Financing has always been a challenge for small businesses. But while the trend toward alternative lending has changed the outlook for many small business borrowers, a nontraditional loan may not necessarily be the best option.

More than ever, prospective and existing business owners need to know what they're getting into before committing to a financing relationship.

From Banks to Alternative Lenders

Access to capital is the engine that drives the small business economy. Without it, entrepreneurs and owners are simply unable to acquire or grow their companies. But while banks insist that they're ready to extend financing to all qualified borrowers, small business owners consistently argue that it's often difficult to secure a commercial loan.

The numbers show that many of the nation's largest banks aren't making nearly as many loans to small businesses as they used to. According to a recent Wall Street Journal report, big banks have reduced the volume of loans to small businesses by more than 38 percent since 2006.

Why aren't commercial banks keen to lend to small businesses? It's primarily a question of profitability. Although large lenders occasionally make loans to small businesses, it simply isn't profitable for them to make business loans of less than $1 million, which is far more than most small business owners qualify for or need.

As a result, the trend in small business financing is toward alternative, online lenders that are eager to make loans of $1million or less--the sweet spot for small companies.

The Dangers of Alternative Lending

Alternative lenders are filling a critical gap in the financial marketplace, and they're doing it in a way that allows them to earn a profit on loans that many traditional lenders typically deem to be unprofitable.

Big data is one of the reasons why alternative lenders can afford to make loans that commercial lenders won't touch. While banks rely heavily on traditional lending criteria, alternative lenders use big data technologies and advanced algorithms to evaluate borrowers' creditworthiness. Data points can include credit card activity, bank account activity, payment histories, earnings deposits and even social media activity.

Armed with data-driven insights, alternative lenders make lending decisions much faster than traditional lenders. In many cases, small businesses receive loan approvals from alternative lenders in a matter of days, rather than the weeks or months it takes for large, commercial banks to act on loan requests.

But alternative lenders' fast turnaround times and willingness to finance small businesses come at a price: exorbitant (if not predatory) interest rates. Since the alternative lending space is largely unregulated, small business owners who are unable to secure traditional financing or acquire capital by some other means find themselves forced to pay much higher rates than they would have been required to pay in a traditional financing scenario.

Tips for Small Business Owners

As a current or future small business owner, financing will likely play a role in helping your business achieve its full potential. But the changing shape of small business financing doesn't mean that you have to settle for high interest rates and costly lending scenarios.

To protect your company's future, there are several things to consider in your search for the right lender:

  • Evaluate your options. Choosing a lender is a serious financial decision. Although it can be challenging for small businesses to secure financing through traditional lenders, carefully evaluate all of your options before settling on the first lender that is willing to approve your request.
  • Consider collaborative lending opportunities. Traditional lenders haven't given up on small businesses, even though they realize that alternative lenders currently have the upper hand. In response to industry trends, banks like JP Morgan Chase are teaming up with alternative lenders to offer loans that are tailored to the needs of small business owners.
  • Understand rates and terms. Whether you're pursuing financing through a traditional bank or an alternative lender, it's important to understand the rate, fees and terms of the loan, and to have loan documents reviewed by competent legal counsel before you sign on the dotted line.

Overall, the emergence of alternative lenders is a positive development for small businesses because it makes it easier for small companies to finance growth and expansion. As the alternative lending industry matures, it will inevitably become more regulated and predictable. But until then, small business owners need to maintain a caveat emptor approach to the financial marketplace.