Many business owners look for short-term working capital solutions to solve a temporary cash crisis.*
However, the structure of many of the short-term business loans offered in the marketplace can easily lead to long-term pain for your business.
Would You Like to Know a Secret?
The most common products offered for obtaining short-term business funding are known as "working capital loans" and "merchant cash advances." These products are both "daily payment" meaning you will make payments every day excluding weekends and holidays, until the loan is repaid.
The main difference between the two: working capital loans take money out of your bank account (via ACH) while merchant cash advances siphon the money out of your daily credit card sales.
While most companies offering either of these solutions will present their products as "short-term", the marketing materials sent out to the broker community usually tell a very different story: There is a strong focus in the broker community on knowing how much funding sources pay on "renewals". This means they have a good idea for when their customer has to return for more money. Renewal payments are very important in broker marketing materials. They rely on customers needing to "re-up" their advances over and over again as the high payments involved suck the business dry. Most customers are not aware of whether they are working with a broker or a funder, or what the difference is between the two.
Make sure the loan repayment plan does not erode your business’s cash flow.
Most companies that offer short-term business loans have two main channels: They sell the product to business owners directly. They also allow brokers to offer their products, usually at a significant markup.
Frequently these business loan brokers boast: Our Average Customer Renews 3+ Times
At first glance this could suggest their customers are happy. However, there’s another way to look at that. Which is if the average "short-term" business loan is renewed 3 or more times, it could be that most aren't exactly short-term in practice.
Why Do Most Business Owners Have to Renew Their Working Capital Loans?
While working capital loans are marketed as fast, easy and short-term, in many cases the payments are so high that by the time the loan has been repaid, you'll be out of money and need funds again.
Most of these products have to be repaid over 6-9 months with payback amounts quoted as a "factor rate" of 1.25 or higher.
Here's how they work:
Imagine a business owner, "Ted" who owns a retail store doing $25,000 per month in sales and needs a loan for $25,000 worth of inventory. If Ted is offered $25,000 over 6 months at a 1.25 rate, that means he'll have to pay back $31,250 over the course of six months.
The payback terms are likely presented in such a way that they sound easy: since there are 250 business days in a year, there are 125 business days in 6 months, so the payback is likely to be presented as "just $250 daily."
Quoting the payback in terms of daily payments take the focus off of two very important aspects of the financing:
- The amount Ted is paying for the financing in terms of an annualized interest rate.
- How much will the loan payback erode Ted's cash flow?
First, calculating the payback of $31,250 against $25,000 over 6 months in terms of an interest rate yields a 96.32% APR (Annual Percentage Rate). This is why you almost NEVER see the letters "APR" mentioned on any of the daily payment lenders' websites.
When questioned, these companies typically maintain that since these loans are only meant to be used for short-term financing, the APR is meaningless. That all sounds good in theory, but as we already discussed, industry people are well aware that these loans are rarely ever "short-term."
The reason these loans are almost never as short-term as they are presented:
The vast majority of business owners tend to think in terms of monthly cash flows, which is part of how converting the loans into a daily payment can obfuscate the real numbers.
As for Ted's case, with that $250 payback, and being that there are 20 business days in a month, the payback amounts to $5,000 monthly against his $25,000 in sales.
Paying back $5,000 against $20,000 equates to 20% of revenues going toward paying back the loan, which for most businesses means either all or most of the gross profits.
(Gross profit means sales minus all expenses, but before loan payments and taxes.)
Business owners on the hook to pay back all or most of the profits to satisfy repayment of a “short-term working capital loan” are at a greater risk of being out of money. This means by the time the loan is repaid, they’ll have to return for more.
Are There Better Options for Business Owners to Access Capital?
While going to a bank for money would certainly be less expensive, the need for collateral, the complicated and long application process makes it a less favorable option for business owners.
In many cases, a small business term loan, such as those offered by LoanMe, could be a very smart alternative to these not-so-short-term options.
With LoanMe's product instead of paying back over six or nine months, the loan can be repaid over up to ten years, with the following features:
- No penalties for early repayment. As opposed to most short-term business funding products, which do penalize you for paying early.
- No payment for the first 15-45 days. Most of these short-term business loans require the first payment the day after initial funding.
- Much lower payments than the same amount borrowed via a short-term product. Our monthly payment does not exceed 10% of gross sales in most programs.
Let's go over the difference in payments between a business term loan and short-term working capital.
Back to our example of Ted, who had to pay back $250 daily against a $25,000 inventory loan, which equated to $5,000 per month.
Using a small business term loan, Ted's payments could be as low as $551.20 per month (assuming a 10 year payback and excellent credit) while if Ted had "fair credit" repaying a 10 year term loan with LoanMe might see minimum monthly payments of $1,439.
Note that the annual percentage rate (APR) for the excellent credit example is 24%. The example for fair credit demonstrates an APR of 69%
These payments would be small enough so that Ted can access the capital he needs to grow without giving up every last dollar of profit to loan repayment.
Lastly, because LoanMe reports to business and personal credit bureaus monthly, Ted would have the opportunity to build his business and personal credit.
In most cases, small business term loans would represent a more sensible alternative to the short-term working capital loans offered today.
*This article has been prepared for general information purposes only. The information presented is not legal, financial, tax or accounting advice, is not to be acted on as such, and is subject to change without notice. Credit approval is subject to LoanMe's credit standards, and actual terms (including actual loan amount) may vary by applicant. LoanMe requires certain supporting documentation with each new application. If you have any questions regarding this, call us at 844-311–2274. California loans are made pursuant to LoanMe's California Department of Business Oversight Finance Lenders Law License #603K061. LoanMe also offers loans in certain other states which may have higher minimum loan amounts. Copyright © 2016 LoanMe, Inc. All rights reserved.