Be Careful When Borrowing From Alternative lenders
Gary O. Shelton
Small business owners often use Merchant cash Advance to solve short term cash flow problems. They shouldnt because it is a death trap.
Generally, alternative business loans are really expensive because of a business loan’s cost structure. We can roughly break the costs down into the following 4 parts:
Lenders’ borrowing cost: Investors who invest in alternative business loans demand annualized net returns in the 10-12% range since these loans are perceived to be more risky, since they are usually under-collateralized and haven’t had a long track record to price their risk accurately.
Provisioned Loan Loss: Lender’s estimate their principal loss based on historical data. The estimated loss can be anywhere between 1-10% depending on the risk they are taking.
Borrower Acquisition Cost: Lenders need to spend on marketing to acquire a borrower. For example, they pay loan brokers 1-13% to acquire a customer. Check out this page and this article to get a sense of how much a loan broker can make.
Lender’s Expenses and Profits: Finally, lenders need to take a cut to cover their operational expenses and make a profit. This can be anywhere between 1-5% depending on the volume of loans they underwrite.
Let’s take an example of a $50K 6-month business loan and analyze its cost. Let’s also assume that this lender doesn’t make any money.
%age Cost Borrowing Cost Based on a 6-month 11% loan $1616.36 Provisioned Loss 5% $2500.00 Borrower Acquisition 5% $2500.00 Lender Keeps 0% $0 Total – $6,616.36
As you can see, before the lender makes any money, it has already spent $6,616.36, 13% of the $50K borrowed, or an equivalent of 43.75% APR!!! If the lender is set to make 3% of the principal amount, the APR becomes 62.32%, which is inline with the APR we observed from the short term loan lenders. They are very expensive not because the lenders make a lot of money but because the cost structure is really broken.
So how do business owners get a more reasonable loan offer? I think there are 3 key aspects to a cheaper business loan:
Longer repayment period: Instead of a 6-month loan, make it 3 years. This way the customer acquisition cost can be amortized for a longer period of time.
Lower borrower acquisition cost: the savings can be passed to borrower directly.
Individualized risk pricing: This is a very involved point. Instead of paying the investors 10-12% from a pool of loans with varying credit quality, make it a marketplace. Investors with low risk tolerance get a lower net yield with extremely high quality borrowers, while investors with high risk tolerance get a higher net yield with more risky borrowers. Let the investors pick and choose the loans they want to invest and lenders will pass the risk to them.
Fortunately, a Community Development Financial Institution (CDFI) is doing exactly what is mentioned above.
Mergers and acquisitions (M&As) should be part of the life cycle of small –medium size
businesses also, not just large corporations. They can help businesses expand, acquire
new knowledge, move into new areas, or improve their output with one simple transaction –
it’s no wonder that M&A activity hit a record high in 2015.
However, There’s no doubt about it – mergers and acquisitions are expensive, and without
huge amounts of spare cash on hand, companies will need alternative financing options in
order to pay for their transactions.
There are a number of different methods that small construction firms can use for financing
mergers and acquisitions, and the chosen method will depend not only on the state of the
company, but also on overall activity in M&A and finance at the time of the transaction.
Read on for an in-depth look at the best M&A financing options on the market today – and
the ones which should be avoided…
Taking on debt
Agreeing to take on the debt owed by a seller is a great alternative to paying in stock or
cash. For many companies, debt is the reason behind any sale, as high interest rates and
poor market conditions make repayment impossible. In these circumstances, the priority for
the indebted company is to reduce the risk of further losses and redundancies by as much
as possible by entering into an M&A transaction with a company which can guarantee its
debts. Unfortunately, the debt of a company can reduce its sale value significantly, and can
even eliminate its price. However, from the creditor’s point of view, it offers a cheap means
of acquiring assets.
