Like so many entrepreneurs with a new business needing a bit of cash, Eric Estoos and Ben Dobyns were not good candidates for bank loans. Estoos needed less than $100,000 to move his startup cloud computing company, HarborCloud, out of his Redmond apartment and to hire more staff. Dobyns, meanwhile, needed money for his independent Seattle film production company, Zombie Orpheus Entertainment.
For all the money that seems to be sloshing around the country thanks to Fed policies that have pushed interest rates down to among the lowest in history, tougher lending standards among banks have made it difficult for small businesses to get loans. So entrepreneurs such as Estoos and Dobyns have turned to what has come to be called “alternative financing” to get the money they need to grow their businesses.
Alternative financing has a long history that encompasses loans sharks and pawn shops, and it’s almost always been more expensive than banks. What’s new is the great variety of ways in which entrepreneurs can now raise money. In addition to approaches that have become well-established during the past decade, such as venture capital, angel investing, credit cards and home equity loans, other approaches include:
• Revenue-based loans, in which the lender takes a percentage of revenue until an agreed-upon cap is reached.
• Factoring, in which the lender provides a cash advance after purchasing a company’s unpaid accounts receivable at a discount.
• Peer-to-peer lending, in which individual investors combine to lend money to a company through an organization that handles the transactions for a fee. Individual investors may receive interest payments until the debt is repaid or they may take equity in the company and share in its profits.
• 401(k) rollovers, in which individuals invest their retirement savings to buy a small business or franchise.
• Community development financial institutions, which are an alternative to banks, providing loans at comparable rates to businesses that fit their missions.
Most alternative financing is expensive. Where a bank might charge 6 percent interest plus fees, alternative lenders may charge from the low teens to 20 percent or more. “If a company can get what they want from a bank, they should take it,” says Kevin Barber, a managing director at Columbia Pacific Advisors, a family of alternative investment funds in Seattle. Barber runs Union Bay Capital, an alternative lending fund that typically makes loans between $1 million and $10 million to fast-growing companies with revenue between $5 million and $50 million. However, Barber acknowledges, “Unless you’ve got a lot of cash flow, collateral or a personal guarantee, it’s really hard to get a loan from a bank.”
In exchange for higher costs, alternative lenders are willing to shoulder more risk than banks, lending to borrowers who may have damaged their credit during the recession or have insufficient cash flow or collateral to interest a bank.
The increase in alternative lending is spurred in part by new technology that makes it easier to automate the lending process by obtaining financial and other data about the borrower online. Some alternative lenders promise loan approval in less than 10 minutes. They exploit niches that are underserved by banks, such as lending to new businesses or to restaurants, retailers, the construction trades and other enterprises that banks may deem too risky. These lenders also will make loans under $100,000, which banks often decline because small loans require as much work as a larger loan while carrying more risk and providing less profit.
For Estoos, Lighter Capital was the answer. The Seattle-based company makes revenue-based loans ranging from $50,000 to $500,000 to small businesses that have at least $150,000 in annual revenue. So far, Lighter Capital has provided more than $5 million in 40 loans to 25 companies, according to CEO BJ Lackland.
Estoos had seriously considered factoring, but he felt the three- to four-month payback was not a good fit for his cloud computing service for small businesses. He also knew he didn’t want venture capital or private angel investment because that would require him to yield an ownership stake in the firm.
Since HarborCloud was less than two years old, the company had a difficult time qualifying for a bank loan and Estoos did not want to provide a personal guarantee that banks typically require. “An unexpected curveball could put you out of business,” says Estoos. If that were to happen, he adds, “You not only have lost your business, you are personally bankrupted.”
Lighter Capital did not require a personal guarantee. Automatic repayment is made monthly as a percentage of the borrower’s top-line revenue until a predetermined cap — for Lighter Capital typically 1.75 to 2.25 times the amount borrowed — is reached. That allows borrowers to pay less when times are tight.
The arrangement has worked well for Estoos. During the past two years, he has borrowed roughly $400,000 from Lighter Capital. HarborCloud now has an office in Bellevue’s Factoria neighborhood, a staff of six, and several thousand customers
The cost has been high compared to a bank loan but, says Estoos, “My business can service the debt and I still have my equity in the company so that the value the capital creates is mine.”
Meanwhile, Zombie Orpheus Entertainment CEO Dobyns turned to the film company’s fan base for funds. “We were all out of college, we had no houses to put up and not a lot of fixed assets,” Dobyns says. “Bank financing wasn’t a feasible option.”
