As a first time borrower evaluating options for non-bank capital, navigating the alternative financing market can be confusing and, in many cases, downright frustrating. There are many different working capital products – small business loans, cash advances, equipment leases, invoice factoring, to name a few – how do you know what is right for your business? There are also many different types of companies – lenders, brokers, and marketplaces – how do you decide which type of firm will help you access the right product for your business? Then you get to the financing providers. There are hundreds, if not thousands, of alternative lenders and cash advance companies. How do you know which company to choose?
Most importantly, how do you know you are working with a financing provider that is looking out for your best interests and won’t induce you into a high cost debt cycle your business may never be able to escape?
To help you navigate this process, we’ve laid out the five key questions you should ask your prospective financing provider. In the alternative finance market, there are many responsible funding companies that will offer the right product for your business; however, there are also hundreds of companies (the vast majority of these companies offer only cash advances) that offer highly predatory products filled with hidden costs that can quickly send your business into a cycle of high cost debt your business may never be able to escape.
Finding the right financing provider is 99% of the battle in alternative finance; to help you find the right funder, we’ve laid out five questions you should ask prospective financing provider. And remember, the first option isn’t always the best option, so if you asked these questions and don’t feel like you’ve received suitable answers, look elsewhere.
Are you a direct lender or a broker?
This is always the first question you should ask. If you find an honest, knowledgeable broker, he or she could help you find the best alternative for your business. However, brokers currently operate under little to no oversight, and many of the unscrupulous brokers will look to place you with the product that generates the most commission for them, not the best product for your business. This result can have catastrophic consequences for your business, so it’s essential you ask this question and do a thorough background and reference check on the broker or funder. If the company states they are a direct lender or direct funder, ensure their company name is on the contract if you pursue a loan, advance, or factoring solution; if it’s not, ask why and if the answer isn’t sufficient, move on. Don’t fall into the trap of enabling a commission-chasing broker to ruin your business.
If you decide to work with a broker, ensure that broker has your best interests in mind. Brokers aren’t regulated, and they are paid (much) more to sell you a high cost cash advance then they are to arrange a low-rate loan product. If you do work with a broker, ensure you ask them to present you several alternatives, not just short-term capital solutions such as cash advances. Most importantly, ask the broker how much they are being paid in commission to arrange the capital; remember, every dollar the broker is paid by the lender directly increases the cost of your loan or cash advance – and in the cash advance market, the broker commissions can be upwards of 15%.
What is the cost of my loan, including fees?
With so many different types of products in the market – short term loans, medium term loans, SBA loans, cash advances, invoice factoring, equipment leasing, to name a few – comparing cost can be difficult as not all offers are presented with a uniform cost metric. While Annual Percentage Rate (“APR”) is the most widely known cost metric, it isn’t universally applicable across all products, especially products that aren’t “credit”. However, Breakout Capital, along with some of the best actors in the space, recognizes the need for uniformity and is pushing towards a universal mechanism that allows small businesses to fully understand the cost of different types of products.
An important distinction is the difference between interest rate and APR. If your financing provider uses the term “interest rate”, ask if that interest rate is actually APR, and if it isn’t, ask for the APR equivalent. “Interest rate” only represents the rate of interest that is charged over a specified time period (e.g. a month, six months, or a year). The good actors will not confuse interest rate with APR, but many of the unscrupulous actors will. These companies may tell you that you are paying an “interest rate” of 20% for six months, and that may sound great, but it can actually represent an APR of upwards of 70% depending on how the loan is structured.
When you are working with a specific financing provider, ensure you know the total cost of the loan, including any upfront fees (origination fees, broker fees, or other) as well as any prepayment penalties or prepayment discounts before you sign any paperwork. If you are searching for a small business loan and would like to evaluate the deal across a few metrics such as total payback and APR, ask the lender to provide them to you. If they won’t provide this to you, you should probably contact another lender.
What happens if I default on my financing?
This is a scenario every business owner doesn’t want to consider, but it’s imperative to understand what happens in the event you experience hiccups in your business and miss a few payments, or in the worst-case scenario, your business fails. Many financing providers will require a personal guarantee, and you need to read that language carefully (even better, have a lawyer look at it) to make sure you know what happens if you are unable to pay the financing back.
One important distinction between a business loan and cash advance is in the personal guarantee. For business loans, the personal guarantee typically will hold you liable for all monies owed regardless of the success of your business. However, for cash advances, the personal guarantee is only a guarantee of performance; that means if you abide by your contract and your business fails, the cash advance company cannot legally collect on the outstanding balance. This is one of the most important features of a cash advance, and the “good” cash advance companies will fully respect the terms of the contract, and will simply ask you for the documentation of business closure.
However, some of the unscrupulous cash advance companies may try to enforce the personal guarantee on a failed business even if you followed the contract perfectly, attempting to prove that you somehow violated the contract and therefore failed the personal guarantee of “performance”. This is another reason you need to carefully understand your contract, and if you have questions, ask an attorney. Finally, understand what liens, if any, are placed on your business and how these liens could restrict your business going forward. Once you pay back your financing, be sure to ask you provider to release the lien on your business.
What happens if I need more capital?
This is a critical question to ask, especially if you are accessing short-term financing. Responsible borrowers typically won’t borrow more money than they need, which leads us to the following question: what happens if you need more money?
You may think you can just go back to your original funder and request more capital, but many short-term funders won’t allow you to access more money unless you are 50% or more paid down on the original financing. And once you do qualify for additional capital, what happens to your outstanding balance? In today’s financing environment, most merchant cash advance providers and short-term lenders require small businesses to pay their current balance in full before the funder will provide the small business with additional capital …and force you to use the money from the next advance or loan to pay off the outstanding balance.
So what’s the problem with this? This is called “double-dipping” and causes the business to pay twice for the same money. “Double-dipping” significantly increases the cost of a funding to a small business (and in turn, significantly enhances revenue to the funder/lender) and frequently there is little to no disclosure about the “double dip, much less the effective cost of the “double dip”. If you receive funding from a provider that “double-dips” at renewal, you are likely paying an incremental $2,500 to $10,000+ for each renewal or refinancing. Learn more about “double dipping”.
Before you sign your funding contract, directly ask your funding provider if they “double dip” at the time of renewal. If they say they don’t know, it’s likely they “double dip” and you may end up paying a lot more for your capital than you expected.
What happens if I want to pay off my loan or advance early?
There are two distinct terms to understand here: “no prepayment penalties” and “early repayment discounts”. They may sound the same, but the meaning is very different. If a loan or advance has “no prepayment penalty”, that means you can pay off the remainder of financing contract at any point without any additional fees outside of contractual amount owed; but that does not necessarily mean you can pay off your contract by just repaying the remaining principal. In the short term financing market, this distinction is critical. Most short-term lenders and cash advance providers use “fixed cost” contracts which, instead of accruing interest on a daily, weekly, or monthly basis, state the amount owed regardless of when the contract is paid in full. In these cases, you need to ask your potential funding provider if there is any early repayment discount or early repayment benefit. An early repayment discount allows you to repay a “fixed cost” contract early and the lender or cash advance provider will waive a certain amount of unpaid interest or fees.
Breakout Capital is committed to responsible funding. We believe it is better for you to keep your business and grow it responsibly than set it up to fail with insurmountable debt. Please contact us today if you’d like to partner with us.