Furthermore, being in control of a large quantity of a company’s debt means increased
control over management in the event of liquidation, as in this instance owners of debt have
priority over shareholders. This can be another huge incentive for would-be creditors who
may wish to restructure the new company or simply take control of assets such as property
Of course, it is possible to trade debt in M&A deals without the threat of bankruptcy. Under
the terms of the deal, one company may offer to buy up a certain amount of corporate
bonds for a favorable interest rate, or bonds may be traded between companies as a means
of spreading risk and cementing a merger. Where a company’s debts are relatively small,
the creditor may simply offer to cover their costs as an extra incentive during the latter
stages of the transaction. As with exchanging stock, taking on debt can merely be one part
of a complex transaction agreement.
Paying with cash
Paying with cash is the most obvious alternative to paying for a transaction with stock. Cash
transactions are instant and mess-free, and cash does not require the same kind of
complicated management as stock would. Furthermore, the value of cash is far less volatile
and does not depend on the performance of a company. One exception is when dealing in
multiple currencies. Exchange rates can vary wildly, as evidenced by the market response
to the yen following the Ban of Japan’s deflation program; and the British pound following
the Brexit. Currency exchange fees can also add extra expense to multi-national
While cash payment is the preferred method, the price of M&A transactions can run into the
millions or even billions, and not many companies can access this much cash from their
But there are ways of obtaining cash from others ahead of an upcoming M&A transaction:
● Bond issuance
Corporate bonds are a quick and easy way of getting cash, either from existing
shareholders or from members of the public. Companies will typically release a number of
bonds covering a defined period of time (anything from one year to twenty years), with a set
interest rate (usually less than five percent). In purchasing these bonds, investors are
essentially loaning money to the company in the expectation that they will receive a return
on their capital over time, but once the investment has been made, their money is locked in
and can’t be touched until the maturation date. This makes them popular with risk-averse,
long-term investors, who tend to snap them up.
In 2015, bond issuances reached a record high as companies took advantage of low
interest rates in the US to fund their expansion plans and investors sought alternatives cash
savings. According to analysts , more than $290 billion of debt was raised for M&A
purposes, almost triple the amount raised in 2014. However, this trend is very much tied to
borrowing costs, and bond issuances will only represent good value for money if they can
access cheap credit and if they have a clear acquisition goal in sight.
Borrowing money can be an expensive affair when undertaking an M&A transaction.
Lenders, or owners who have agreed to accept payments over an extended period of time,
will demand a reasonable interest rate for the loans they have made. Even when the
interest is relatively small, when you are dealing with a multi-million-dollar M&A transaction,
the costs can really add up. Interest rates, therefore, are an important consideration in
funding M&A transactions with debt, and low interest rates will spike the number of
transactions funded with loans. In 2015, for instance, loans became very popular following
central banks’ quantitative easing programs, which greatly reduced US interest rates. In the
first two quarters of 2015, the amount of debt ($290 billion) used to fund mergers and
acquisitions was triple the amount used in that period of 2014.
However, given that 2015 was the best ever year for M&A transactions, it is not surprising
that performance slowed slightly in 2016.
Other loan options include re-mortgaging (which is only a viable option if the company has a
large property portfolio), and bridge financing. A bridge loan is a very short-term loan which
is intended to ‘bridge’ the gap between expected payments. For instance, a company may
be expecting a slew of invoices dividends just after the M&A deadline. A bridge loan would
cover the shortfall by lending the money to the company over a set period of weeks or
months. In a way, this is the payday loan equivalent of the business world, and should be
approached as a last resort. Interest rates are higher than average, and late payment
penalties can be severe. Furthermore, use of a bridge loan in an M&A transaction may raise
concerns with the other party, undermining the deal.
Where cash isn’t an option, there are plenty of alternative methods of financing mergers and
acquisitions, many of which will result in a speedy and lucrative transaction. The best
method will depend on the companies in question, their share situation, debt liabilities, and
the total value of their assets. Each method comes with its own risks, hidden fees, and
But for most companies, the end result will make it all worthwhile, by creating a stronger,
more diverse entity which will cover all the initial costs, and more.