Grow your business: Commercial lending or private credit?
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To grow or not to grow? That is the question. In 2023, the U.S. Small Business Administration (SBA) indicated 99.4% of businesses in the state of Indiana had less than 500 employees. That represents a number in excess of 530,000 businesses employing a total of more than 1.2 million people. In order to grow, most businesses are faced with making the decision to obtain a loan in order to expand.
Here is a brief primer for companies who are looking to expand, but feel a loan of some sort is going to be required.
Commercial Lending is usually provided by banks, savings and loan associations, credit unions, or other types of established and credible financial institutions. Typically, loans from these organizations are used to cover expanded operations, buying additional equipment, or financing other aspects of the company needed in order to grow the company. Commercial lending institutions offer loans such as:
Term Loans- For a set amount of money borrowed for a specific length of time with regular (usually monthly) payments.
Lines of Credit: Are usually established with a certain not to exceed dollar limit. But the borrower is only charged interest on the amount actually borrowed, up to the specified limit.
Equipment Loans: These are very straight forward loans. They are for purchasing specific pieces of equipment.
Commercial Real Estate Loans: Are used for buying new property or for re-financing other forms of commercial property.
Interest Rates: The financial institution usually charges a rate of interest that is based on the current prime rate, plus a percentage amount. The total interest rate itself can be fixed or variable over the term of the loan.
Collateral: Usually in the form of another business asset, real estate, or the personal guarantee of the borrower, is usually a requirement in order to secure a loan.
Regulation: These types of loans, while very popular and useful for the buisness owner, are regulated by several different governmental agencies in order to insure and protect both the consumer borrower and the financial institution lender.
Private Credit is usually provided by privately held/owned companies or individuals. Examples would be private equity firms, private debt funds or other types and kinds of lenders that are not the traditional financial institutions discussed above. One key point regarding private credit is these loans are usually offered to companies that, for some reason, are not able to obtain a loan from traditional institutions. Here are some examples:
Mezzanine Loans: They usually consist of a mix of debt and equity where the borrower receives certain terms based upon the risk associated with the business. In order to receive more favorable terms, the borrower might need to give up equity (stock) in the business. In the event of a default, this form of debt is typically subordinated (behind or below) any other more traditional bank type loans, when it comes to re-paying the obligation.
Distressed Debt: Is a very specialized niche form of financing that companies resort to using when they are in trouble. Lenders for this type of debt are very specialized and they usually get involved with the objective being that of restructuring the company.
Venture Debt: Startup companies can offer this form of loan to individuals (also known as Angel Investors) or other companies, as well. Many times the loan includes the addition of some form of equity participation, usually in the form of stock warrants, offered to the lender.
Interest Rates: Due to the inherent higher risk associated with private credit, interest rates for these instruments are usually higher than more traditional commercial loans.
Collateral: While collateral can be required, the private credit market is usually more flexible in determining what is needed in order to qualify for a loan.
Regulation: Once again, due to the nature of private credit being used in higher risk situations, there are usually fewer regulations, which allow for more flexibility in terms of the ‘deal’. “Buyer Beware” is an appropriate phrase to consider.
In summary, Commercial Lending is traditionally used by established companies who can provide a good track record of stable financial performance. Private Credit is more often suited for firms who are, for any number of reasons, unable to meet the standards of conventional lending institutions. Examples include start-up companies or businesses that are in a turnaround phase. Private Credit is usually more flexible when it comes to how a loan is structured, yet it also has a much higher cost associated with it. The path you choose should be based on the individual needs of your company.