Bank Loans vs Alternative Lenders for SMEs in India: Pros, Cons, and Decision Framework

Capital is the one element that every business needs in order to run operations, expand reach, manage cash flows, and cover emergencies. Primarily, there are only two options to look for-conventional banks or alternative sources to access funds. However, lack of understanding might make it difficult for entrepreneurs to choose a lending source.

For a long time, banks have been the key focus for business financing offering structured short-term and long-term business loans. However, lately multiple sources of alternative lending have emerged helping businesses to bridge credit gaps. Before making the decision to avail business loans, it’s critical for businesses to comprehend their business needs and the type of lender ideal for their goals.

What are alternative lenders for SMEs?

Alternative lending sources are certain financial institutions that operate outside of the traditional banking sphere easing the lending process for the borrower businesses. They allow borrowers to submit queries, connect with experts and process loans entirely through digital channels rather than seeking physical presence. Among the typical sources of alternative financing are:

1. Non-Banking Financial Companies (NBFCs)– NBFCs are financial institutions which operate without a bank license from the Reserve Bank of India. They provide the majority of traditional bank services, including financial products, leasing, and credit. Some of the key features include-

• Relaxed eligibility requirements for businesses.
• Strong regional presence making capital more accessible in Tier-III and Tier-IV cities.
• Offer customized financial solutions as per the industry requirements (i.e. manufacturing, transportation, retail, and services.

2. Fintech Platforms– Fintech companies are organizations who employ advanced technologies (like Artificial Intelligence, automation, Machine Learning, etc.) to deliver financial services in an effective manner. They make credit more accessible and often less expensive compared to conventional lending institutions. Some key features include-

• Fast approval and payment (usually in a day or two).
• Minimal documentation reduces administrative burden.
• Helps small scale businesses lacking credit history.
• Offers short term loans (i.e. line of credit and working capital loans) for routine business requirements.

3. Peer-to-Peer (P2P) Lending Platforms– P2P financing platforms are online marketplaces that connect borrower businesses to individual lenders. In this market, borrowers are often motivated by the desire to obtain better interest rates. P2P lending can provide greater financial accessibility generally ignored by conventional lenders. Certain unique features are-

• Greater access to diverse funding sources.
• Potentially competitive interest rates.
• Transparent and streamlined digital process.
• Ideal for small and micro businesses for temporary unsecured debt.

4. Micro-finance Institutions – Micro- finance institutions focus on smaller businesses and microentrepreneurs lacking access to traditional banking. Such micro-loans offer a scaled-down financing option with modest loan amounts without any substantial collateral. The funds could be used to set up a new business, acquiring essential supplies, managing operating expenses, or maintaining liquidity in early business stages. Some key features include-

• Helps small businesses to grow starting with smaller loan sizes
• Come with least paperwork and no security requirements.
• Extends eligibility to businesses without conventional lending options.

5. Venture Capital Firms – In India, venture capital (VC) firms are well run investment entities which combine funds from corporations, financial institutions, and affluent people to fund enterprises with proven development potential. Certain key features include-

• After establishing product-market alignment, business traction, or demonstrable scalability, VCs often invest between ₹1 crore to ₹500 crore, based on the financing round and phase.
• It comes with increased funding capacity, formal control, and strategic engagement in increasing operations.
• Offer assistance to businesses for recruiting staff, enabling market expansion and seeking successive investments.

6. Angel Investors– Angel fund investors in India are high-income people who put their personal assets into early-stage enterprises, typically during the brainstorming, prototype, or early-revenue stages. Certain features include-

• The loan amount offered varies between Rs. 5L-Rs. 2cr although professional network could allow higher amounts.
• Apart from the loans, angel investors offer guidance and assistance to manage business effectively, access to professional connections and guidance to sustain and expand their operations.
• Typical investment terms could include discounts at subsequent investment rounds, a valuation cap, and convertible assets with a notional interest rate of 0–6%.
• Swift and flexible decision making, minimal due diligence and hands-on mentorship are distinct features of Angel investors.

7. Government Grants and Subsidies – Government subsidies offer considerable alternate finance for small businesses. Such organizations offer monetary incentives to viable businesses helping to reduce operational costs, support priority industries, encourage entrepreneurship, and drive innovation.

