Banks have two primary criteria for determining high-risk business loans. One is based on the creditworthiness of the loan applicant regarding credit score, cash flow, and length of time in business. The other is based on whether the business is included in one of the financial industry’s “high-risk industries.” Most traditional commercial lenders will steer clear of issuing high-risk business loans for either of these reasons unless significant collateral is available as security.
Fortunately, several non-traditional lenders have emerged to deliver critical financing options to this underserved market segment. Business owners who need financing are no longer disqualified just because a bank declared them to be high risk. They now have alternative business financing options discussed below.
Table of Contents
- What are High-Risk Business Loans?
- Types of High-Risk Business Loans
- Some Final Words
What are High-Risk Business Loans?
As the term suggests, high-risk business loans are financing options offered to entrepreneurs who don’t meet the standards of the traditional banking industry. They generally carry higher interest charges and shorter repayment terms to offset the risks involved but can be a useful source of short-term cash for business owners who need to bridge a gap in their finances.
There are several reasons for being declared “high risk” due to a perceived lack of creditworthiness.
In all of these cases, alternative lenders have devised innovative solutions to not only reduce their risk but provide operating funds to business owners who have previously been shut out of the lending marketplace. We discuss these innovative solutions below.
Industry type is used to ascertain whether financing is classified as low-, middle-, or high-risk business loans. Even loan applicants with acceptable credit scores can be refused short-term financing if they’re in a high-risk industry.
There’s really no universal definition of “high risk industries.” It varies from lender to lender. But there are some commonalities:
- High-risk classification due to 5-year industry failure rate.
Start-up failure rates are already fairly high. According to the Bureau of Labor Statistics, 20 percent of start-ups will fail within the first year. Another 10 percent fail by the end of the second year with 44 percent failing to make it to the fifth year. The good news is that 56 percent succeed into the fifth year!
By tracking industry trends, the Census Bureau was able to determine that some industry types fail more often than others. For example:
- Construction Industry – Just 36.4 percent of start-ups in the highly-competitive construction industry make it to their fifth anniversary. This puts the industry into the high-risk category for business loans from conventional lenders.
- Transportation and Trucking Industry – From bicycle couriers to taxis and from local delivery services to international freight, only 39.4 percent of transportation start-ups reach their fifth year.
- Financial, Insurance, and Real Estate Services Industries – These are highly-competitive markets where too many businesses chase too few clients. Nearly 60 percent of start-ups in these high-risk industries exceed four years in operation.
- Retail Industry – Another highly-competitive market is the retail industry whether brick-and-mortar, e-commerce, or both. Only 41.1 percent keep their doors open for five years.
- Wholesale Industry – Faring better than retail, the wholesale industry has a 5-year success rate of 47.4 percent.
- Restaurant, Bar and Nightclub Industry – There’s significant misinformation on failure rates in the food service and hospitality industry, but most agree that about 40 percent see their fifth year. High start-up costs and competitive marketplace are causes for failure.
- Manufacturing Industry – 5-year success rates for the manufacturing industry is 48.4 percent.
There are a variety of reasons why start-ups in these industries fail more often than others. But the #2 reason why these companies failed (29%) is due to lack of cash and the #16 reason is that they couldn’t secure business financing in time to save the business. This revelation makes one wonder if start-up success rates would improve through access to business loans from alternative lenders.
- High-risk classification due to reputational risk.
Traditional commercial lenders must please a wide range of stakeholders including customers, shareholders, employees, and public opinion. In order to maintain their corporate image, they often shun industries they feel may damage their reputation. Examples include:
- Liquor Store Industry – Alcohol is a perfectly legal product consumed by millions of Americans, yet conventional thinking at some traditional lenders is to avoid issuing high-risk business loans to the alcohol industry. Bars and nightclubs may also be viewed negatively by some commercial lenders.
- Adult Entertainment Industry – Many conventional lenders do not want to be associated with this industry.
- Gambling Industry – The gambling industry has an historical connection to organized crime causing many lenders to consider the industry a reputational risk.
These industries are sometimes referred to as “sin” industries causing some conventional commercial lenders to shy away from issuing high-risk business loans to protect their brand.
- High-risk brick-and-mortar businesses.
American consumers are doing more and more shopping online from the comfort of their own home or while stuck in commuter traffic on the way home from work. It’s becoming more difficult to get enough foot traffic to brick-and-mortar businesses to become a success. High-risk brick-and-mortar industries include the:
- Retail Stores – High start-up and operating costs make it difficult for brick-and-mortar retail operations to compete with their low-cost e-commerce cousins. Retailers with insufficient start-up capital often find cash outflows exceed customer acquisition and quickly run out of working capital. At the very least, physical retail operations need an online presence for product and price comparison purposes and to attract shoppers.
- Newspaper and Magazine Publishers – Digital publishers are taking over the publishing industry as more and more Americans turn to their computers and phones for news and commentary.
- Staffing Agencies – Brick-and-mortar staffing agencies are losing ground to online and social media recruiters.
