Learn about high-risk business loans and potential financing alternatives.
- A high-risk business loan is a financing option for certain types of businesses (e.g., those with poor credit, no credit, startups, new businesses, businesses with uncontrolled revenue streams, businesses based in volatile or risky industries, etc.)
- High-risk loans typically have high interest rates, large or frequent payment requirements, short-term agreements, and interest rate hikes if you default.
- Some alternatives to high-risk business loans include peer-to-peer lending, angel investors, external lenders, a loan co-signer, or borrowing from friends or family.
One of the most common problems that business owners face is securing the right funding for their businesses. Regardless of how world-changing you think your business idea is, you will need some type of financing to get it off the ground.
There is no one-size-fits-all funding solution, since the best business loan or financing option for each business depends on several factors; however, many business owners and entrepreneurs turn to business loans as a temporary means to an end.
Traditional lenders typically require businesses to have a good credit history. They follow strict guidelines to assess how risky each investment is, which ultimately determines whether or not they are willing to lend your business money. This is something that many startups and businesses in risky industries struggle with. As a result, some businesses and entrepreneurs have no choice but to finance their business with a high-risk business loan.
What is a high-risk business loan?
High-risk business loans (e.g., merchant cash advance, short term loan, invoice factoring, etc.) are last-resort financing options for businesses that are considered too risky by traditional lending standards.
When approving someone for a business loan, traditional lenders analyze a business's creditworthiness based on the five C's of credit: character, capacity, capital, collateral and conditions. Businesses that fall short in any of these categories are categorized as "high risk" and will likely find it difficult to obtain a traditional business loan. As such, they will have to seek alternative funding instead.
High-risk business loans are often too risky for traditional lenders to approve. Neal Salisian, a business attorney and partner of Salisian Lee LLP, represents predominantly lenders and investors, as well as small- to medium-size businesses. As someone familiar with lending and investing, he said there are specific conditions that often constitute a high-risk loan.
"High-risk business loans are ones with high interest rates, large payments or frequent payment requirements, [they are] short term, [have] interest rate hikes at default, [and are] collateralized with important assets or [they are] ones that are personally guaranteed," Salisian told business.com.
Although the conditions for financing a high-risk business may be somewhat similar, there are a few different high-risk business loan options to choose from. Each comes with its own set of advantages, disadvantages and stipulations. We spoke with financial experts to learn what the most common loan options are.
Jared Weitz, CEO and founder of United Capital Source, said short-term loans and invoice factoring are other common high-risk financing options, and he said that business credit cards, asset-based loans, and personal business loans are also financing alternatives that can be considered.
There are many financing options available to high-risk businesses, but that doesn't necessarily mean they are right for your business. Research each type of alternative lending option and high-risk loan available to learn which one fits your specific needs. Keep in mind, high-risk loans should be looked at as short-term fixes during temporary working capital shortfalls.
"High-risk loans can be a good tool to get a business back from the brink if used properly, but they shouldn't be considered a long-term financing solution because of the risk and because of what they can signal to the industry (consumers, investors, potential partners included) about your business's health," said Salisian.
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What businesses are considered high risk?
Business financing is tricky to navigate. There are many requirements, and sometimes applying for a loan or funding seems hopeless. It is important that you understand how lenders view your business so you apply for financing that makes the most sense for your specific company. Knowing whether you are a high risk is just one step to understanding your status.
Businesses with bad credit
As expected, companies with a poor credit history are considered high risk. Both the business credit history and your personal credit score can impact this analysis. If you have a poor track record for repaying on credit, it is unlikely that a traditional lender will invest in you.
Businesses with no credit
Like bad credit, businesses with no credit at all are considered high-risk investments. If you don't have a credit history, lenders have no frame of reference to assess the likelihood that you will repay them. You can make all the promises you want, but without a solid credit history to back you up, traditional lenders will likely turn you away.
New businesses and startups
Startups and new businesses typically have very little revenue and unstable business metrics for lenders to evaluate. Although being a new business can drop you in the "high-risk" box, there are ways to receive funding. To prove your value to a lender, use a well-thought-out business plan to demonstrate your anticipated revenue and projections.
