The Great Recession created many tectonic shifts in the way the economy functions, dramatically impacting small business’ accessibility to credit. The economic contraction during and especially after the recession created a credit crunch in the banking industry that left many small businesses in the dust when it came to finding working capital or financing. Banks have historically served as the principal source of outside capital for small businesses. In light of the financial vacuum following in the wake of the recession, alternative lending options have emerged to help small businesses find the funding necessary to meet their strategic objectives.
Alternative lenders’ relatively high rate of returns has piqued the interest of sellers and investors. According to Harvard Business School Working Knowledge, traditional bank loans yield approximately 6 percent, while alternative lending options might provide a return anywhere between 30 to 120 percent. Below are a few common examples of alternative lending options.
“Alternative lenders can potentially provide larger returns than traditional options.”
With seller financing, the selling shareholder allows the buyer to make payments directly to him or her, without a bank acting as the middleman. In this process, the buyer will sign a promissory note that includes the interest rates, the repayment schedule and any default consequences. Using this method, the seller could earn an equal or better return than he or she would see from another investment vehicle. Plus, the seller is well versed in the company’s historical performance and potential future after owning and operating the business for a number of years. Finally, seller financing lets the owner keep the asset if the buyer discontinues payment, and the holder of the promissory note can sell it to another investor for a lump sum for an immediate buyout if necessary.
Business Development Company
A Business Development Company is a publicly traded closed-end fund that provides financing to small and mid-sized businesses with lower trading volumes. These companies operate with a transparent portfolio of loans and must invest at least 70 percent of their resources in eligible assets before making any investments in non-eligible assets. BDCs often raise funds in the public markets and then explore ways to securely invest the capital. A capital injection from a BDC can provide funds for improvements that will increase the company’s competitive footing or allow for geographic expansion.
Investors can achieve an above-market return by investing in a hedge fund. These funds are designed to protect investments from uncertainties in the market and provide a steady return regardless of the economic climate. Only accredited investors are able to participate, meaning that the investor must have made $200,000 for the past two years or have a net worth over $1 million.
Much like a BDC, a hedge fund will invest in a company if they can reasonably expect a positive return on the investment. Both options can be more beneficial for the company since these investors generally offer a longer repayment period than a traditional business loan. In addition to the longer lending periods, these alternative lenders may provide a capital tranche that does not amortize, as long as the principal is paid upon the loan’s maturity.