Alternative financing: what it is & how it’s changing the funding landscape
Have you been discovering more alternative financing companies lately? If so, you’re not alone — the financing market is evolving to include players beyond traditional banks.
What’s driving the change?
Long story short, it’s about an acceleration in technology adoption, which has been happening faster in recent years. As more people are working remotely and choosing to stay home, there’s been a rise in the need for digital services. Many companies are under pressure to pace the demands of the market, as a result.
Given this economic transition, startups need financial resources to adapt to the market and pursue opportunities for expansion. There’s high competition in the technology ecosystem, and it’s critical that companies have access to the working capital that they need to meet the moment in their business journeys.
According to the Fed’s quarterly Senior Loan Officer Opinion Survey, U.S. banks saw a substantial increase in the demand for business funding.
To meet the demands of founders, new types of financial services providers are emerging, ranging from independent private financing partners to small banks and venture-backed technology companies. There are a range of options available.
What is alternative financing?
Simply put, alternative financing is funding that’s available outside of traditional major banks. It gives founders more flexibility and variety for choosing solutions for financial services.
Specifically, alternative financing describes a category of financing products, including venture capital and debt, that address gaps in mainstream financial markets. This trend is part of a larger financial inclusion movement, in which more people are gaining access to formal banking systems. Financial inclusion is about making sure that businesses have access to useful and affordable financial products that meet their needs, in a responsible and sustainable way, according to the World Bank.
For instance, how can financial institutions better serve people with imperfect credit histories? What about people who don’t qualify for traditional mortgages? Or companies that don’t qualify for traditional bank loans?
Morgan Stanley points out that alternative financing models are arising due to a market opportunity for individual investors. These models include peer-to-peer (P2P) financing, in addition to online platforms that use technology to bring together founders underserved by traditional financing institutions. In return, alternative investment companies generate attractive returns. Many alternative financing partners offer products to founders that are ineligible for bank loans (or would receive loans with unfavorable terms otherwise).
The field is now evolving and expanding. Alternative financing gives people and businesses the power of choice over their funding options.
Examples of alternative financing
Put short, there are a lot of financial products out there. So it’s a good idea to educate yourself and shop around before committing to a specific solution
Here are a few different options that startups are likely to come across:
Invoice financing or factoring. This type of financing solution is for businesses that rely on accounts receivables (AR) with clients. It helps founders create smoother cash flow operations, to avoid payment delays.
Crowdfunding. Founders rely on marketplaces to generate funds for their operations and endeavors.
P2P lending. Founders and financing partners can connect directly to share resources on their own terms. P2P financing partners tend to be individual investors and companies.
Lines of credit. Similar to traditional banks, lines of credit are available through alternative finance marketplaces. These lines of credit tend to have less stringent funding criteria than major banks.
Term loans. With term loans, founders are able to apply for a fixed amount of funds, repayable over a specified period of time. Alternative term loans are similar to bank loans with established interest rates and a set number of payments; however the interest rates of term loans tend to be higher.
Merchant cash advances. This short-term financing solution is for merchants that need cash quickly. During the application and underwriting process, financing partners will examine a company’s credit card receipts to assess repayment ability, payback periods, interest rates, and other fees.
Revenue based financing. Revenue financing is a type of business credit that provides cash advances against monthly or annual recurring revenue (MRR or ARR). Founders can use revenue financing to access upfront capital, reduce the cost of managing cash, and invest in growth initiatives. This type of financing tends to be the best fit for Software as a Service (SaaS), ecommerce, and subscription-based companies.
Equity vs. non-equity financing
With alternative financing, founders and financing partners have more tools to hold on to their equity and avoid dilution. Lines of credit and other debt products do not require founders or investors to give up ownership in their business.
As a result, founders can maximize their access to working capital without relying on investment from a venture capital firm. Instead of taking on funding, companies can use predictable revenue streams to manage cash and always ensure that there is enough in the bank.
Non-equity financing is instrumental in helping businesses maintain their stability — especially if unforeseen circumstances or payment delays arise. Alternative financing helps founders maximize their options.
Additional considerations
Making sense of alternative financing may feel like a challenge, especially when you’re navigating time constraints to secure capital. How can you be sure that you can trust a financing partner that you learn about on the internet? After all, fraud and security are legitimate problems in finance.
That’s why it’s important to do your due diligence.
The alternative financing ecosystem is outside of traditional banking. Every financing partner has its unique underwriting criteria, customer support programs, and approaches to establishing repayment terms. Above all, as a founder, it is crucial that you can fully trust your financing. Here are some concrete steps you can take, to ensure that you’re in the best possible position:
Ask for detailed references or case studies from other customers
Seek clarification as to whether your financing partner understands your business model
Get clear on underwriting criteria
Ensure that repayment terms are clearly defined
Do research about direct competitors of the financing partner you’re considering
Read reviews on third-party website, even cold reach out to companies that have publicly shared that they’re using the financing partner
Research the financing partner’s leadership team and funding sources
Above all, it’s important to work with a financing partner that is committed to your business’ success and evolution over the long-term. Founders should never settle for anything less.
Author(s): Afshan Qureshi
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