When money is tight and banks have a reduced appetite for risk, small businesses, particularly Minority/Women-owned Disadvantaged Business Enterprises (MWDBEs), have fewer options for financing.
MWDBEs are an underserved market for financing even under normal circumstances. Short-term credit crunches can force these business owners to seek alternative sources of financing making them particularly vulnerable to providers of short-term high-interest loans.
Lenders that make these types of loans can take advantage of a borrower’s circumstances or lack of financial knowledge.
Providers of Short-Term High-Interest Loans
Minority-owned businesses often lack sufficient access to business funding options for several reasons, including: a lack of collateral, lower net worth, too little credit and banking history, or other tangible and intangible barriers. And, to pursue certain opportunities, businesses may need faster approvals and access to funds than banks and other types of lenders can offer.
Because of the obstacles to obtaining traditional loans, minority-owned businesses may be taken in by providers of short-term high-interest loans.
These lenders use deceptive tactics to exploit borrowers and entangle them in an endless cycle of debt. They target communities where few other credit options exist.
The growth of internet lending by fintech companies has exploded because of ease of access and approval. The fintech lending market was valued at approximately $450 billion in 2020, and is expected to grow to almost $5 trillion by 2030, a compound annual growth rate (CAGR) of approximately 27%. Business lending is expected to account for a significant portion of this increase.
Minority businesses that are caught in a short-term cash crunch are susceptible to fintech lenders because of the ease of access and approval. However, they often overlook the terms and high-interest rates of the loans and then miss payments. In which case, they may be forced to default and refinance at even higher interest rates or seek bankruptcy protection.
Payday lenders and app-based cash advance services provide loans against the borrower’s next paycheck. The APR on these loans is often hard to calculate and in some cased they can reach three figures, and in some cases, four figures. Because of their high borrowing costs, these services could do more harm than good.
Merchant cash advances (MCAs) sound attractive to minority-owned businesses that are is a cash squeeze. They are promoted as a loan against future sales. MCAs include a fee on top of the amount advanced. This fee can be far higher than the interest rate on other types of loans.
Warning Signs
The warning signs for short-term high-interest loans that MWDBEs should be aware of include:
- It sounds too good to be true.
- Fast approvals (advertised as approvals within a day)
- No credit check
- Pressure to act quickly/ unreasonable sense of urgency (aggressive sales tactics)
The purpose of these deceptive tactics is to exploit the borrowers’ lack of understanding of financial transactions.
Some of the dangers of short-term high-interest loans include: unreasonable high fees and interest rates, hidden fees, lack of transparency, and unsustainable repayment conditions that can strip the borrower of assets and equity.
Short-term high-interest loans could land a business owner in a never-ending cycle of debt, and place a creditworthy borrower in a lower credit-rated (and more expensive) loan facility. They should be avoided at all costs.
Financial brokers and ISOs need to make MWDBE clients aware of more appropriate forms of funding when they are faced with a cash squeeze or an opportunity to expand operations. They are likely to feel pressured to seek out providers of short-term high-interest loans to get them over the hump. There are other options minority-owned businesses can consider including single invoice factoring, more commonly known as “spot factoring,” that may be a better solution for their cash needs.
Spot Factoring or Single Invoice Factoring
Factoring is a business funding solution that allows businesses to sell their outstanding invoices to a third-party company, known as a factoring company, at a discount in exchange for immediate cash. Factoring can be a program to purchase all eligible accounts receivable for continuous and reliable cash flow. The factoring company works to develop a seamless process that dovetails with a client’s business model.
In some situations, however, spot factoring or single invoice factoring may be a better solution. It can be a great option for MWDBEs that need quick access to cash to fill a gap in their cash flow without having to take out high-interest loans.
Spot factoring can help small businesses get through a short-term credit crunch, and enable them to accept unexpected large orders and seasonal orders. For example, a manufacturer or distributor of lawn and garden products may have an opportunity for a large spring order from a retailer, but the retailer requires Net 180 day terms to cover the sell-in and sell-through of the products.
Many MWDBEs don’t have the financial resources to carry large accounts receivable balances for 180 days. With spot factoring, they don’t have to wait 180 days to be paid. They can sell the invoice(s) to a third-party company in exchange for immediate cash to pay employees and operating expenses.
With spot factoring, there is no multi-year contract required or obligation to sell a minimum number of invoices per year or over the term of the contract. The client retains the flexibility of selling invoices only when cash is needed.
Spot factoring can also be tied into purchase order financing if the business needs cash to order materials or product for the corresponding order.
As an added plus, customers of MWDBEs are often used to suppliers utilizing invoice factoring to finance their orders. It also gives them assurance that their suppliers will have funding to fulfill their orders.
Spot factoring is the fastest method of obtaining cash for immediate business needs. It is the ideal solution for businesses simply in need of immediate cash.
Spot Factoring is an Excellent Funding Solution for Contractors
Spot factoring is particularly helpful in the area of construction project financing. If the MWDBE is a contractor or subcontractor and will be working on a large new construction project, they may have a lot of one-time capital needs as they start a project.
Spot factoring can be an excellent solution to cover supplier costs or payroll on an as-needed basis. There is no contract or obligation. Once the project is completed, and they no longer have that gap in cash flow, they don’t have to continue selling their invoices to the factoring company.
Why Invoice Factoring is the Smarter Funding Solution
Whether an ongoing factoring program or spot factoring is the better solution for an MWDBE, invoice factoring is the smarter funding solution for a number of reasons, including:
- Accessibility to cash flow: When MWDBEs utilize invoice factoring they have immediate access to business funding. They don’t have to wait 60+ days to be paid, and there is no need to chase customers for payment. Cash flow is available to pay for things such as operating expenses, a business growth opportunity, or for purchase of inventory and supplies to fill customer orders.
- Flexibility: Factoring is more flexible than other business funding solutions. Factoring programs can be custom tailored to fit any business model.
- Easier to obtain than loans: Loans can take weeks or even months to be approved and closed, and credit approval is based on the client’s financial strength and collateral. With invoice factoring, credit approval is primarily based on the MWDBE’s customer’s financial strength and credit history, instead of the minority-owned business’s credit profile. As a result, the approval process is easier and faster than a loan.
- No additional debt: Businesses sell invoices to a factoring company. They don’t need to assume extra debt or pay to service that debt.
- Personal liability is limited: MWDBE business owners have limited personal liability.
- Reduces the need to draw on existing credit facilities: Utilizing invoice factoring instead of drawing down existing bank lines of credit or other credit facilities, leaves them available to fund other working capital requirements.
- Tie in with purchase order financing: Invoice factoring can be tied in with purchase order financing if the business needs cash to order materials or product for the order financed.
- Makes it possible for MWDBEs to pursue new business opportunities: With invoice factoring, businesses can pursue new opportunities that might not otherwise be possible if a loan is required.
- Reduces credit and collection costs: MWDBEs can reduce credit and collection costs. The factoring company underwrites the client’s customer’s credit lines and follows-up with the customer for payment, allowing it to conserve resources to grow its business.
- No long-term contracts: If spot factoring is the best solution for an MWDBE, there is no contract or obligation to sell a minimum number of invoices per year or over the term of a contract.
Partner With Capstone for Reliable Business Funding
Minority-owned businesses in all types of industries need to deliver products or services, issue invoices, and then wait to get paid. They may find it impossible to access sufficient funding for their businesses.
Capstone is an expert in making sure that small businesses can obtain the funding they need to run smoothly and pursue growth opportunities. Capstone’s invoice factoring services can provide adequate access to reliable business funding to get MWDBEs the working capital they need to pay operating expenses and invest in growth.
