Alternative lenders aren't banks and aren't subject to banking regulations, which is both a blessing and a curse for the industry.
In recent years many small businesses, seeking faster access to capital than many traditional banks can offer, have turned to a growing market: online alternative lenders.
While it’s hard to find an exact number to define the size of the alternative lending market, estimates of alternative lending companies’ market share in 2015 range from four percent to 10 percent, and economist agree that growth is expected to continue.
Names like Kabbage, OnDeck, and PayPal have become familiar players in the market, offering a wide range of products from lines of credit to business loans. It’s easy to understand the appeal of alternative lending, especially in the wake of the 2008 financial crisis, which led to traditional banks increasing scrutiny in the lending process.
Rise of Alternative Lending
Generally, alternative lenders offer a faster loan process than traditional banks – sometimes as fast as just a few days and don’t have the strict requirements that come with a bank loan. This is particularly appealing to people who are past the “starting a business” phase but do not yet have enough financial history to be creditworthy by traditional banking standards.
It can also be challenging for many small businesses to provide collateral, a common requirement for traditional bank loans. Collateral can be difficult to value, economists say, since it can vary so widely, from machinery to trucks. Banks may sometimes have a hard time pinning down a value for collateral, too, especially if it’s a newer product coming to market. Since most non-traditional lenders don’t require collateral, working with them can be a much simpler process.
In addition to faster loan times and looser requirements, alternative lenders may be more flexible in how a business makes payments. Borrowers can, for instance, pay a certain percentage of their sales each month, instead of a set amount. If a borrower has a lean month, they are paying a percentage of the lean sales and don’t have to worry about scrounging up cash for a payment they may not be able to make.
Credible Lenders Face Challenges
There are many reasons borrowers are flocking to alternative lenders, but there’s also some dissatisfaction among small business borrowers when it comes to the overall experience. That’s according to a small business survey done by a group of Federal Reserve Banks that included New York, Atlanta, Boston, Cleveland, Philadelphia, Richmond, and St. Louis in 2015 that includes responses from more than 3,400 employers in 26 states.
The survey found that satisfaction levels with online alternative lenders were lower than with traditional lenders. The reasons cited for this dissatisfaction were unfavorable repayment terms and high-interest rates. A focus group study by the Federal Reserve Bank of Cleveland and Board of Governors showed that may small business owners also don’t fully understand the way alternative lending products work and the costs associated with them.
In addition to confusion regarding payment, there are also so-called bad actors in the alternative lending marketplace, those that use deceptive practices and can lead borrowers into financial disaster. Some lenders, for instance, do what’s known as “double dipping,” something many alternative lenders decry as a hidden cost and deceitful practice.
Double dipping is when “funders encourage business owners to refinance, and force them to use the money from the next advance or loan to pay off the outstanding balance,” according to alternative lender Breakout Capital, which is opposed to the practice. “[Double dipping] causes the business to pay twice for the same money.”
Coalition to Promote Transparency
These are all issues that many alternative lenders are aware of, and hoping to address. Several of them have formed the Coalition for Responsible Business Finance (CRBF), a group whose goal is to represent non-traditional lenders, educate policymakers about online business lenders, and develop a set of best practices for alternative lenders.
CRBF members are open to federal regulation of the alternative lending industry, and say they hope that such regulation would be based on direct input from the small business community.
Groups like the CRBF, the Responsible Business Lending Coalition, the Innovative Lending Platform’s SMART box (Straightforward Metrics Around Rate and Total Cost), and the Innovative Lending Platform Association also hope that guidelines encouraging transparency and best business practices can be developed.
“There’s an aggressive push for disclosing all fees and all costs associated with a loan,” says Tom Sullivan, executive director of the CRBF. “Our coalition members want to establish themselves as white knights in the non-traditional lending sector.”
What does that look like? In part, it’s avoiding practices like double dipping, aggressive sales tactics, and lending amounts larger than a company can responsibly afford. Some alternative lenders offer performance rewards and term improvement programs to help customers move to lower cost financing over time.
It also means helping to develop standards in the industry like the SMART box and the borrower’s bill of rights. SMART box is an effort to create a chart with standardized pricing comparisons and explanations that will help business owners understand the costs around different loan products in order to make a fully informed decision. And the borrower’s bill of rights is an effort by brokers, online lenders, credit marketplaces, and small business advocates to establish a set of responsible lending practices.
“As our industry rapidly evolves, we believe it is critical to provide the tools and transparency businesses need to make informed borrowing decisions,” said Kabbage co-founder and COO, Kathryn Petralia of the SMART box initiative. Kabbage is a member of the Innovative Lending Platform Association.