A high-risk loan or alternative financing is any funding given to a business that the financing provider deems less likely to repay its debts. There are several reasons a business might be classified as high risk: a low credit score, a short credit history, missed payments in the past, or even operating in an industry deemed high-risk. As lenders see it, businesses meeting these criteria present a high risk of the lender losing money on the loan.
In turn, lenders use several techniques to protect themselves from the prospect of significant loss on a high-risk loan. Those techniques, like higher interest rates, create lending options that can be expensive, nontraditional, and risky for borrowers but are sometimes the best or only option to receive the sort of funding needed to make a business grow.
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Several factors or events can make a business a high-risk borrower. You may fit into one or more of these criteria, and that’s alright! Some criteria you can recover from, while others change in time.
New Businesses. According to data from the United States Bureau of Labor Statistics, about 20% of all businesses go under within a year of being established. That statistic alone shows why new businesses are seen as a risky proposition. A business that no longer exists cannot pay back its loans. That’s why so many loan applications want to see years of consistent annual revenue as a pre-requisite for lending: a startup has a very limited record of bringing in money, and the unknown means risk.
Companies with low credit scores. Three main credit bureaus (Experian, Equifax, and Dun & Bradstreet) calculate business credit scores using a variety of data points. While each bureau’s credit report is calculated a little bit differently, they all incorporate a few similar pieces of information. Those include the size of your company, the industry it operates in, the age of its credit history, debt payment history, and public financial history like bankruptcies. As demerits pile up, your score goes down. A low business credit score will likely mean your company is considered high-risk.
High-Risk Industries. Lenders are also loath to underwrite significant loans to businesses operating in industries seen as risky. An industry can be considered risky for any number of reasons. For example, cannabis dispensaries are considered risky because of the ever-shifting rules and regulations surrounding the legality of cannabis products. The same is true of alcohol producers to an extent. Other industries, like the food and beverage industries, see a higher rate of failure than other industries. Look at your company from a lender’s point of view: how safe of a bet is the average company in your industry?
How Do Financing Providers Protect Themselves from Risky Borrowers?
We know lenders give loans to companies in these risky industries, and new businesses and lenders give loans to companies in these risky industries, to new businesses, and to companies with bad credit. But how do these lenders protect themselves when they offer funding options to risky businesses? They use several strategies.
Collateral. Many high-risk business owners will only receive the funding they need if they agree to put up business assets as collateral. These assets can take many different forms. Real estate, inventory, equipment, and accounts receivable are all common assets used as collateral. If the borrower is unable to repay the loan, the lender can take possession of the collateral and liquidate it as appropriate, protecting them from losing too much money.
High Interest. Lenders attach high interest rates to loans underwritten to risky borrowers. Like any bet, it only makes sense to put money on a risky proposition if that proposition is highly profitable. If these loans come with low interest, the lender would take on all the risk with very little prospect of a reward.
Personal guarantees. Many lenders require personal guarantees for business loans. That means that the small business owner’s personal credit score is put on the line if the business defaults on its loan.
Non-traditional repayment. While some small business loans come with the once-a-month payment structure we all know and love, many lenders use alternative repayment structures to protect themselves from the higher chance of default inherent with riskier borrowers. These structures can include more frequent (weekly, even daily) repayments, varying interest rates,
Smaller loan amounts. Of course, one of the best ways to prevent yourself from losing significant amounts of money on risky borrowers is to simply not lend huge sums to companies with poor credit. It’s a win-win, really. By making smaller loans, lenders are protected from losing too much, but it also creates a situation in which borrowers are more likely to be able to pay the loan off, thus raising their scores, and creating greater creditworthiness down the line.
Types of High-Risk Business Financing
There are several types of financial products in the marketplace that are perfect for borrowers who may seem to be a risky proposition to most lenders. Depending on your company’s finances, structure, and industry, you may want to examine your eligibility for some or all of the following:
Loans
Short-Term Loans
Short-term loans are offered by any number of lenders: traditional lenders like banks offer them, as do alternative online lenders. Short-term loan options work much like the huge, long-term loans used to buy things like real estate: the borrower receives the total loan amount up front and makes monthly payments to pay it back.
But unlike giant bank loans, short-term loans are uniquely suited for high-risk businesses. That’s because by their nature they protect lenders from excessive financial risk. Short-term loans are small, come with high interest, and require repayment within just a few months (typically fewer than 18 of them).
One huge upside for borrowers is that if you’re able to pay off a small short-term business loan, you’ll help your credit score. Because MCAs and invoice factoring aren’t loans, they typically won’t have any impact on your credit. By successfully navigating a short-term loan, you’re helping build the track record of a company worthy of larger loans in the future.