• Such financial assistance could be in form of financial grants, capital subsidy, credit linked subsidy, tax exemptions, reimbursement-based incentives.
• Since subsidies do not need repayment like loans, making them an appealing form of financial support for small businesses going through challenging periods or lack collateral required for conventional borrowing.
• Certain subsidies may come with performance-linked conditions, such as job creation, production output, innovation benchmarks, or geographical incentives for setting up businesses in backward or rural areas.

Financing from Traditional Banks-Pros and Cons

Traditional banks have been the cornerstone of company financing for several decades. They are governed by stringent regulatory oversight while offering robust financial instruments that safeguard and legitimize businesses. Businesses with consistent revenues, reliable financial records, and adequate security have particular advantages for banks. It is vital to highlight that their lending strategy focuses on extended, scheduled loans and interpersonal support.

Pros

1. Competitive and consistent Interest Rates- When compared to alternative lenders, traditional banks often provide more competitive and consistent interest rates. It is generally ideal for stable businesses seeking long term capital.
2. Comprehensive Range of Financial Products- Banks provide an extensive variety of financial services, including long and short-term loans such as lines of credit, capital loans, and equipment financing. It allows firms to integrate multiple financial requirements into a single lending institution.
3. Extended repayment term- Traditional banks offer extended repayment term which may range from five to fifteen years which substantially reduces repayment obligation.
4. High institutional trust and strict regulation – Banks function under the comprehensive regulatory guidelines enforced by the Reserve Bank of India. These rules guarantee high standards of governance and transparency for the customers. It promotes trust and gives businesses assurance that their financial agreements are safe and entails legal implications.
5. Tailored Products and Interpersonal Support- Conventional banks frequently designate relationship managers which offer personalized loans, specialized guidance, strengthen comprehension of the business strategy, and decide lending terms on sustained participation. This can result in increasingly favourable situations over time.
6. Ability to higher loan amounts- Well-established banks generally have the financial strength to provide substantial loans to diverse individuals and businesses. Banks possess the ability to offer substantial loan sizes that could be riskier for alternate lenders.

 

Cons

1. Stringent Eligibility and Collateral Requirements- Generally, banks demand proven profitability, certified financial records, secured collateral, and reliable credit records. Start-ups and MSMEs may not always qualify for the eligibility criteria.
2. Lengthy and Complex Application Processes- Stringent regulations may require banks to fulfil underwriting and due-diligence procedures making it a lengthy and tiresome process. It may discourage entrepreneurs in need of funds urgently.
3. Inflexible processes- Owing to their conservative risk-assessment methodologies, traditional banks may not prefer to lend businesses with little operational history, fluctuating cash flows or distinctive business structures.
4. Significant Documentation Requirements- Business strategies, financial statements, tax returns, and asset values, etc. are certain documents usually sought from borrowers which puts administrative strain on SMEs with limited manpower and resources.
5. Lower approvals for certain businesses- SMEs which lack adequate collateral and financial records may face rejection from banks. It could be difficult for business owners seeking quick access to funding to achieve their objectives.

Alternative Lenders-Pros and Cons

With technology-driven procedures and non-traditional credit evaluations, the emergence of alternate financiers has advanced business financing. Such lenders employ real time information i.e. bank details, GST reports, digital cash flow patterns to offer quick, flexible, and accessible funding. Short-term financing is made available based on the borrower’s credit profile, risk tolerance, and expected cash flow and revenue.

Pros

1. Faster Approval and Disbursement- Alternate lending sources particularly fintech services have the benefit of faster and effective loan processing (anywhere between two-four days). It helps organizations to address urgent needs and manage working capital.
2. Flexible Credit Assessment- Rather than just relying on credit rating of an organization solely, alternate lenders employ additional measures (like sales data and cash flows). Thus, it helps to extend eligibility criteria for businesses with lack of credit history.
3. Accessible to Startups and Small Businesses- Alternate lenders offer financing solutions catering to business requirements for scalable emerging businesses otherwise rejected due to lack of collateral.
4. Diverse offerings- Invoice financing, Supply chain financing, Merchant Cash Advances, Crowdfunding and Peer-to-Peer lending, etc. are some innovative and diverse offerings put forth by alternate lenders to address their liquidity needs.
5. Innovative Digital Platforms- Novel features such as digital repayment systems, automated systems, and digital applications will administratively work and easily interface with SMEs’ current accounting or sales platforms.

