The second reason MCA lenders were willing to take on riskier loans was that the structure of the product provided a new and valuable type of collateral. Small business lenders, including the Small Business Administration (SBA), often rely on a personal guarantee from the business owner to provide greater certainty of repayment. In such a case, the bank uses the borrower’s assets, often their home, as collateral. Technology allowed MCA lenders to extract loan payments directly from the borrower’s bank account or credit card receipts. This technique gave the lender a new kind of collateral—immediate access to customer receipts—rather than waiting for the borrower to make a payment.
Many online lenders followed the structure and pricing levels set by CAN to create pricing for the riskiest loans. The new products were generally priced at a fixed amount. A borrower might receive $10,000 and repay $12,000, by remitting some percentage of daily receipts to the lender as they came in. This was appealing to some small business owners, as their repayment schedule would vary based on actual sales. Business owners also liked knowing the total cost of the loan. But because the schedule to repay the loan was based on sales and not a fixed timeframe, it was nearly impossible to calculate an annual percentage rate (APR) or interest rate before knowing when the loan would be paid back, creating difficulties for small business owners trying to compare the cost of an MCA to that of a traditional loan.11 With a standard repayment time frame, APR prices could be well north of 30 percent, and even reach 100 percent or more.
New Sources of Capital
Another early fintech was Lending Club, which began as a consumer lending company in 2007. Lending Club was a pioneer of peer-to-peer lending, using technology to bring one of the oldest and most basic forms of consumer lending into the modern world. Like Prosper, another early entrant in consumer loans, peer-to-peer lenders did not make the loans themselves. Instead, they matched individuals and institutional investors willing to provide funding to borrowers seeking capital. By 2010, Lending Club owned 80 percent of the U.S. peer-to-peer lending market.
During its first few years of operation, Lending Club mostly provided consumer loans, reaching $1 billion in loan volume in 2012. The company went public in 2014 with an $8.5 billion valuation, one of the largest IPOs ever for a consumer-facing Internet company.12 In 2015, Lending Club began to extend credit by matching investors with small business borrowers, providing small-dollar loans between $15,000 and $100,000, with “fixed interest rates starting at 5.9% with terms of one to five years, no hidden fees and no prepayment penalties.”13 Lending Club aimed for ease and simplicity in the loan application process, specifically targeting the painful customer experience that borrowers were getting at banks. In order to sell more of these loans, Lending Club partnered with BancAlliance to gain access to a referral network of hundreds of community banks.14
New Data
Another fintech first mover was Kabbage, which launched in 2010. Unlike Lending Club, which began with consumer loans, Kabbage focused on small businesses from the start. Their early business model was to provide working capital loans to eBay merchants, using eBay’s newly developed open API to access data on potential small business borrowers and make underwriting decisions.
Kabbage engaged with several partners, including Celtic Bank, using that relationship to scale lending products from the Kabbage platform. Partnerships with Intuit and UPS provided access to customer data to assess creditworthiness, and a partnership with online payment processor Stripe opened up access to more small business customers. Co-founder Kathryn Petralia noted that while Kabbage had started as a niche e-commerce lender, by 2018, a full 90 percent of its business borrowers were offline businesses, and the company had originated a total of $5 billion in loans to more than 130,000 small businesses.15,16
Founded in 2006, OnDeck also set out to provide small business credit using a proprietary credit scoring system, known as OnDeck Score. This system integrated public records, accounting, and social data in addition to personal credit scores.17 In 2012, at a small business lending conference held by the SBA and the U.S. Department of the Treasury (Treasury), OnDeck told the gathering that it was using bank account data to obtain real-time information on small business transactions. This announcement sent a signal to lenders: why use historical data if one could determine creditworthiness in real time? OnDeck went public in 2014 with a $1.3 billion valuation, and in 2015 they began offering credit lines and long-term loan products.18 By 2018, OnDeck touted itself as the largest online small business lender in the United States, having issued over $8 billion in small business loans.19
As with Lending Club and Kabbage, OnDeck’s proprietary creditworthiness score could only have been created through APIs that provided access to data from non-traditional sources. In a 2018 interview, LendIt co-founder Peter Renton remarked on how the first movers had set the stage for the fintech revolution. “The data that Kabbage was getting from UPS, eBay, etc., and how they were using it to make predictions—this had never been done before,” said Renton. “This was brand new intelligence. There has always been data available, but no one knew how to use it until Kabbage and OnDeck came in and pulled it together.”20
The Small Business Lending Ecosystem—Circa 2015
The success of the early entrants did not go unnoticed. From 2013 to 2015, dozens of new firms entered the small business online lending ecosystem. The space changed so rapidly that it didn’t even have a fixed name. Sometimes the sector was called marketplace lending, reflecting the early success of Prosper, Lending Club, and other peer-to-peer lenders, while at other times, it was called online, alternative, or fintech lending.
