If you have ventured outside of traditional commercial banking, you may have discovered that the non-traditional world of funding is very different. Fees and rates are normally higher.

I know when I first entered that market, I thought that they must be insane. In some cases they are, but it is helpful to understand why things are so different.

The first thing you have to realize is that banks are very different from investor based funds. Because banks use fractional reserves on deposits and have the federal reserve to lend them capital, they make money by leveraging their capital at certain specified ratios. So, if a bank is lending (that is a joke), then it would not be unrealistic for their actual return on capital to be 9 times the rate to an individual borrower. In other words, if the lending rate at a bank is 5% then they make actually be working on a total return on capital of 45%. We will save the detailed banking explanation for another day.

Funds, on the other hand, do not have the leverage model of banks, but have to raise every dollar of capital from investors. Now, realize, that they have to raise those funds with the expectation that the investor will do better than they would at the very secure rates at a bank. So, first of all, if a bank is paying 3% on a CD and charging 6% as a commercial rate, then it is likely that a fund will be at 8%-9% on very secure lending and 10%-12% on more speculative deals.

Remember this kind of funding is not at home mortgage rates!

You will quickly encounter the other aspect of fund financing; the fees.

There are generally, two types of fees. The first is application or due diligence fees. Theses are fees charged by funds to consider and research your deal. They vary greatly based on the fund and type of deal, but can range from $2500 to $20,000.

The second type of fee is loan points. Almost all loans from funds have points. The points will usually range from 2 to 6 depending on the type of loan, the duration of the loan and the risk.

Between commitment fees, points and interest, it is not uncommon to have the total cost of the loan in the first year be between 10% and 16%. One associate of mine says, that he knows if a deal is good, meaning a viable business, when it can stand a total first year cost of money of 20%.

Ouch! Yes that may be painful, but after I recovered from the shock, and looked at it from a lenders perspective I see how that is a decent test. In other words, if a deal only works because of low cost funding, then it is not likely that it has the kind of cushion or margin of error it needs to be successful anyway, at any rate.

Yes, money is expensive! It is important to understand that investors make returns on successfully managing risk, and risk is reduced by high entry fees to weed out weak deals, high rates to cover the risk of not being in control of the target company, and to encourage a quick exit strategy and the return of the invested capital.

I hope this helps to set the expectations you should have in terms of fees and rates, so you can build your business plan accordingly.