traditional financing highlights how risk-averse banks often are. They favor larger, established businesses and create a challenge for smaller businesses without the track record. A volatile economy tightens their reins even further, reducing the number and dollar-value of loans offered as they increase their capital and liquidity requirements.

Can Businesses Seek Alternative Options at Any Stage?

A short company history, a low credit score or financial documents that illustrate an  inability to repay a loan can dismiss an application before it’s even been sent to underwriting. 

Paro fractional CFO William B. shares two examples when business owners with an established business may need to turn to alternative finance. 

“A founder, who is also the chief rainmaker and salesman, comes out with a major illness. The lender is going to have some reservations about making a loan, because they’re making a loan to a business that’s really relying on one person to perform,” states William.

Market changes beyond the owner’s control can also set the stage for a denied application. “Suppose [Linda] has done great for the last 30 years selling fireworks. But now there’s legislation pending that says we’re not going to allow fireworks to be sold in my state. So Linda is going to be nervous, because in addition to the credit and character of the borrower, [the lender] is also looking at pending legislation, and that may be something that borrower has no influence over.”

What is Invoice Factoring?

Invoice or receivables factoring is a common alternative financing solution. 

“If you’re unable to get bank financing, the next least expensive [option] is factoring,” says William. 

When a business extends credit to their clients, they have an accounts receivable asset on their books. Their cash flow is stymied for the 30, 60 or 90 days before the payment arrives. Companies can sell—or factor—their accounts receivable to banks and others in exchange for cash. 

A typical buyer will initially pay the seller an advance between 75% and 85% of the face value of the receivables. The buyer then handles the collections, and when the payment is received, they will pay the balance to the seller less the agreed upon factor. If the factor is 10% and the receivables are collected within 90 days, the effective annualized interest rate paid is 40%. 

If a business determines that the cost of financing is offset by the profits made from the proceeds, invoice factoring is a wise step if better options do not exist. Showing a good track record with a factor can also create trust with traditional banks and help secure a loan down the line. 

What are Merchant Cash Advances?

MCAs are another avenue of alternative financing—one that should be considered only as a last resort. The hallmark of an MCA is the extremely high rates charged, often reaching deep into the triple digits.

“An MCA lender doesn’t want to buy your receivables. Instead he advances you money against future receivables—those that don’t exist yet,” says William. The monies advanced to businesses are not loans, so no interest is involved. A factor rate is used instead. 

The amount of capital advanced is multiplied by the factor to equal the amount owed to the MCA lender. A percentage of each sale is paid automatically to the lender by credit and debit card processors or through transfers based on daily bank receipts. This happens until the loan is paid off.  Other administrative, underwriting and processing fees can also add to the balance.

MCAs always require a personal guarantee and typically require a validity guarantee for the invoices. The lender may ask you to sign a confession of judgment in advance to avoid going to court if any payment is missed or you default. MCAs can be aggressive with their collections. When a default occurs, they can go after the owner’s future cash flow to collect their monies. 

What Other Financing Options Exist?

There are numerous alternative financing options, though businesses will mostly encounter invoice factoring and MCAs. While a few are specific to startup and early stage businesses, most are available to businesses at any stage of growth. 

Some forms of financing are equity-based, although most are not. Equity-based financing is when a portion of your business is given in exchange for receiving funds. 

Non-equity financing includes both monies that need to be repaid and those that do not require repayment. Either option may have restrictions placed on the use of the funds, as well as annualized interest rates and factors that can range from zero to several hundred percent.

Other alternative finance options include: 

  • Peer-to-peer (P2P) lending: These online platforms match your business to an individual investor. This option is currently unregulated. 
  • Equity crowdfunding: These platforms match your business to multiple investors, who take equity shares in your company. You must adhere to regular filing requirements.  
  • Working capital loan: A bank loan used for seasonal businesses, usually during low season, to cover daily operations. This loan cannot be used for investments. 
  • Small Business Association loan: Easier to secure than traditional bank loans, SBA loans often have lower rates, but they often have longer terms. 
  • Lines of credit: Suppliers provide goods or services in advance of receiving payment. 
  • Venture debt: High-growth, VC-backed startups can secure these loans from banks or alternative lenders that have secured interest provisions. 

Why Choose One Over the Other

For those exploring financing alternatives, decisions must be made about whether to provide an ownership interest in the business in exchange for the funds. When the owner wants to avoid diluting their equity, exploring different non-equity alternatives is in order. 

Lower credit requirements and easier qualification for loans speeds up the process, but business owners need to assess their risk tolerance if something goes wrong during the repayment period. This situation is particularly profound with MCAs. Since MCAs are not loans, they fall outside of usury laws that protect individuals and businesses against predatory lending. 

William advises owners to consider the ramifications of an MCA loan—or any loan—if it is not paid off:

“If litigated, can you pay the legal expenses for both sides if you lose? If the lender doesn’t collect, they may try to sell their interest in your business to your competitor. Understand that something could go sideways.“

Secure Alternative Financing with Help from an Expert

If you’re experiencing a working capital shortage or struggling to secure traditional bank loans, seek the strategic guidance of a fractional finance expert. Paro offers flexible solutions to help your business make the right decisions for your capital needs.