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Getting A Small Business Loan in Bad Economic Times

Alternatives are available, even with tight credit

By Fred Yager
ConsumerAffairs.com

November 13, 2008

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Despite the $700 billion dollar government bailout plan for financial institutions which was supposed to encourage commercial banks to start lending again, and recent news stories about a so-called thaw in the frozen credit markets, getting a loan these days is still difficult, even for those with pristine credit ratings.

If you're a small business owner who depends on access to credit to keep a steady cash-flow just to stay in business, you're probably scrambling to find alternative sources of capital.

Any new funding resource should be cost-effective, and borrowers must watch out for unscrupulous lenders looking for an inexpensive way to buy a business through a devious strategy known as "loan to own."

"Loan to own" means that they loan you money hoping that you will default on the loan, because when you do, they gain ownership of your company, even though the amount that was loaned may be a fraction of what the company is actually worth.

According to the Web site receivablesexchange.com, a new site set up for companies to trade accounts receivable, 42 percent of small business owners reported a cash-flow problem during the past three months.

With commercial bank credit still restricted, here are some possible alternatives. Each comes with its own set of conditions that may make a particular option either more expensive or more trouble than its worth. Always make sure to look at the whole list of terms--not just the cost of the loan--when making a decision.

Securities-Based Lending

Perhaps the least expensive form of borrowing is Securities-Based Lending. It's inexpensive because you're primarily borrowing money from yourself, or from your partners. Let's say you've been fairly successful and have socked away a tidy sum in an investment account. There are financial services companies that will let you borrow money using those securities as collateral, and you don't even have to reassign them or put them in a different account. They remain in your name in your account and continue to grow and appreciate, and your small business gets access to much needed capital.

For example, at Merrill Lynch, this is called a Loan Management Account. It allows you to use multiple pools of collateral against the same loan, such as your investment account, your wife's account, or even a trust account. (Full disclosure: I'm a Merrill Lynch client--soon to be a Bank of America client.)

Friendly Capital

Other sources of inexpensive funding include something called "friendly capital," which basically is borrowing money from friends and family members who believe in you and your business. If you decide to go the "friendly capital route," make sure that your friends or family know that it might be a long time before you can repay them, if ever. You may also discuss if it's better to have the loan formalized in a letter agreement or if a more informal approach is acceptable to all parties concerned.

Trade Credit

There's also the option of relying on "trade credit." This is where one company agrees to provide goods or services to another company on credit with an agreement to be paid later. Experts say there are some well-capitalized companies whose priority is grabbing market share and are offering more relaxed more credit terms just to win more customers. If you're in that position, you may be able to buy yourself a few extra days on your accounts payable, which amounts to free credit.

Royalty Financing

A more expensive alternative is "royalty financing." This type of credit is often seen with franchises. It's tied to the amount of revenue your business generates, which means you have to have a fairly high margin business to be able to afford it. Businesses that typically use royalty financing include those with intellectual property, mining, commodities, or resource-based businesses.

Royalty financing is also used by early stage start ups where an idea has been developed, you're ready to go and you've built up significant client demand, yet you still don't have any collateral because revenues haven't been generated yet. With royalty financing, you give up a percentage of future sales in exchange for financing now. Just be aware that these deals can last for a very long period of time, even into perpetuity.

Factoring

Another option is "factoring," which is sometimes called accounts receivable financing. With factoring, you get cash for your accounts receivable. On the plus side, factoring doesn't create any more debt and therefore has fewer restrictions and covenants than debt financing. On the downside, it can be expensive. Some factors have been charging as high as 20 to 30 percent interest.

Factors are usually privately funded financiers with lots of cash. They buy your accounts receivable and give you an advancing that amounts to a percentage of the account's cash value. Once the factor receives payment on the account, they reimburse themselves first for the original amount advanced, take out a fee, and return the rest to you.

Peer-to-Peer Lending

Another possibility, which may be slightly less expensive that factoring, is a relatively new financing option known as online peer-to-peer (P2P). Lending sites, such as prosper.com, lendingclub.com and circlelending.com, arrange borrowing between people who are needing money with those who have cash but want better returns on their money than a money market or savings account. Interest rates on peer-to-peer lending programs range from more than seven percent to more than 19 percent, depending on the quality of the borrower's credit.

Hedge Funds

If any kind of credit is out of reach, you may find yourself forced to offer equity in your business in exchange for funds. This is where things can really get dicey. Experts warn that there are many deals out there that are onerously expensive and have very restrictive terms, particularly with hedge funds. Even worse, there are hedge funds that are looking for a loan to own scenario. This is where they make you a loan with the belief that you're going to default. Then once the default occurs, they take ownership in your property. It's a way for them to buy property at a steep discount. But there are some legitimate and positive hedge fund lending options that might be suitable and beneficial for your company. Just be very cautious if you explore this option and read the fine print very carefully about what you're getting and especially what you're promising in return.

Community Banks

A safer choice may be your local community bank. Some local banks are still making loans and offering lines of credit. Unlike the megabanks which took on debt that they shouldn't have, local banks have largely avoided taking on potentially bad loans. You have to have pretty good credit rating and a lot of collateral because they maintain a conservative approach to lending.

Credit Cards

Finally, there's that old stand-by--the credit card. Entrepreneurs have been funding start ups with credit cards for years. But you have to be careful to only use them if you can pay them back and on time. Interest rates on credit cards go up quickly if you're late or miss just one monthly payment. If you are considering the credit card route, find the card with the longest lead time for that zero-percent introductory rate.

If you plan to also buy goods with a particular card, seek out the card that offers the most attractive rewards program, plus the zero-percent interest, but sometimes you have to go for one benefit over the other. Since your primary reason for the new credit card is to get a cash advance at zero percent you might want to consider a non-rewards card.

Only you will know which funding option best fits your needs, your time horizon and your future plans. As a business owner, it's important for you to maintain your energy and your passion for your business, while also remaining practical, open, and flexible. You have to be realistic about alternative and potentially appropriate lending solutions for where your business is today. These are challenging times and you shouldn't make these kinds of decision in a vacuum. Talk to your accountant, financial advisor or lawyer about what you need and what options you plan to explore.

Before considering any funding options, make sure the terms match up well with your expectations as well as your needs. Gather the information you need about what kind of funding is available and at what cost. That will minimize the possibility of any unpleasant surprises down the road.

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Fred Yager, a veteran AP and CBS News journalist, was formerly president of Merrill-Lynch Broadcasting.

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