Confused by Alternative Finance? 10 Types of Alternative Lending Explained

The alternative financing industry has been growing by leaps and bounds, and it has been a boon for countless small business owners in need of funding. But all this growth has turned the industry into an unregulated hodgepodge of lenders, platforms, and products.

The truth is the term "alternative finance" is really catch-all phrase that describes several, very different financing arrangements. Today, just about any non-bank lender technically qualifies for that description. Moreover, as increasing numbers of small business owners seek non-traditional funding platforms, the alternative financing industry keeps expanding with new, yet similar-sounding products.

So how can you as a small business owner looking for non-bank financing make sense of it all? The following are 10 simple explanations of the most popular forms of alternative financing available to small business owners:

Non-Bank Financial Institutions

1. Credit Unions
Though they may look like a regular bank from the outside, credit unions work by a different set of rules. Credit unions are non-profit cooperatives owned by their members. In order to maintain their non-profit status, these financial institutions have to restrict membership to a particular group of people, such as those attending or working at an educational institution, or residents of a particular community. The tax advantage associated with being a non-profit typically allows credit unions to offer lower interest rates on loans, and higher rates on savings accounts and other savings products.

Lately credit unions have been more aggressive in soliciting new accounts. To get a list of credit unions in your area, go to the website of The National Association of Federal Credit Unions (NAFCU).

2. Community Development Financial Institutions (CDFI)
CDFIs are financial institutions that offer financing and other financial services to economically disadvantaged and under-served communities within the United States. There are several different institutions that can take on this title including: a community development bank, a community development credit union, a community development loan fund, a community development venture capital fund, a micro-enterprise development loan fund, or a community development corporation.
CDFIs are certified by the Community Development Financial Institutions Fund (CDFI Fund) at the U.S. Department of the Treasury, which provides funds to CDFIs through a variety of programs, yet they themselves are not government entities. The CDFIs were established by the Reigle Community Development and Regulatory Improvement Act of 1994.

3. Micro Lenders
Micro-loans are short-term loans of small amounts, typically no more than $25,000 spread out over 5 years. There is a network of commercial micro-lenders and non-profits that offer these loans to small business owners. If you are a minority, have a low-income, or are seeking to start a business in an economically challenged area then your chances for being accepted for funding increase dramatically.

There are several umbrella organizations that deal with micro lenders and micro loans. The most popular are the SBA Microloan Program in the US, Accion USA, and Kiva. For a more comprehensive list of micro loan providers in the US and world-wide, see my earlier post on micro financing.

Asset-Based Financing

4. Factoring or Financing Accounts Receivables
If your business deals with customer invoicing, then you may be able to leverage your outstanding customer Accounts Receivables (AR) in exchange for instant financing. Keep in mind though that there is a difference between AR factoring and AR financing.
When factoring accounts receivables, your business would receive 70-90% of the total value of the outstanding receivable up front, the rate is generally dependent on the age of the account. The factor company would then assume responsibility for collecting the outstanding invoice. Upon full receipt of the payment from the customer, the factor company will return the remaining balance, minus a small processing fee. With AR financing, your business would use its outstanding invoices as collateral for financing, but you would still be responsible for collecting payment from your customers.

5. Business Cash Advances
A business cash advance (also known as a merchant cash advance) is a form of alternative financing based on future credit card sales. In this set up, the cash advance provider purchases some of a business' future credit card receipts at a discount, which generally ranges between 20%-30% of the amount funded. In exchange, the business receives a predetermined amount of instant cash which can be used as working capital. The cash advance company then collects a set daily percentage of future credit card sales until the full amount funded has been paid off.

One big benefit to this kind of financing is that since repayment is based on a percentage of sales, there is no set time to repay the amount owed, and the owner of a seasonal business does not have to worry about making payments during periods of slow or no sales. Cash advance companies usually require that a company be in operation between 3 and 6 months, and may also require a minimum sales volume.

6. Revenue Based Financing
Similar to business cash advances above, revenue-based financing allows borrowers to get up front funding, usually in the form of a cash advance, and then pay off the amount funded via a monthly allocation of the revenue their business generates. But, unlike the cash advance, a business' whole revenue stream is considered. While interest rates are again on the higher side, this finance product allows business owners to maintain ownership of their companies while not being forced to borrow against their homes and possessions.

7. Purchase Order Financing
Also called inventory financing or PO funding, purchase order financing is a short-term, commercial finance option that provides capital to pay suppliers upfront for products or inventory so the borrowing company doesn't have to deplete its available working capital. The products or inventory then serve as collateral for the loan if the business does not sell its products or otherwise cannot repay the obligation. Inventory financing is especially useful for businesses that must pay their suppliers within a short payment cycle or a longer period of time than it takes them to sell off their inventory. It also provides a solution to seasonal fluctuations in cash flow and can help a business support a higher sales volume by, for example, allowing a business to purchase bulk orders of inventory to sell later on.

8. Lease-Back Programs
Also known as a "sale and leaseback," lease-back programs allow the owner of a property or other valuable asset, such as equipment or vehicles, to "sell" it to a lender and then lease it back during a set period of time. Under this arrangement, the original property owner can quickly free up working capital while retaining possession and use of the property.

Some leaseback arrangements allow the lessee the option to buy back the property at a future date. During the life of the leaseback, however, the buyer derives tax benefits from the arrangement, such as being credited for depreciation of the property.

Peer-Based Alternative Financing

9. Peer-to-Peer Lenders
Peer-to-peer, or P2P lending is a form of financing that occurs directly between individuals or "peers" without the involvement of a traditional financial institution. Loan amounts are typically small. The two biggest P2P lenders, Lending Club and, offer a maximum of $35,000 and $25,000 respectively. Loan terms are also pretty short, from 1 to 5 years.

Much of the success of P2P lending is a result of the social networking power and infrastructure of the Internet. P2P lending sites, such as Lending Club and Prosper mentioned above, offer an online marketplace where borrowers and lenders can come together. Often, there will be several private lenders per borrower who each share in partially funding a a given loan amount.

These sites typically provide identification and verification services as well as an assessment of the borrowers' creditworthiness and the risk involved in lending to them. Clear, precise documentation covers the loan's terms and conditions as well as the repayment schedule and tax payments as determined by both parties.

10. Crowd Funding
With crowd funding, business owners and entrepreneurs can raise the funds they need by requesting a small amount of money from many different people online. By tapping into the power of the internet, entrepreneurs can pitch their ideas to a large group of people, who, if interested will respond by donating a small portion of the money they need to help them reach their target.

Unlike more traditional forms of business capital, the money raised through crowd funding is not directly repaid. Recipients may instead offer their investors some specified item or service in return for their financial support, such as a free sample of their product. In some, crowd funding models, such as the one supported by Sellaband, investors also get a cut of the recipients' future sales revenues.

In Closing...

Keep in mind that many of these alternative funding platforms are relatively new, and there is still, as of yet, very little regulation. This means, you have to exercise your full due diligence before agreeing to anything. As I've mentioned throughout, many alternative financing arrangements will cost you more. But there are still some industry norms. If you are being charged more than 30%, then move elsewhere. As you can see above, you may have more options for financing than you think.