Startups and businesses with poor credit often have few places to turn to for financing help. While it might not be the best option, one source of financing they may be able to secure is a high-risk loan. While these loans are typically available to businesses with low credit scores or unsteady revenue streams, they usually have high interest rates, strict repayment guidelines and short-term agreements.
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What is a high-risk business loan?
A high-risk business loan is a last-resort financing option 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 areas are categorized as high risk and will likely find it challenging to obtain a traditional business loan. Instead, they will have to seek alternative financing.
What constitutes a high-risk business loan?
Neal Salisian, business attorney and partner at Salisian Lee LLP, represents lenders and investors as well as small and midsize businesses. 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,” Salisian told business.com. “They are short-term, have interest rate hikes at default, and are collateralized with important assets or are personally guaranteed.”
Although the conditions for financing a high-risk business may be somewhat similar, there are a few different high-risk business loan options. Each comes with its own set of advantages, disadvantages and stipulations.
“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 and potential partners – about your business’s health,” Salisian said.
Bottom line: High-risk business loans typically have high interest rates, frequent payment requirements or hefty payments.
Common types of high-risk business loans
Many types of business funding options are available to high-risk businesses, but that doesn’t necessarily mean they are right for your business. Research every alternative lending option to learn which one fits your specific needs. High-risk loans should be used only as short-term fixes during temporary working capital shortfalls.
Here are several high-risk business loans you should know about.
Merchant cash advance
A merchant cash advance is not a traditional loan; it’s a cash advance that a lender provides based on your business’s past and current sales. You give the lender a percentage of your future revenue, typically credit card sales, until you repay the loan and interest. To qualify, a small business owner typically needs a personal credit score of 500 or higher, and the business must be in business for at least five months and have an annual revenue of $75,000 or more.
This funding option is designed for a business owner who has outstanding unpaid invoices, such as those with longer remittance terms (30 days or longer). The invoice factoring company buys your accounts receivables and advances you a portion of their value. Your clients’ credit scores are usually examined instead of yours – to verify that your customers have a good track record of paying their bills.
Short-term loans are the most traditional high-risk loan and have a maturity of 18 months or less, according to Zachary Weiner, owner and CEO of Restaurant Accounting.
“The shorter time frame provides money lenders with an assurance of lesser default risk than conventional loans,” Weiner said.
You may be able to get a short-term loan from a bank, credit union or alternative lender such as Fora Financial. Typically, business owners need a personal credit score of 550 or higher. Your business must be in operation for at least one year and have a minimum of $50,000 in annual sales revenue. Learn more in our review of Fora Financial.
As long as you follow the set terms of the loan, a personal loan can be a good option for a startup with no credit history and little annual revenue. You will need a high credit score to get a personal loan, which you can get from a bank, credit union or online lender.
It’s often easy for a business with a low credit score and sales revenue to get approved for a business credit card, but interest rates can be higher than other lending options. There are instances where using a credit card can be a more affordable option, as some have cash-back features or an introductory 0% APR.
Subprime business loans and equipment financing
Subprime loans are generally intended for borrowers with a poor credit score or borrowing history. Chances are that lenders offering prime-rate loans won’t approve these borrowers, so they’ll need to go elsewhere for their loans. Subprime equipment financing and other business loans are an option, though their name is misleading. Interest rates for these loans are higher, not lower, than the standard, which is the main risk of taking out these loans.
Did you know? The term “subprime” is misleading. Subprime loans have interest rates above, not below, the prime rate.
Hard money loan
When you take out a hard money loan, your loan’s value is based on something you put up as collateral, often real estate. Typically, your loan’s value will be a percentage of the collateral’s appraised value. As such, the value of your collateral is more important to hard money lenders than your credit score or borrowing history. The risk is that if you can’t repay these loans quickly, their high interest rates can make them prohibitively expensive.
An asset-based loan is any loan you secure by offering collateral. Hard money loans fall under this definition, as do all secured loans. The latter category can include SBA loans, term loans and business lines of credit. Equipment, inventory and invoice financing can also fit this description. Whichever asset-based loan you choose, the risk is clear: Failing to repay entails the seizure of your assets.
Which businesses are considered high risk?
Business financing is tricky to navigate. There are many requirements, and sometimes applying for a loan can seem futile.
As you evaluate the best option for your business, consider how lenders view your business. Apply for financing that makes the most sense for your specific company.
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 credit, it is unlikely that a traditional lender will invest in you.
Businesses with no credit
Like bad credit, businesses with no credit history 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.
Startups 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 bucket, there are ways to receive funding. To prove your value to a lender, use a well-thought-out business plan to demonstrate your projected revenue.
Businesses with unsteady revenue streams
Business revenue also impacts how risky your company appears to a lender. 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 or risky industries
The industry you operate in impacts how lenders perceive your business in terms of risk. Although this can vary on a case-by-case basis, the uncertainty of how the economy may impact your ability to repay can be problematic to traditional lenders. Conventional lenders often see “sin” industries – adult entertainment, tobacco, marijuana and gambling – as high risks as well, according to Rob Misheloff, president of Smarter Finance USA.
What constitutes a high-risk commercial lender?
High-risk commercial lenders provide money 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 ‘nonprime’ transactions,” Misheloff said. “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, a high-risk business might have to make large payments or pay a high interest rate to receive a loan. Some lenders require a business to provide collateral.
Jared Weitz, CEO and founder of United Capital Source, said high-risk lenders must pay special attention to unexpected losses. Some businesses are too risky, even 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,” he said. “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 liabilities to giving or receiving a high-risk loan, a few benefits can make it worthwhile for 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.
“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,” Misheloff said. “Without access to those funds, the business may lose an opportunity.”
Acquiring a high-risk loan may be the only option left for some entrepreneurs and business owners. 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,” Weitz said.
It may seem like the potential consequences of lending money to high-risk businesses aren’t worth the rewards. 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 most considerable benefit being money.
Just because high-risk lenders provide money to high-risk borrowers doesn’t mean they give money to everyone who applies. They vet potential borrowers to see who has the strongest likelihood of repaying.
While some borrowers won’t have the means to repay their loans, 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 by 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 – a high risk – the experts we interviewed recommend that small businesses and entrepreneurs rely on them only as a last resort. There are several alternatives 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,” Weitz said. “All [are] enticing options that should be vetted during the financing process.”
Here are some reasons why these options are great alternatives to high-risk business loans:
- Angel investors don’t require repayment if your business fails. This flexibility is exceedingly rare among small business funding routes.
- Peer-to-peer lending often has lower costs, and the relationship undergirding it is between you and a person instead of an institution. Individual people are typically more sympathetic than banks, private lenders and the government if you encounter repayment issues.
- Co-signers can help you cover the portion of your costs currently out of reach to you. Then, when you are able to pay that portion, you can arrange to do so with the co-signer, not an institution.
Misheloff added that small business owners can investigate other alternatives, such as supplier (trade) financing, borrowing from friends and family, and seeking a personal loan. He said that personal loans are often cheaper than business loans.
How you finance your business is a major decision that greatly impacts your overall financial success. Analyze every possible 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.
Max Freedman and Skye Schooley contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.