Small Businesses in Financial Difficulty Often End Up in More Trouble with High Interest Loans

Debt is not a bad thing for a small business. Businesses need debt to purchase equipment, expand operations, help with the fluctuations in cash flow, or keep the doors open during slow periods. The issue is not debt, but the type and amount of debt a small business takes on. Unfortunately, small businesses can make their financial troubles worse by taking on the wrong type and too much debt.

Generally speaking, a small business’s first choice for 3rd-party financing is from a traditional lender (i.e., a bank or credit union). Unfortunately, in many circumstances, a traditional lender will not provide the financing that is needed. In these situations, a small business can reach out to a non-traditional or alternative lender to get financing. While an alternative lender typically charges higher interest rates, the benefits of getting the necessary financing from a non-traditional lender often outweighs the costs.

What’s the Difference Between Alternative & Distressed Lenders?

For the purpose of this discussion, we’d like to put alternative/non-traditional lenders into two categories: alternative and distressed lenders.

Getting a loan from an alternative lender is like getting a mortgage on your house from someone other then a bank (or like getting a 2nd mortgage on your house). Their interest rates are higher than banks and credit unions.

A loan from a distressed lender is like getting a 3rd or 4th mortgage on your home. Their interest rates are often more than 20%.

It’s also important to understand that the interest rate isn’t the only cost of the loan that you need to understand. Some alternative lenders and most distressed lenders often charge additional administration fees that increase the cost of the loan. For example, a distressed lender might quote their interest rate at 15% but after extra fees and charges the effective rate is closer to 40%.

Some distressed lenders charge 15% interest, but this is calculated on the original balance. Even as the loan is paid down, they continue to charge 15% on the higher original balance until the full amount is paid. The effective interest rate on these types of loans is much higher than 15%.

Alternative lenders and distressed lenders usually take security over the business assets and in many cases ask for a personal guarantee from the business owner (and their spouse). This means that if the business cannot repay the loan, the lender can take the assets that are secured and ask the guarantor to personally pay the balance due on the loan.

Retailers & Restaurants

We have seen a number of retailers and restaurants that have turned to distressed lenders to try to borrow their way out of financial trouble. These distressed lenders are taking 20% of all credit card sales as loan payments. The low margins for retailers and restaurants means that the cost of using a distressed lender makes the financial trouble worse. In addition, by taking 20% of the gross credit card sales, the distressed lender is taking the HST that the small business is supposed to be paying to the Canada Revenue Agency. This makes matters worse for the business and the business owner because the directors of a company are personally liable if there is anything owing for HST.

In addition to considering the type of lender a small business uses, the business owner must be careful to not take on too much debt. While some debt is good, too much debt will push the business over the edge. The amount of debt a business can handle will depend on the nature of the business, the cash flow, and the business’s ability to repay the loan.

Navigating the way through the type of lender to use and the type of debt to take on can be confusing and overwhelming for a small business owner. If your small business is thinking about taking on new debt to weather a financial storm or to get out of financial trouble, speak to Farber.

Our lending experts and restructuring specialists are able to review your financial situation and provide all options available to you. In fact, our lending experts work for you, not the lender. Our focus is on finding our clients the right financing solution that best fits their business’s needs.

From a restructuring perspective, when a business is struggling financially, rather than getting a loan from an alternative or distressed lender, business owners can choose a Proposal to Creditors as a way to get legal protection from creditors and reduce the debts of a business by making a legal offer to its creditors.