The following is first in a three-part series on mezzanine level borrowing for small and mid-sized businesses.
If you own or manage a business, there may have been times when your company has needed an infusion of capital funds and, perhaps, you researched some borrowing possibilities at that time. You may have considered which of several types of borrowing options would be best for the health of your business. The two most common options are to obtain a loan from a traditional source, such as a bank, or borrowing from a non-traditional lender, often referred to as “business lenders.”
There are advantages and disadvantages associated with both types of borrowing and the steps toward a decision should include identifying your specific needs and then comparing the pros and cons of both types of borrowing. Those steps should help you reach a conclusion as to the right path for your business.
Reasons for Borrowing
In one instance, the borrower – let’s call them Borrower “A” – may be interested in an entire financing package such as purchasing real estate, a building, or acquiring another company, all of which are typically longer term loans often made through a traditional lender.
Depending upon other types of needs, some businesses – Borrower “B” – may have an immediate need for cash to address a specific need such as purchasing or leasing a piece of equipment, making a down payment on real estate or a building, expanding a building, adding needed inventory to satisfy a customer’s needs, or to capitalize on an emerging opportunity with a new customer or to meet increased demand from an existing customer. In each of these instances, the borrower may need to act quickly.
In the case of the Borrower A, who is seeking an entire financing package, a traditional lender may very well be the best option. Large acquisitions such as real estate, facilities, or a business acquisition do not always require a very quick turn-around. In addition, large loans – sometimes in the millions of dollars – are usually paid back over a longer period of time. In fact, there is a great deal of similarity in structure between these types of large dollar-amount business loans and residential mortgages. Payback of the loan can be seven years, 10 years, 15 years, or longer. Interest rates may be fixed for the duration of the loan or fluctuate with the prime rate (the interest rate for banks when they borrow from the Federal Reserve for their own needs). Adjustable rates for business loans also act like home mortgages in that they rise and fall with the ups and downs of the prime rate. Importantly, the type of longer term loan that Borrower A is seeking also comes at a lower interest rate and, in some cases, the interest rate may be significantly lower than a short-term loan.
In contrast to Borrower A, Borrower B may not have the luxury of time or the latitude associated with what is often a significantly slower borrowing process associated with a complete financing package through a traditional lender.
Typically, applications for and the approval processes through a traditional lender, such as a bank loan for a piece of equipment, might take 60 days or more. Short-term lenders typically provide speed and certainty of capital, often within two weeks for the application, approval, and actually receiving the needed funds. In some special cases, a business lender may be able to expedite the loan process and reduce the time required to obtain the loan to a matter of days. Very fast turn-around is even more likely if the borrower has maintained orderly financial records.
Interest rates on short-term loans are generally higher than loans from traditional lenders such as banks because the short-term loan is repaid much more quickly. The cost of the loan – the interest – in absolute dollars may, however, compare very favorably to the total accumulated interest on longer term loans. In fact, most loans through lenders like Great Oak Funding, are paid off in 18 months or less.
There are other factors that can steer a borrower to a short-term business lender. Some borrowers may have had an issue that prevents them from obtaining a conventional loan. These borrowers may have a lower credit rating or lack sufficient assets – their own cash or liquid assets that can readily be converted to cash – to collateralize the loan. Fast turn-around and short-term borrowing allows a company to use a short-term loan to buy equipment or capitalize growth. The capacity to grow rapidly, for example, may allow the borrower to retain an existing customer that has immediate or increased need for the borrower’s products or services. Likewise, the ability to obtain capital quickly may allow a borrower to acquire new customers or to provide additional products of services.
In both cases, if the borrower can earn back the cost of the loan through generation of additional revenue for the borrower’s business, it lessens or can even eliminate the concern associated with paying a higher interest rate. The cost of the loan truly provides a profitable return to the borrower in this type of circumstance. The quick injection of borrowed capital can allow the company to be more nimble and more competitive.
When considering the options between traditional and non-traditional lenders, there are additional variations that can and should be explored. Lenders strive to structure loans to give borrowers as many ways as possible to obtain the funding they need. It is in the lender’s best interest to offer options and make loans readily available. It is in your best interests, too.