Generally, borrowing funds from alternative debt financing sources is more expensive than taking out a traditional bank loan. However, many times companies either do not qualify for a traditional bank loan or credit line or must pay very high interest rates, include a co-signer/co-borrower, and/or attach communal assets. In that case, these alternative sources are excellent financing sources. Remember, banks determine the interest rate charged based on risk. The highest credit grade corporate customers are charged prime. All other businesses are charged prime + a risk factor. If a bank will not provide financing, the perceived associated risk is higher. These alternative funding sources mitigate their risks by specializing in a particular industry or asset class and compensate for this risk by charging higher fees and/or interest rates.
Example- SBA loan.
A data housing firm, Acme Technologies, made the decision to spin off its data management operations in preparation for its strategic acquisition by a larger corporation. The data management division had largely gone unnoticed despite its successful management by the division’s management. Needing to recoup some value from the division, which Acme’s CFO suspected might be terminated by Acme’s acquirer, Acme’s CFO made the offer to sell the business to the division’s management.
Although the division’s management team was skilled in a number of functional areas including sales, operations, and cash management, they had no experience handling complex financial transactions. They needed guidance so they used their network to find an advisor. They approached a U.S. Department of Commerce-sponsored Minority Business Enterprise Center (MBEC) located at a renowned university for assistance. The MBEC assigned a business advisor to help them.
The business advisor advised the management team to create a company to buy the assets of their employer. She then found a lawyer that completed their incorporation documents and successfully registered the company within three business days. Next, she spent hours requesting and compiling documentation to create an Executive Summary, pro-forma financials, and management team resumes to present to banks and direct lenders. Finally, she used her relationships with financial institutions to locate three entities that financed acquisitions and worked rapidly.
The CFO initially gave management six weeks from the time the offer was made to complete the transaction. The business advisor pushed back in conversations with the CFO and wrangled an extension. Several issues arose which the business advisor worked through quickly with the management team.
Two institutions, one direct lender and one community bank, emerged as the front runners. Both were highly responsive and flexible and recommended the use of an SBA loan. The community bank met face-to-face with the management team and championed the other banking functions it could provide, along with the long-term benefits of working with them. Subsequently, the management team opted to obtain financing from the bank.
Five weeks after meeting with the business advisor, the community bank provided a Letter of Commitment (LOC) to finance the acquisition. Three weeks after obtaining the LOC, the management team closed on the financing and the purchase of the division and began operating under the new company name, Acton Technologies.