Could Micro-Lending Provide A Solution To Alternative Business Financing?

Obtaining sufficient operating capital has always been a challenge for small business owners and entrepreneurs. During the depths of the financial crisis, banks and other lenders were especially stingy about extending credit even to established small businesses with sound business plans. Startup businesses and entrepreneurs with credit challenges faced nearly impossible odds when seeking funding.

Alternative lenders emerged to fill the gap, just as they had done for consumer lending with payday loans. Alternative lending for businesses works on a slightly different model, but the costs associated with business payday loans are often comparable to those of consumer payday loans.

But many savvy business owners and would-be entrepreneurs have managed to escape the trap of these small business loans. Micro-loans represent one of the most promising alternatives to business cash advances.

Many small businesses are launched with no more funding than the would-be entrepreneur can draw from his or her credit cards. Other popular bootstrapping strategies include borrowing from family and friends or continuing to work full-time or part-time while establishing a business. But for many businesses, bootstrapping simply does not generate sufficient working capital.

The conventional means of obtaining working capital involves writing a business plan and submitting it, along with detailed personal and financial information to a bank, angel investor, venture capitalist or grantor. But the irony of this lending model is that entrepreneurs and business owners who need assistance the most are often unable to qualify. Personal credit problems or lack of established business accomplishments frequently cause lenders to turn down otherwise promising small business applications.

Micro-loans were first developed by Muhummad Yunus in Bangladesh as a means of enabling extremely poor individuals to lift themselves from poverty through self employment. Yunus was awarded the 2006 Nobel Peace Price for the concept.

In the original model of this lending system, individuals would receive small amounts of money, often as little $50 or $100 US, which they used to purchase essential tools like a sewing machine or a milk-producing goat.

In the United States, nonprofit microloans range from a few hundred dollars to tens of thousands of dollars. Instead of conventional banks, micro-loans are administered by nonprofit institutions. The application process is similar to that of a conventional loan, but with more latitude for business owners with credit problems or with limited business history to qualify. Funds from micro-loans can be used for working capital, to build inventory, office furniture, manufacturing fixtures and essential equipment.

The repayment process for micro-loans is automatic, with periodic withdrawals taken from sales or credit card receipts. The interest percentage charged for micro-loans and deducted from sales receipts is pre-determined between business owners and lenders. Interest and fees charged are based on borrower’s credit and other factors, and average between about 8.5 percent and 15 percent, according to a June 2014 report in the National Journal. Repayments are reported on borrowers’ credit reports, which could essentially make qualifying for credit easier in the future.

The United States Small Business Administration also administers a microloan program, working with nonprofit agencies around the country. The SBA provides funding for nonprofit lenders, which devise their own programs and requirements for borrowers. SBA program microloans can be as much as $50,000 but average about $13,000. Business owners cannot use funds from microloans to pay down existing debt or purchase real estate. The maximum repayment period for an SBA microloan is six years.

Micro-loans represent a relatively new source of funding for entrepreneurs and business owners. In past years, business owners who needed more money than they could bootstrap but could not qualify for conventional loans, frequently found themselves with few options. Merchant cash advances often represented their only hope for funding.

The approval process for these types of advances is based on projected sales for the applicants’ businesses. Funding often takes place as quickly as with conventional payday loans, usually with deposits to business owners’ bank accounts. The repayment process is similar to that of nonprofit micro-loans, taking place through direct withdrawals from a percentage of sales generated by the business. Withdrawals continue until the loan has been repaid. But that’s where the similarity ends.

Interest charged for these types of loans can be as exorbitant as those for consumer payday loans. For instance, one small business lender charges borrowers in Idaho, Nevada or Washington $175 in interest and fees per $1,000 for loans repaid within 30 days. The same lender charges California business owner borrowers an eye-popping $487.50 in interest and fees for 30-day, $1,000 loans. Interest charges of $3,500 for a $10,000 business cash advance loan payable in six months are not uncommon, according to the National Journal.

Although there are similarities between the two, nonprofit micro-lending represents a more desirable option for small business owners and entrepreneurs to obtain capital than these expensive alternatives. Interest rates charged for micro-loans are much lower and repayments can also help boost business owners’ credit profiles. Not so with alternative lending.

But these alternative loans offer funding with no credit check, which can present a major lure for entrepreneurs with badly damaged credit. Funding is also much quicker than funding from a micro-loan, taking place within hours or overnight. Micro-loans can require days or weeks to process. Nonetheless, the high interest rates charged by many of these alternative financing opportunities expose business owners to a never-ending financial trap that ends up costing more than they are worth.