Small Business Financing September 1, 2009, 10:50AM EST

Entrepreneurs Turn to Alternative Finance

With bank lending standards not loosening any time soon, asset-based lenders, factors, and merchant cash advance providers are filling the void

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The credit binge and the crash that followed have left entrepreneurs in a bind. Banks, faced with rising defaults, dramatically tightened lending standards to reduce their risk. Small business owners who borrowed liberally when credit was easy were blindsided by the downturn, and many now find their credit scores wrecked. Those with little debt on their books but facing slipping sales are also perceived as risky: They're shut out of traditional loans and even credit cards, and represent a growing market of businesses that banks won't touch.

Enter the alternative finance companies. They include asset-based lenders (which make secured loans for purchases of equipment or inventory), factors (which buy unpaid invoices at a discount), and merchant cash advance providers (which pay up front for the right to collect a share of a retailer's future credit-card sales). These sources of funds generally cost more, sometimes much more, than bank credit. But businesses that survived the recession will need to buy inventory and equipment, expand operations, and hire workers during a recovery—and they are finding few other options to fund their growth.

Banks don't plan to resume normal lending any time soon, even when economic growth returns. The Federal Reserve's most recent survey of senior loan officers found that most expect to maintain higher lending standards through the second half of next year. For riskier borrowers—including many small businesses—credit "will remain tighter than average for the foreseeable future," according to the report. Credit-card lending, once an easy source of unsecured funds, has also been curbed: 58 million cardholders had their limits reduced between April 2008 and April 2009, according to FICO (FICO).

A Ripe Time for Asset-Based Lenders

So alternative finance is growing even with credit markets seized up. While some finance companies like CIT have faltered, asset-based lending increased 8% in 2008, according to the Commercial Finance Assn., which represents some 300 asset-based lenders and factors. The group's CEO, Andrej Suskavcevic, sees continued growth ahead, as private equity groups and hedge funds look for profitable investments in nontraditional lenders. Companies squeezed by banks' rising credit standards—including distressed firms, startups, or those trying to finance exponential growth—are "perfect clients for asset-based lenders," he says.

Others, like Chicago entrepreneur Jim Mayer, are building innovative businesses to meet the borrowing needs of risky companies. Mayer is reviving a firm called DiversiCorp, which he ran in the mid-1980s and 1990s. DiversiCorp operated in a narrow field called collateral control. The company would reassure creditors by safeguarding inventory after it was shipped but before it was paid for—by keeping it under lock and key in the buyer's warehouse, for example, and releasing it as the buyer made payments. With Mayer on board, lenders—including suppliers, banks, or outside finance companies—could extend credit to riskier borrowers, knowing they would recover their collateral if the buyer didn't pay.

DiversiCorp did brisk business in the aftermath of the savings and loan crisis in the late 1980s, and Mayer sees a similar opportunity now. "We're going to be looking probably at two years that regulated lenders are going be bending to err in caution," Mayer says.