Alternative online lenders meet the financing needs of small businesses


(Editor’s note: This is the last in a series of four articles based on a Harvard Business School working paper by Karen Mills that analyzes the current state of availability of bank capital for small businesses.)

Banks are the primary source of outside capital for small businesses, but there have always been other forms of loan capital available, including credit unions, community development financial institutions (CDFIs), merchant cash, equipment rental and factoring products.

Historically, this segment of the market has been small compared to the $700 billion in small business bank credit assets. But since the onset of the financial crisis, and particularly during the economic recovery, there has been significant growth in innovative online alternative financing for small businesses. The outstanding portfolio of online lenders has increased by around 175% per year, compared to a decline of around 3% in the traditional banking sector. However, it still represents less than $10 billion of outstanding debt capital.

Despite their small size, these alternative players have the potential to fundamentally change how small businesses access capital , creating greater competition, price transparency and a better customer experience. Emerging online players are pushing innovation in the lending industry the same way other online startups like changed retail and Square changed the small business payments industry.

A few factors explain the rapid growth of entrants. First, institutional debt and equity investors have been attracted by the relatively high rate of return offered by loans in this market. Traditional bank loans can generate a return of 5-7%, but many alternative lending platforms charge returns ranging from 30-120% of the loan value, depending on the size, term and risk profile of the loan.

Growth is also being driven by the ways in which alternative lenders are innovating in small business lending, particularly in terms of the simplicity and convenience of the application process and the speed of delivery of capital. For example, all of the biggest emerging players in the alternative lending space offer online and mobile applications, many of which can be completed in less than 30 minutes. These are not just inquiries; these are real loan agreements. This compares to the average of about 25 hours that small businesses spend to complete paperwork at an average of three conventional banks before obtaining any form of credit, according to the Federal Reserve Bank of New York’s Fall 2013 Small Business Credit Survey. After completing an online application, owners can be approved within hours and have the money in their account within days, whereas in the conventional banking model, small business owners may not be approved for several weeks. .

New ways to make loan decisions

Overall, new online alternative lenders are making lending decisions using predictive modeling, data aggregation and electronic payment technology to assess the health of a business. Traditional lenders typically focus on both the personal credit history of small business owners and key metrics about the borrower’s business, such as industry-specific trends and number of employees. Alternative lenders use these metrics, but also focus on current cash flow and small business performance using a wide range of traditional and non-traditional data sources.

New lenders generally fall into three categories.

The first wave of technology-based alternative lenders included companies like OnDeck Capital and Kabbage and can be characterized as online balance sheet lenders. Their loans are usually short-term, less than nine months, and fund working capital and inventory purchases. Many of these loan products work similarly to a merchant cash advance, with a fixed amount or percentage of sales deducted daily from the borrower’s bank account over several months. Given the short-term loan terms, the rate a small business borrower could pay on an annualized basis is a median of around 50% at OnDeck for a commercial term loan, but can vary from 30% to 120 %, with average loans around $40,000. .

Lending Club, Prosper, Funding Circle and Fundation use a peer-to-peer (P2P) model. Backed by individual investors, these companies make lending decisions based on proprietary credit models and typically target mid-tier or near-prime borrowers. Interest rates range from 8-24% for loans up to $250,000 which can be extended for three years. P2P platforms offer repayable loans with fixed interest rates and maturities of three to five years.

A third emerging online player in small business lending are independent lender marketplaces, which create their own marketplace where small business borrowers can compare a range of products from various lenders – including community and regional banks, online balance sheet lenders, and others. Some of these larger players include Biz2Credit, Lendio, and Fundera. One of the coolest things about these marketplaces is that they alleviate one of the biggest problems that borrowers and lenders face: search costs. Typically, these marketplaces generate revenue by charging a small fee on top of the loan if the borrower is funded and accepts the terms of a loan from their platform.

disruptive force

Clearly, new online entrants pose a challenge for established players in the small business loan market. They’ve been on the scene since 2007, but the momentum has grown significantly over the past 12-18 months. Lending Club recently filed for an IPO with a valuation of around $4 billion, and OnDeck is preparing an IPO later this year that has been valued at $1.5 billion.

While the online market is in the early stages of its transformation, it is clear that the traditional small business bank lending model has left gaps that, with the help of technology, challengers are finding promising and profitable. This should benefit small businesses who, although facing higher interest rates in some cases, might find more transparency in product and pricing options, lower search costs and better speed and better customer service.

The advantages of entrepreneurial new entrants could be tested if incumbents decided to target market gaps and new approaches themselves. Large traditional banks and credit card companies have access to three types of assets that could make them big players.

First, they have millions of small business customers with information about activity in company accounts, which can be valuable in a predictive model. Second, they have a built-in source of small businesses looking for loans. Finally, these banks have their own balance sheets on which to lend and do not have to raise high-cost capital to be competitive.

All of these factors could make them strong competitors in new markets, but institutionally they need to be nimble and aggressively explore the appeal of new entrants and develop new capabilities.

The role of regulation

Although the online small business loan market is in its infancy, there is already disagreement about the appropriate level of regulation.

Many view new entrants as disruptors of an old and inefficient market and caution against regulating too early or aggressively for fear of interrupting innovation that could secure more capital for small businesses.

But, on the other hand, there are already fears that, if left unchecked, small business lending could become the next subprime loan crisis. Traditional players, such as community banks, are also weighing in on the debate, fearing that tighter regulatory oversight in the wake of the recession will make them less competitive with new entrants who have so far operated in markets largely unregulated.

Transparency and disclosure issues are the most important considerations facing regulators and can be broken down into several key questions. Are online lenders accurately and transparently disclosing the terms of their loans to small business borrowers? How much information should online lenders disclose to regulators and policymakers? And should there be more standardization, transparency or regulation of online credit brokers?

In addition, there is the issue of monitoring and follow-up. Currently, the SEC partially regulates peer-to-peer lending and state banking laws apply, but the online small business lending industry is largely unregulated at the federal level. Should borrower and lender protections be consolidated under a single federal regulator, and if so, which regulator is best equipped to play this role?

Reason to be optimistic

The financial crisis has dramatically changed the small business lending landscape in the United States, both for owners and entrepreneurs and for the institutions that lend to them. As we have seen, lending to small businesses through traditional sources, large and small banks, has yet to recover to pre-recession levels.

This has created political challenges for legislators and regulators, as well as, I believe, economic challenges with respect to the weak job growth that we experienced in the years following the Great Recession. But as is often the case during times of transition, market opportunities are emerging and we are seeing alternative online lenders step up to take advantage of these opportunities.

Looking ahead, there is reason to be optimistic about the future of small business lending. As technology and innovation continue to drive process and decision-making changes in this market, those with the most to gain are small businesses and ultimately economic growth and competitiveness. long term of our country.

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About the Author: Karen Mills is a senior fellow at Harvard Business School and Harvard Kennedy School, specializing in competitiveness, entrepreneurship, and innovation. She served as a member of President Obama’s cabinet and was a trustee of the US Small Business Administration from 2009 to 2013.

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