Equipment Financing
Equipment financing is used, as you may have guessed, specifically for equipment. They can be used to buy, rent, lease, upgrade, repair, or replace any equipment necessary for operating your business. That can mean an industry fridge in a liquor store, computers and monitors in a lawyer’s office, or a tractor for a farmer.
Equipment loans protect lenders by their very nature: the borrower puts up a down payment on the equipment, and then the lender finances the rest, holding the equipment in question as collateral. If the borrower should prove unable to repay the loan, the lender will repossess the equipment and sell it, protecting them from losing too much money on the transaction.
That limited downside means equipment loans are a safe bet for most business lenders and they’re able to offer them to even high-risk businesses.
Non-Loan Options: Alternative Financing
Merchant Cash Advances
Merchant cash advances, or MCAs, are ideal for risky borrowers. But they’re not loans by definition. Instead, MCAs function by an advance provider purchasing a percentage of another company’s future debit and credit card sales. In a traditional loan, borrowers receive a lump sum and begin making payments each month until the loan is paid back, with interest. With an MCA, repayment terms are very different.
First and foremost, there’s no interest rate associated with the advance. Instead, MCA providers make their money using what are called factor rates. Factor rates are multiplied by the size of the advance to find the borrower’s total repayment amount. For example, if you receive an MCA of $9,000 at a factor rate of 1.2, you’ll repay 9000 x 1.2, or $10,800.
In addition to their unusual payment, you’ll also repay an MCA differently. Instead of regular-sized monthly payments, MCA payments are usually made every single day and vary in size based on each day’s credit and debit card sales. That payment is typically around 10% of each transaction.
If your business brings in $500 one day, you will pay $50 to your MCA provider. If another day brings in $4,000, you’ll pay $400. And days when you don’t make any sales, you won’t make a payment at all.
So why do MCAs function well for high-risk borrowers?
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They don’t take your credit into account. Because of the way MCA repayment works, a bad credit score doesn’t matter very much to the companies that give them out. What’s far more important is the volume of your credit and debit card sales. If your company has poor credit, or if you’re a startup, but you can demonstrate that you’re processing a large volume of sales, you’ll be an appealing borrower for MCA providers.
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They’re expensive. MCAs are one of the most expensive financing options available to high-risk small businesses. That’s because of how factor rates work. In a traditional loan, paying the lender back quickly means saving money on total interest, as interest usually only accrues on the remaining principal. Not so with MCAs. Whether you pay your MCA back in two months or two years, you’ll pay the same total. And because repayment is based on daily sales, you don’t have much control over that repayment rate. Paying an MCA back very quickly can drive their APRs into the triple digits.
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Providers are getting constant payback. For lenders, it’s simple to watch as borrowers make payments each and every day on their advances. If that borrower is a high-risk business, those daily payments allow for constant monitoring.
The daily payments associated with MCAs can also be tough for companies with already-limited working capital. Look over your company’s financial statements and determine if you’ll be able to meet your existing obligations at 90% of your current monthly income. If that’s not feasible, you may want to consider an alternate form of funding.
Invoice Factoring
Invoice factoring is another transaction-based business funding option. Like MCAs, invoice factoring isn’t a loan, and is therefore not subject to the same laws and regulations as a loan.
While MCAs involve selling a portion of debit and credit card sales, invoice factoring means selling a factoring company your unpaid invoices, or accounts receivable.
Say your company’s got $12,000 in accounts receivable but you can’t afford to wait on your clientele to pay you. Maybe you’ve got another payment to make, or an opportunity has arisen. An invoice factoring company might offer you around 95% of the value of your invoices – $11,400 in this case. You get that quick infusion of cash (though not the total amount of the invoices in question), while the invoice factoring company turns around and takes over collecting those payments.
This is another great option for high-risk businesses that deal with invoicing. Because the funding is based entirely on existing accounts receivable, your credit history is effectively meaningless. There’s no need to investigate a company’s history of debt payments when the invoice total is in black and white.
For high-risk companies, invoice factoring is great because there’s no long-term payment commitment. No need to adjust projections for your company’s cash flow months or years down the road. Sure, you’ll take a hit in the short term, but your business’s finances are back to normal immediately thereafter.
Final Thoughts
Being a high-risk borrower doesn’t necessarily mean you won’t be able to receive funding. While you may have to put up assets as collateral and pay more for your money than you’d like, high-risk lenders can use those loans to set themselves up for more favorable terms in future lending.