Businesses with uncontrolled revenue streams
Your stream of business revenue also impacts how risky a lender sees your company. Salisian said two primary business types that can be considered high risk to a lender are those with cyclical or irregular income streams and those with little to no control over repayment capacity (e.g., a business where current funding depends on third parties or external controls).
Businesses in volatile and risky industries
The industry you operate in impacts how risky your business is perceived by lenders. Although this can vary on a case-by-case basis, the uncertainty of how the economy may impact your ability to repay can be worrisome to traditional lenders. Misheloff also said that "sin" industries – adult entertainment, tobacco, marijuana, and gambling – are often seen as high risk to traditional lenders.
What constitutes a high-risk commercial lender?
High-risk commercial lenders provide financial investments to risky businesses that are unable to secure funding through traditional lending options. By assuming a greater risk in investment, high-risk lenders expect to receive a greater return.
"High-risk commercial lenders specialize in 'non-prime' transactions," said Misheloff. "They are typically smaller private institutions."
To offset the danger of lending to risky companies, high-risk commercial lenders often require businesses to agree to aggressive repayment terms. For example, to receive a loan, a high-risk business might have to make large payments or pay high interest rates. Some lenders even require a business to provide some collateral, in case they are unable to repay their loan.
Weitz said high-risk lenders must pay special attention to unexpected losses. Some businesses are, in fact, too risky for high-risk lenders.
Lenders must also build reserves in the event of an unexpected loss from a high-risk loan. Weitz explained how this reserve can be built as loss prevention.
"One way that lenders work with conditions like this is through establishing a borrowing base, where the line of credit is provided based on the level of accounts receivable and inventory," said Weitz. "This will be set up such that the borrowed amount is aligned to the assets needed to be converted to cash in order to repay."
What are the benefits of high-risk loans?
Although there can be many downfalls to giving or receiving a high-risk loan, there are a few benefits that can make it worthwhile for some lenders and small businesses. Before committing to a high-risk loan, weigh the pros and cons to see if it is the right financial move for your company.
Small businesses and entrepreneurs should proceed with caution when they are looking into high-risk loans, as there are many risks. There are a few benefits they can take advantage of though, with the two primary benefits being accessibility and money.
"When a business can make enough profit to justify the high cost of funds and cannot access capital any other way, high-risk loans make good business sense," said Misheloff. "Without access to those funds, the business may lose an opportunity."
Acquiring a high-risk loan may be the only option left for some businesses and entrepreneurs. If this is the case, it is important to project your future earnings as honestly as possible and use the money wisely to avoid digging yourself into a deeper hole.
"Be smart to optimize the usage of this financing and build a solid return on investment that will offset any higher interest rates or fees based upon your risk assessment standing," said Weitz.
Lending money to high-risk businesses may seem like the consequences aren't worth the rewards. For example, what if you lend to people who can't or won't pay you back? Rest assured, there are a few benefits to being a high-risk lender, with the largest benefit being money.
Just because high-risk lenders provide money to high-risk borrowers doesn't mean they provide money to everyone who applies. They vet potential borrowers to see who has the strongest likelihood of repaying.
While it may be true that some borrowers won't have the means to repay their loan, high-risk lenders have guidelines in place to remit those losses. High-risk lenders protect themselves by requiring that borrowers make large or frequent payments and charging high interest rates. When it comes time to collect, their return on investment is often considerably higher than what a traditional lender would receive.
What are alternatives to high-risk business loans?
Since high-risk loans are just that – high risk – it is recommended that small businesses and entrepreneurs only rely on them as a last resort. There are several other alternatives that you can seek out, depending on the reason behind your "high-risk" status.
"Alternatives for high-risk loans include peer-to-peer lending, angel investors, external lenders and getting a co-signer for the loan," said Weitz. "All enticing options that should be vetted out during the financing process."
Misheloff added that small business owners can investigate other alternatives like supplier (trade) financing, borrowing from friends and family, or possibly even seeking a personal loan. He said that personal loans can sometimes be cheaper than business loans.
How you finance your business is a major decision that greatly impacts your overall financial success. Analyze every possible funding option to determine which one is best for your business. Once you receive funding, manage your cash flow wisely so you can avoid borrowing again in the future.