Cons

1. Higher Cost of Capital- Loans from alternative lenders generally carry higher interest rates or fees than traditional banks, reflecting the higher risk and faster funding they provide.
2. Limited Loan Amounts and Product Scope- Most alternate lenders depend on asset backed collateral or partner networks which may fail to provide large size and long-term funding including revolving line of credit or term loans.
3. Shorter Repayment Terms- Certain financing products like Some products, such as merchant cash advances or invoice financing, may come with brief repayment period which may put strain on the finances of SMEs facing irregular cash flows.
4. Variable Terms and Fees- Certain alternate lenders might have additional fees and charges (i.e. factor rate in case of Merchant case advances) which reduces transparency in processes and demands a cautious approach by business owners.
5. Limited Regulatory Oversight- Certain alternative lenders may have laxer regulations depending on the area, which puts small businesses at more danger if the lender’s operations are opaque or poorly managed.

Bank vs Alternative Lenders-which works best for the SMEs?

Small and medium-sized firms (SMEs) in India often face severe challenges in the form of lack of sufficient capital which affects their growth cycle and competency. Absence of timely funding also undermines a business’s capability to make contribution towards job creation and hence economic development.

While each has their pros and cons, traditional banks and alternative lenders both have crucial contributions in SME financing with certain differences in their approach. Before making any choice, businesses must assess certain strategic, financial, and operational aspects to identify sources that align best with their business needs. Here are the key factors which should be considered-

1. Overall cost of borrowing- One primary aspect to be considered by SMEs is the overall cost of borrowing including processing charges, applicable interest rates, penalties and other costs applicable on the loan. Due to more strict risk evaluations and low-cost deposits, banks may offer loans at reasonable rates. Given that alternative financiers are not regulated with extensive regulations, their borrowing costs may be higher overall.
2. Eligibility criteria and documentation- Banks frequently require thorough financial documentation, security, certified statements, and an impeccable credit history, which restricts entry for startups and unsteady businesses. However, alternate lenders rely on other crucial measures such as sales records or cash flows rather than just going after the credit score of the borrower.
3. Time involved in process- Conventional banks may take longer to process loan applications but alternate lenders leverage technology to complete due diligence faster. Hence, SMEs with urgent operating capital requirements or time-sensitive possibilities may go for alternate lenders.
4. Loan structure and relevance- Next, SMEs need to evaluate the relevance of loan products as well as their structure. As banks are more than capable to offer support capital expenditures or business expansion, they are excellent at offering long term loans. Alternate lenders offer more innovative and flexible funding offerings in short-term. Loan products like Invoice financing, cash advances, unsecured working capital loans, etc. are more suited for bridging cash-flow gaps or meeting operational requirements.
5. Risk appetite and repayment ability- The SME’s risk tolerance and repayment capability also impact the decision. Businesses must ensure that their cash flows are adequate to meet repayments as alternate lenders come with a shorter tenure and higher rate of interest. In contrast, if a SME could qualify for bank loan eligibility criteria it may be able to gain advantages from simpler repayment terms and more affordable interest rates.
6. Additional Support- Finally, SMEs should examine advisory support and relationship value. Banks often offer a wide range of financial services, including trade finance, overdraft capabilities, and cash management, as well as long-term relationship benefits. Alternate lending, while typically more transactional, offers personalized assistance and hands-on support specifically tailored to the needs of small businesses.

Conclusion

Choosing a lender between a traditional bank or innovative alternative lenders should be determined on the basis of the borrower’s needs and their financial health. While traditional banks have a good reputation, competitive interest rates, and the ability to offer larger amounts, alternative lenders may offer flexible terms, quicker approval, and specialized support. Thus, instead of making rash decisions, borrowers should carefully consider interest rates, eligibility conditions, and processing time.

Understanding the distinctions and identifying a suitable lender can assist businesses in obtaining the financing they need to expand and prosper. Regardless of the choice, business owners should ensure that the funds are managed effectively to fulfil business goals.