The entrants active in this period fell into six categories. There were four types of lenders: balance sheet, peer-to-peer, platform players, and invoice and payables financers. In addition, there were multi-lender marketplaces where small businesses could shop for and compare lenders and their products, and firms that provided data to the other players in the ecosystem (Figure 7.1).
Figure 7.1 Small Business Fintech Lending Ecosystem in 2015
Source: Author’s analysis based on Jackson Mueller, “U.S. Online, Non-Bank Finance Landscape,” Milken Institute Center for Financial Markets, curated through May 2016.
Balance Sheet and Peer-to-Peer Lenders
Balance sheet lenders included those offering MCA products and one to two-year term loans. These companies held the loans on their firm’s balance sheet. Peer-to-peer lenders, by contrast, matched interested investors with potential borrowers. They dominated the early fintech landscape, particularly in the United Kingdom, where government support for new lenders increased following the financial crisis. One particularly strong U.K. entrant was Funding Circle, a small business-focused peer-to-peer lender that entered the U.S. market in 2013 through a merger.21
Platform Players
Although they grew to be critical players in online lending, platform lenders did not enter the emerging market until 2011 and their efforts did not gain momentum until a couple of years later. The most visible platform, Amazon, launched Amazon Lending in 2011 and, by the summer of 2017, they were lending $1 billion annually to small businesses with loans ranging from $1,000 to $750,000.22,23 With the clear potential to expand into other products and services, they became the player to watch. PayPal launched PayPal Working Capital in 2013 and, by 2017, they had lent a total of $3 billion to small businesses.24
Square had a built-in base of small businesses using their card payment processing device that could be easily attached to a smartphone. Jack Dorsey, Square’s founder (and co-founder and later CEO of Twitter) saw that customers needed small amounts of capital to meet their fluctuating cash needs. He also saw the value of the insights that Square could glean from using their proprietary data on businesses’ daily cash receipts and the advantage of having first access to the receipts for debt repayment. In 2014, he formed Square Capital and, in 2015, he hired Jacqueline Reses from Yahoo to lead the effort. By 2016, Square had lent $1
billion, with an average loan size of $6000.25 By 2018, Square Capital was originating almost $400 million in loans per quarter, largely to the underserved segment of extremely small businesses seeking very small loans.26
Another important platform player was American Express, which already had a customer base of thousands of small business credit card users, and had built visibility and good will through its Small Business Saturday initiative and the OPEN small business brand. American Express began utilizing its access to sales and payments information to provide capital to qualified American Express credit card users, allowing these small businesses to access short-term financing at a lower interest rate.
Invoice and Payables Financing
Several new companies began providing invoice financing to help businesses with late-paying customers or seasonal cash flow fluctuations. While factoring—a form of lending that allows a business to sell its invoices to a provider and get immediate cash in exchange for a fee—had long existed, the automation of that process allowed it to occur more seamlessly.
