How Do Private Loans Work for Small Businesses?
Last Updated: December 06, 2024
Key Takeaways:
- Small businesses get private loans from alternative lenders instead of traditional banks or government institutions.
- To increase chances of approval, a small business can show lenders their Business Plan, financial statements, and more.
- Private Loans are beneficial for small businesses because they offer flexibility, lenient criteria, and faster approval.
Table of Contents
Small businesses are the backbone of the U.S. economy, driving innovation and creating jobs. But don’t just take our word for it: In 2019, the Small Business Administration (SBA) reported that small businesses are responsible for 44% of all economic activity in the United States.
In fact, small businesses have created 12.9 million new jobs over the past 25 years, accounting for two-thirds of new jobs.
Despite playing a pivotal role in sustaining the economy, small businesses can face financial challenges that hinder their growth. Many small businesses take out loans to combat these challenges and ensure growth.
The obvious choice is for businesses to take loans from big banks. But that’s easier said than done. In April 2023, major banks only approved 13.5% of small business loan applications.
One solution small businesses pursue for obtaining much-needed capital is private loans from alternative lenders. This article will explore how private loans work for small businesses and the key factors to consider when seeking alternative financing.
What is a private loan for small businesses?
A private business loan, or an alternative business loan, is a lump sum of cash a small business borrows from a private entity or individual instead of a traditional bank or government institution, such as the Small Business Administration (SBA).
Similarly to personal lending, lenders and small businesses use a Loan Agreement or Promissory Note to outline private business lending.
The entities and individuals that provide private loans are known as alternative lenders.
Who are alternative lenders?
As stated above, alternative lenders are non-traditional private entities or individuals who provide business loans.
They’re known for their flexibility in lending criteria, faster approval times, and willingness to work with businesses that may have limited credit history or lower credit scores. According to the Biz2Credit Small Business Lending Index, as business loans from banks have declined, approval rates from alternative lenders have risen to 29.5%.
Alternative lenders can include the following:
- Online lenders are digital platforms that offer loans entirely online. They often provide a streamlined application process, quick approvals, and fast disbursal of funds.
- Peer-to-peer (P2P) lending platforms connect individual investors or lenders with borrowers through an online marketplace. Borrowers create loan listings, and investors can choose which loans to fund.
Here are some examples of online lenders and peer-to-peer lenders:
What do small businesses use private loans for?
Small businesses use private loans for a variety of things, including any of the following:
- Working capital to cover day-to-day operational expenses, such as payroll, rent, utilities, and inventory replenishment
- Business expansion , whether it's opening new locations, entering new markets, or launching additional product lines or services
- Purchasing equipment , such as machinery, vehicles, or technology to improve operations and productivity
- Purchasing inventory , whether it’s in bulk or to take advantage of seasonal discounts
- Marketing and advertising to attract new customers and grow sales
- Consolidating debt , such as multiple outstanding loans or high-interest debts, into a single loan with better terms
- Hiring new employees and expanding the workforce to meet increased demand
- Renovations to update or improve a business’s operating space
- Emergency expenses and unexpected financial challenges, such as repairs or unforeseen business disruptions
- Seasonal financing to bridge gaps in cash flow during off-peak seasons
How do small businesses get private loans?
The criteria and requirements for loan approval can vary between alternative lenders. For this reason, small businesses may have to provide some or all of the following documents and information to support their loan application.
1. Business Plan
If a new business applies for a loan, the alternative lender may request a Business Plan as part of their application package. Even if the lender doesn’t request one, the applying business can still provide a Business Plan to help earn trust.
Presenting a Business Plan is helpful for startups and new businesses looking for a loan, as they may not have the sales to prove they can repay the loan. A plan can demonstrate a business’s viability, financial projections, risks, market research, and more.
When a lender reviews these things in a well-organized, comprehensive plan, it demonstrates the business owner's commitment and seriousness, giving them confidence in the borrower.
It conveys that the business owner has taken the time to thoroughly plan and consider all aspects of the business, which can be reassuring to lenders.
2. Financial statements
Alternative lenders can ask small businesses to provide financial documents when applying for a private loan. These documents can show a business’s financial health and creditworthiness.
Some of the key financial documents that alternative lenders may request include the following:
- A balance sheet is a snapshot of a business's financial position at a specific point in time, detailing the company's assets, liabilities, and equity. This helps a lender gauge the business's overall financial stability and its ability to meet its financial obligations.
- An income statement summarizes a company's revenues, expenses, and profits (or losses) over a specific period. This document helps lenders evaluate the business's profitability and capacity to generate income to repay the loan.
- A cash flow statement outlines how funds move in and out of the business. It categorizes cash flows into operating, investing, and financing activities. Lenders pay close attention to this statement to assess the business's liquidity and ability to manage its cash effectively.
