One of the biggest digs against alternative lending like merchant cash advance, ACH loans, and factoring is the high cost of acquiring capital this way. In a recent conference on small business lending sponsored by the Federal Reserve Bank of New York, Coleman Report publisher Bob Coleman, asked an executive from OnDeck (one of the big players in the space and part of the Lendio network), if it was reasonable to charge small business owners an annualized interest rate that could be as high as 134 percent? Although Coleman didn’t put it this way, he was basically asking if this type of funding is the small business equivalent of a payday loan?
I’m convinced the short answer is ‘No,’ but the complete answer might be, ‘Maybe.’
Before I explain my answer, this is how Andrea Gellert, the OnDeck executive at the meeting answered Coleman’s question about whether or not it was reasonable to charge an APR of 134 percent: “We think it is. APRs somewhat distort the true economic costs and the cost-return relationship on the loan,” she said. “If I buy … inventory for a dollar and sell that inventory for $2 in a six-month period, that’s a 200 percent return. So my 54 percent cost makes absolute sense. I will make that tradeoff every single time.”
Gellert’s answer identifies a great reason many small business owners turn to alternative lending and also identifies a legitimate scenario where this type of short-term funding might really benefit a small business borrower—particularly in a small business environment where far too many business owners aren’t able to access capital anywhere else. Which in my opinion is the elephant in the room. That said, Gellert’s response is why my short answer is “No.” I don’t think alternative small business lending is the same thing as a payday loan. The ability to access this capital in small loan amounts in hours or days vs. weeks or months, makes this financing highly valuable for taking advantage of opportunities that require quick access to capital.
Although community banks have been the capital resource most Main Street business owners have relied on over the last several years, that just isn’t the case today. Capital for the smallest small businesses, the businesses most likely to need alternative lending, just isn’t available like it may have been and Main Street has been compelled to look at alternatives. Many of which are more expensive.
I recently spoke with Craig Coleman (no relation to Bob Coleman that I’m aware of), founder and CEO of Forwardline, one of the pioneers in the merchant lending space. They are also part of the Lendio network. He describes the challenge facing small business owners as one of supply and demand. “The loan sizes that Main Street businesses are seeking are just too small for traditional lenders to justify cranking up the time-consuming process,” he says. “As a result, many traditional lenders have ‘house minimums’, meaning minimum loan sizes they will accept.”
He describes the average loan size at Forwardline as $30,000 compared to most traditional lenders who don’t want to mess with anything less than $150,000.
That said, the new SBA Administrator Maria Contreras-Sweet is really pushing member lenders to offer smaller loans to their customers by removing fees and working to streamline the cumbersome process. Granted, the SBA isn’t the biggest source of traditional capital for small business, but they do set a tone. I hope she is successful in her efforts, but only time will tell.
In many communities, access to low-interest traditional term financing just isn’t available to Main Street—which exacerbates the capital challenges they face and part of why my complete answer is “Maybe.” Having spent a fair amount of time in the trenches of small business ownership myself, I understand there are times when the need for capital overcomes the ability to rationally evaluate whether or not the cost of capital is justified. The idea that the industry has no responsibility regarding whether or not the borrower should take a high-interest alternative loan (even if he or she can) definitely nudges us nearer the payday loan scale of the equation.
Granted, it’s not reasonable to assume that every lender be expected to hold the hand of any borrower who may or may not know what they’re doing. But the way many alternative lenders do business now definitely makes it easier for a small business owner to borrow him or herself out of business. At the very least, we should be offering education and advice regarding when these non-traditional loan products make sense and when they don’t.
Alternative lending is a valuable tool small business owners can take advantage of to grow and strengthen their businesses. That doesn’t mean it’s a one-size-fits-all solution for all the financing needs of every small business. Although there are times when an alternative financing approach is the right approach, it’s far too often treated as a solution of last resort by borrowers who aren’t able to get financing any other way. Before you sign on the dotted line, make sure you understand all the terms, know exactly what your cost of capital is going to be, and feel good about the loan and the lender. Just because you can doesn’t always mean you should.