As “financial technology” moves from back office to a front and center player in small business lending, this series takes a broad look at the impact of the growing fintech industry, attempts at regulation and how banks can compete.
Financial Disintermediation – The New Consumer and SME Lenders
Rising from the morass of the 2008 financial crisis, the financial technology industry (fintech) has grabbed the reins of banking and lending and has been gaining market share each year, particularly with small business and individual borrowers. Grappling with regulatory pressure to reduce balance sheets and avoid heightened regulatory oversight themselves, large banks have not picked up their lending to small and medium enterprises (SMEs) and ceded this market segment, while the fintech industry has expanded their market share and matured and evolved their offerings. Fintech saw a veritable explosion in 2015 with enormous amounts of money being invested in platforms that tap into the need for access to capital and a preference for online application. Vastly improving the weeks-long online application processes common since the mid-1980s, creditworthiness was now assessed within seconds using big data and proprietary algorithms. No longer a small, complementary piece of the main traditional lending marketplace, fintech has established a significant and permanent place in the lending market for consumers and small businesses.
This first article looks at SME “alternative funding” sources – SME loans, equity crowdfunding and peer-to-peer funding, as well as invoice factoring and merchant cash advances. Future articles will address the diverse range of fintech innovation and disruption of financial services, advances like virtual reality and blockchain technology, cybersecurity and regulatory challenges, and how the banking industry can regroup to compete.
While traditional bank lending uses the status quo credit scoring model to judge creditworthiness, fintech employs a new paradigm that uses real-time business data (think monthly revenues and profit margins among various data points on an applicant) pumped through various proprietary models loaded with algorithms to determine if loans will be approved – all within a matter of seconds. The new paradigm may be changing the pace of the loan approval process in the same way using computer-based loan applications changed the speed of lending in the 1980s. That being said, a bank’s usual lending process often takes days to weeks, and they lose the lending game to potential borrowers before they even arrive at a decision.
Modern fintech companies like Kabbage (venture funded) and OnDeck (publicly traded) offer the alluring scenario of simple, hassle-free business loans with streamlined and secure online application and quick turnarounds – decisions in seconds to minutes and funding sometimes within 24 hours. Interest rates provided by fintech may be higher than banks due to their higher cost of funds but are less of a factor to the borrowers than the availability of capital and speed of process. Especially for start-ups and small businesses with critical cash flow needs, these lending sources are a lifeline to capital.
Peer-to-peer (P2P) scenarios allow small businesses to borrow from individual investors without a traditional financial intermediary. P2P platforms are not lenders but act as matchmakers between the borrowers and the lenders/investors by providing the online platform and tools that facilitate the borrowing process and the lending lifecycle. Companies like Lending Club (the first P2P lender to register as securities with the SEC), Funding Circle (venture funded) and Prosper (personal loans, transaction based) offer advantages for small businesses because they may not have the same equity requirements as traditional lending. Investors are drawn to P2P lending as the investment amounts can be small and can be spread among multiple borrowers for a portfolio effect. Another draw is that they tend to offer quick returns on investments, which traditional markets may not be able to provide due to low interest rates and stagnant government bond performance.
As with SME loans, P2P lending terms are usually short-term (three to five years) and often are employed to provide cash flow for businesses or consolidate debt for individuals. Borrowers list their loan request online, are vetted by the platform for creditworthiness and once the loan is fully funded by investors, the loan amount is dispersed.
Equity crowdfunding (capital markets) offers startups and existing SME businesses loans through contributions from a large number of individual private investors who in return become a shareholder in the business. This is the space traditionally occupied by angel investors or the friends and family rounds of funding. Examples of some of the more reputable U.S.-based online equity crowdfunding platforms are OneVest, Crowdfunder and FoundersClub.
Investors enjoy the role of venture capitalist and often have a choice of companies to fund. The future value of shares is determined by the success of the companies backed. Follow-on funding for successful companies is usually sought from other sources. This type of funding places the assessment and due diligence on the investors who may not be qualified or competent to properly evaluate a good investment from a bad investment. Only recently have regulators allowed equity crowdfunding. Guidelines surrounding such investing are in the early stages and are expected to evolve as this type of investing matures. To date, no high-profile failure or fraud has been reported to serve as a lesson or trip a movement to tighten up the crowdfunding method with more protections.
Invoice factoring keeps cash flow stable by selling invoices to a third party at a discount. This type of revenue-based finance has been available for a long time and has always been an option for large companies and those in certain industries with receivables from companies with strong credit capacity. Companies like BlueVine, Dealstruck and Fundbox now offer this service to SMEs. Small businesses may be drawn to invoice factoring to combat regular cash flow shortfalls when invoices are not paid on time or to manage slow periods for seasonal businesses. The factoring process can either be done for individual invoices or for all invoices. The trade-off in fees and discounts on the face value of the invoices is usually worth the immediate payment, especially when large customers have leverage over SMEs and can dictate long payment terms of 45 to 60 days or more.
Merchant Cash Advances
Merchant Cash Advances (MCAs) provide a lump-sum payment in return for a pre-determined fixed percentage of the borrower’s daily (or future) credit and debit card sales until the full amount is repaid. The MCA authorizes the payment processor of the business to split and forward the payment receipts directly to the business and the funder as per the agreement.
It is very important to note that the language of this type of agreement is not a loan but acts more like a royalty agreement whereby the funder is entitled to a portion of future sales. Currently this critical distinction allows MCAs to avoid most lending regulations as they are not “lenders.” Until this is successfully challenged in a court of law or addressed by the legislature or regulators, these MCAs act similar to a loan but are not technically loans. Borrowers need to understand the terms of the agreement and make sure that the sales of the business after the portion of sales diverted to the royal payments will be sufficient to run their business and cover other costs and expenses.
On the other hand, because the payback is tied to the sales levels, borrowers can pay back less in months where sales are slower and more in months when business is going well – a favored scenario for small seasonal businesses that may have little collateral or a less than stellar credit history. This type of financing has APR rates that are usually very high. Also, the term “stacking” of MCAs refers to having multiple MCAs in effect at once. This is a dangerous practice as it may divert too much of the cash flow of a business to royalty payments and create a liquidity crisis that will put them out of business and kill the golden goose.
A New Age of SME Lending
Small business fintech lending has become a fast-growing industry sector that has increased the speed of lending decisions, lowered the cost of obtaining loans for the borrower and even offers an appeal for lenders as well. The availability of financing speaks to businesses that may be scoped out of traditional loans due to their size, limited history, past financial performance or equity situation. Accelerating the credit approval process also appeals to customers who cannot endure the traditional SME lending process and who may not even qualify under traditional bank lending guidelines.
Traditional lenders are adapting their approaches to address the changes fintech has brought to the small business lending market. Established financial services companies are investing in fintech technologies in an attempt to attract customers, cut costs and buoy profits. In addition, they are purchasing portfolios originated by these fintech companies and viewing them as alternative origination sources.
The banks are also viewing these fintech companies as corporate banking clients and providing them with warehouse lines of credit or securitization services. Banks are looking at their scale, brand and customer distribution channels to determine how they can match fintech’s on-demand services, which market segments they want to stay in and which ones they want to leave, or if they want to simply change their role in the lending supply chain. Some lenders may even look to acquire fintech companies to ensure they have a path to delivering SME, peer-to-peer and other cutting-edge lending options to their customers.
In the next edition of our series, we will discuss how banks are addressing pressures from innovators.
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