The company, which distributes its fantasy, comedy and science fiction web series as well as feature films over the internet, has now raised a total of $650,000 through Kickstarter, the New York-based online fundraising engine that charges a 5 percent fee for its services. Zombie Orpheus is now able to cover its expenses through subscriptions from fans of its various productions, Dobyns says.
While Kickstarter is a plausible source for funding specific projects, it’s not a long-term answer for day-to-day operations. But crowdfunding through the JOBS Act, passed by Congress in 2012, might be. A provision in the act — JOBS stands for Jumpstart Our Business Startups — allows companies to raise up to $1 million a year from the public without having to satisfy the type of stringent Securities and Exchange Commission (SEC) rules that accompany a typical public offering of stock. Still, the SEC requires detailed information about a firm’s finances, operations and intended use of the money raised.
A much shorter-term option is PayPal, which now offers 90,000 e-retailers in the United States the opportunity to pay a flat fee to borrow against 10 to 30 percent of their daily PayPal receipts. Many borrowers have used the program to purchase more inventory for their businesses.
In early December, Seattle retail consultants Pat Johnson and Dick Outcalt set up a new division of their Retail Owners Institute to make it easier for retailers to raise money. Banks4Retailers (banks4retailers.com) helps merchants comparison shop for loans through five firms that match borrowers to more than 2,500 financing sources.
“The market is decidedly underbanked,” notes Johnson. “Up to 65 percent to 80 percent of a typical retailer’s assets that they might want to use as collateral are in inventory and banks traditionally are very skittish about that constituting their collateral.”
Banks4Retailers participants are Lendio, Kabbage, Biz2Credit, OnDeck and Fundation. These firms pull together prospective borrowers’ bank account information, credit histories, company sales, customer traffic and buyer reviews to obtain loan approval within minutes.
“It’s a change that’s enabled by technology and empowered by opportunity that was created by banks choosing to sit on their assets,” Outcalt explains.
Lending declined during the recession as banks struggled with mounting defaults and businesses curtailed their growth. While lending is still down from its peak, bankers say competition is now increasing.
“Community banks are much more aggressive today than they were 12 to 24 months ago,” says Tim Brown, senior vice president and regional manager at Wells Fargo Commmercial Banking in Seattle, citing more competitive loan pricing and fewer restrictions. Small-business lending at Wells Fargo was up 24 percent in dollar volume in the first three quarters of 2013, while the dollar amount of SBA loans was up 18.3 percent from 2012, Brown notes.
David Nilssen, CEO of Guidant Financial Group in Bellevue, maintains that bank lending continues to favor more established businesses. “It looks like there is amazing momentum, but the problem remains profound at the low end of the loans small businesses are seeking,” Nilssen says.
Still, increased competition among banks has led to a reduction in loan origination fees from 1 percent to less than 1 percent based on relationship pricing, says Christine Liu, a vice president and senior business banker at KeyBank. Additionally, underwriting standards have eased during the past three years at KeyBank, from a debt service coverage ratio of 1.20 to 1.10. This means that for every dollar in debt payment, the business needs to demonstrate it has $1.10 in net income.
“We try to make loans more doable for businesses that are profitable but somewhat leveraged,” Liu says.
What may be misinterpreted as a disinclination to lend, adds Kelly McPhee, spokeswoman for Spokane-based AmericanWest Bank, is the impact of diminished property values, which have eroded the value of some borrowers’ collateral, thus sharply reducing the amount of money they can borrow. Prospective borrowers may also be turned away if their bank has made a lot of loans to similar businesses and wants to diversify its portfolio.
“Don’t assume it’s you,” McPhee says. “It could be they have a concentration in that segment. You should go to another bank.”
Banks may also refer borrowers to community development financial institutions or partner with them to meet federal community reinvestment requirements. Lending was up about 15 percent in 2013 at Seattle-based Community Capital Development, reports COO Alice Davis. The nonprofit lender provides training and loans to small-business owners, especially low-income borrowers, women and minorities in distressed communities. Community Capital loans range in size from $2,500 up to $250,000, with a maximum term of seven years and an average interest rate of 8.7 percent, Davis says. The company has made about 220 loans totaling about $10 million, according to Davis.
And then there are those who like to do it themselves. Guidant Financial Group provides a variety of financing packages, including portfolio loans that let people borrow against their stock portfolios and 401(k) rollovers that enable people to invest their retirement savings in a business they then operate.
“These are people who have the experience, education and financial wherewithal to start a business on their own,” Nilssen says. “They choose this path because they believe in investing in themselves more than in the stock market.”