- Personal and business tax returns can help assess financial stability. Business tax returns provide insights into the company's financial performance, income, and deductions.
- Bank statements can show that a business makes deposits consistently, helping lenders assess how it manages its finances daily.
If the loan is between a lender and the small business owner (rather than the business itself), the owner can provide a Personal Financial Statement.
3. Guarantee Form
Having a guarantor can significantly increase the chances of loan approval for small businesses, providing the lender with additional repayment assurance.
A guarantor is an individual or entity that agrees to repay the loan if the business is unable to meet its obligations. This arrangement adds an extra layer of security for the lender.
The guarantor must sign a Guarantee Form that outlines their obligations. This way, the lender can pursue the guarantor for repayment if the business cannot meet its financial commitments.
However, it's essential for both the business owner and the guarantor to understand the obligations and risks involved in this arrangement. If the business defaults on the loan, the guarantor's personal finances and credit can be adversely affected.
4. Resumes and Reference Lists
When small businesses apply for a loan from an alternative lender, they may provide the Resumes and Reference Lists of all owners.
Resumes can provide insight into the owners’ qualifications, experience, and business expertise. If the business operates in a specific industry, the owner’s Resume can highlight their industry-specific experience, instilling confidence in the lender.
Reference Lists can help the lender verify the character and reliability of the business owner. References can vouch for the owners' work ethic, trustworthiness, and ability to repay a loan on time. Positive references can enhance the credibility of the loan application.
Benefits of private loans for small businesses
Private loans from non-traditional lenders are beneficial for many reasons. We reached out to the finance community and asked, “What is the top benefit of small businesses seeking private loans from alternative lenders?” Here are three of the answers we received:
Benefit #1: Flexibility
Mark Stewart, a certified public accountant (CPA) from Step By Step Business, said that private lenders offer flexibility.
He said, “They can provide customized loan solutions that match a business's needs, which is helpful for small businesses facing opportunities or financial challenges.”
For example, borrowers can discuss and adjust repayment schedules, including the option to create an Amortization Schedule that aligns with their cash flow, making it easier to manage monthly payments.
Collateral requirements in private loans can often be more negotiable, allowing borrowers to use a wider range of assets as collateral or even secure a loan without any collateral, depending on their relationship with the lender and their credit history.
Benefit #2: Approval likelihood
Alternative lenders often have more lenient criteria for loan approval than traditional bank lenders. Andrew Lokenauth, the founder of BeFluentInFinance.com and TheFinanceNewsletter.com, told us, “Private lenders look beyond credit scores and financials.”
For this reason, private loans can be a viable option for businesses with lower credit scores or poor credit history. While traditional banks prioritize a strong credit history, alternative lenders may emphasize the business's cash flow, revenue, and overall financial health.
This leniency is especially beneficial for small businesses that may not meet traditional banks' stringent credit score requirements but still have the potential for growth and success.
Benefit #3: Speed of approval
Megan B. Shepherd, a personal finance expert with Finder.com told us that “alternative lending platforms like online lenders or peer-to-peer, tend to have a more easy and streamlined application process, which makes approval and funding much faster.”
This expedited approval can be a game-changer for businesses that need money quickly. As a result, small businesses can secure the financing they require in a matter of days or weeks, rather than the prolonged timeline associated with traditional banks.
This swift approval process helps small businesses seize opportunities, manage cash flows, and address unforeseen challenges.
Risks of private loans for small businesses
Despite having many benefits, private loans from alternative lenders come with risks.
Alternative lenders often charge higher interest rates compared to traditional banks. A higher interest rate can result in a more expensive loan for a small business over the long term. Businesses with poor credit may encounter even higher interest rates.
In addition, some alternative loans have shorter repayment terms, which can lead to higher monthly payments and potential cash flow challenges for the business.
Lastly, some alternative lenders may require significant collateral or personal guarantees, putting business owners' assets at risk if the business cannot repay the loan.
Golden opportunity or risky move?
Private loans from alternative lenders offer a valuable financing source with benefits and risks for small businesses.
These loans provide flexibility in terms and conditions, making them accessible to a broader range of businesses, including those with lower credit scores. The speed of approval is a significant advantage, allowing small businesses to address their financial needs quickly.
However, it's crucial to be mindful of the higher costs associated with alternative lenders, including interest rates and fees, which can make these loans more expensive in the long run. Additionally, businesses must consider the potential challenges of shorter repayment terms and the risks associated with collateral requirements and personal guarantees.
Therefore, while private loans from alternative lenders can be a lifeline for small businesses, careful evaluation and consideration of the terms and potential risks are essential to make informed financial decisions.
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