- Travel Agencies – Many people are now making their own travel arrangements online. Widespread internet communication is causing the need for brick-and-mortar storefronts to decline.
The primary thread that runs through all of these industries is that each one can boast several success stories. Alternative commercial lenders take the position that providing high-risk business loans to those needing a short-term cash infusion will lower the failure rate.
Modern financial technology (Fintech) drives today’s alternative commercial loan industry. They use machine learning, artificial intelligence, and predictive analytics to assess whether a business owner meets criteria that leads to success rather than failure. Their goal is to “include” more companies in the business loan marketplace rather than “exclude” based on someone else’s failure.
Types of High-Risk Business Loans
Increasingly, owners are turning to online high-risk business loans to fund their operations. American Banker reports on a 2018 Federal Reserve survey that found, “32% of credit-seeking small businesses applied to an online lender, up from 19% in 2016.”
Companies in high-risk industries, those with moderate to bad credit scores, and borrowers prioritizing fast approval were among those opting for online business loans and alternative financing options.
Most high-risk business loans are short term. They act as a “bridge financing option” for entrepreneurs facing short-term cash problems due to slow-paying customers or a seasonal slump.
Fast, High Approval Business Loans
In many instances, urgent cash flow problems are the result of an extended “cash conversion cycle.” This cycle calculates the time it takes for a company to turn invested working capital into cash returned from sales. Slow-paying customers can disrupt the best-laid cash flow plans sometimes putting the small business at existential risk. Current projects may have to be put on hold, critical purchases may have to be delayed, and employees may not be paid on time.
The solution is fast access to short-term capital to bridge the cash-flow gap. Traditional lenders are generally not geared to fast-tracking short-term business loan applications sometimes taking several weeks to approve. It’s online lenders who are providing small business owners with fast, high-approval rate commercial loans to keep operations afloat.
The combined factors of speed and high approval rates (80% – 90%) are desired by hardworking entrepreneurs focused on success rates rather than failure rates. This evidence is from the Federal Reserve survey mentioned above who found that business owners are attracted to the speed of the online lending industry to approve and fund a commercial finance request.
The following are high-risk business loans that can be approved in hours and funded within days:
Working Capital Micro-Loans
Sometimes all that is needed is a short-term cash infusion of $5,000 to $25,000. Business owners with decent FICO scores above 670 are most qualified for these no-collateral high-risk business loans. Even entrepreneurs in high-risk industries can access working capital micro-loans. Though interest rates are typically higher than on conventional loans, many owners are attracted to the problem-solving expediency of fast approvals, funding, and shorter payment schedules.
Short-Term Business Loans in High-Risk Industries
Having a business classified as being in a high-risk industry should not disqualify an owner for business financing. After all, even a 60% industry failure rate results in a 40% success rate. The restaurant industry, for example, is often classified as high risk. Yet the National Restaurant Association projected 2019 sales at $863 billion. Obviously, the industry is ripe for success with adequate business financing.
Short-term high-risk business loans often carry higher interest rates, double- and triple-digit APR, but are set up to promote fast payback. Loan terms are typically 18 months and less. Unsecured short-term business loans generally require a FICO score above 670. Loan amounts can range from $50,000 to millions depending on the commercial lender. Bad credit high-risk business loan applicants have other financing options.
Bad Credit Invoice Financing
Some companies classified as high-risk industries like construction and manufacturing find themselves short of cash due to a lengthy cash conversion cycle. They purchase inventory and pay employees long before a customer pays their invoice. With little available cash, new projects have difficulty getting off the ground. Losing customers because you can’t deliver can destroy a company’s reputation.
Invoice financing can provide a bad credit borrower with the funds needed to keep the business rolling. Invoice financing involves using your company’s unpaid invoices as collateral for a business cash advance. An online lender advances from 75% – 90% of the face value of the invoices. When your customer pays the invoice, you pay back the loan. These high-risk business loans are useful for companies with relatively large invoices. FICO scores are not weighed heavily in loan approval as the invoices act as security for the cash advance.
High-Risk Business Loans – Merchant Cash Advances
Merchant Cash Advances are high-risk business loans designed for companies with high-volume debit and credit card sales like retail, professional services, and healthcare providers. Cash advances are calculated based on your daily, weekly, and monthly “card” sales volume. Typically, at least $10,000 per month in sales is required to qualify for the advance. A poor credit history or high-risk industry classification doesn’t disqualify loan applicants for this type of high-risk business loan because repayment is based on future daily or weekly sales.
Some Final Words
How important are small- and medium-sized enterprises (SME) to a healthy economy? The International Federation of Accountants states, “according to the World Trade Organization, small-and medium-sized enterprises (SMEs) represent over 90 per cent of the business population, 60-70% of employment and 55% of GDP in developed economies.”
It seems counterproductive to exclude poor credit or high-risk industry owners from accessing the cash needed to continue operations. Fintech commercial lenders are filling the void by providing high-risk business loans to a wide variety of small- and medium-sized companies in all industries. And they’re approval and funding process is based on speed providing owners with the cash they need in hours and days rather than weeks and months of traditional lenders.