Invoice financing solutions are particularly important for small supply chain companies, which play an underappreciated role in the U.S. economy.27 Recall our example from Chapter 2 of Transportation and Logistical Services (TLS), a trucking company with ten employees outside of Birmingham, Alabama. Now imagine that Coca-Cola, one of its biggest customers, decides to delay their payment terms from 30 days to 60 days. This would create an unexpected cash crunch for TLS. Online invoice financing provides a solution for small suppliers like TLS to get paid more quickly if they need to.
On the other side of this equation, a second set of products such as Working Capital Terms created by American Express, allowed companies to delay a payment by having the platform pay the vendor, with the company taking on the obligation to pay back the money in 30, 60, or 90 days. This product acted like a business credit card, but provided more flexibility in that payments could be made to entities that didn’t accept cards, and terms and pricing were more like those of a short-term loan.
Many fintechs and platforms developed innovative invoice and payments solutions including Fundbox, BlueVine, NOWAccount, and C2FO. Some products were classified as loans, while others were not. All of the providers of these products, however, recognized the reduced risk of lending when they had access to a small business’s invoices, a strong piece of collateral to back up the advance.
From the perspective of small businesses, for whom late customer payments have long been a potentially life-threatening nightmare, the new innovations provided a large range of more cost effective and accessible options. Traditional factoring companies such as CIT, once the industry leader, were never inclined to create this kind of innovation, and their products were notoriously expensive and difficult to obtain. As we saw with the government’s QuickPay program in Chapter 3, timely payments improve cash buffers and small business performance. Thus, the availability of these fintech products might save thousands of small businesses from untimely demise as a result of cash timing gaps.
Marketplaces
Another group of entrants that emerged during this time were the online lending marketplaces. Companies such as Fundera and Lendio offered small businesses the ability to comparison shop for loan products from both banks and alternative lenders. Marketplaces took a referral fee for each loan originated through their site, which proved worthwhile to many fintechs struggling with customer acquisition. Consumer marketplaces for loans and mortgages have long existed, but small business loan comparisons are more difficult as the products have more variability and small business owners often have less clarity about what kind of loan they need. Nonetheless, online small business marketplaces are a much-needed vehicle to create a more transparent, easier to navigate credit experience.
Data Providers
Data providers became an important part of the new technology-enabled lending ecosystem. Xero and FreshBooks began competing with QuickBooks as a software through which small businesses could manage their finances. Yodlee, an account aggregator, provided software to help businesses predict future cash flows and expenses.
Others collected information on the lending industry itself. PayNet gathered data from banks and commercial finance companies to provide insights and credit ratings to the lenders on their platform. Meanwhile, Orchard collected and shared data about the new fintech players, tracking the number of companies and loan originations, and providing advanced analytics on the nascent industry.28 These providers developed important information streams for both banks and online lenders, as well as policymakers and regulators.
Small Business Online Lending Appeared Poised for Takeoff
By 2015, online lenders were originating around $5 billion annually in small business loans.29 Morgan Stanley predicted that these firms would comprise 16.1 percent of the small business lending market by 2020, but that banks would not be at risk, losing only 4.6 percent of their origination volume. The company also predicted that a significant amount of the growth in online lending volumes—$35 billion—would come from expanding credit to underserved borrowers.30 The new entrants would have plenty of room to grow by addressing the market gap in small business lending, particularly the small-dollar loans that banks did not want to make.
During this time, venture capital investment in fintech skyrocketed, growing by almost 200 percent between 2013 and 2014 alone, reaching nearly $10 billion across 493 deals (Figure 7.2).31
Figure 7.2 Venture Capital Investment in Fintech by Year
Source: “Fintech Investment in U.S. Nearly Tripled in 2014, According to Report by Accenture and Partnership Fund for New York City,” Accenture, June 25, 2015, Accenture analysis of CB Insights data.
The new fintech small business lending market seemed poised for takeoff—the phase of the innovation cycle in which volume accelerates and new customers jump into the marketplace, leaving behind old products and companies. Yet, despite the investment and the hype, this expected jump did not occur. What happened instead was another cycle of innovation. This time, the incumbent banks and other new entrants—namely platform companies—took the lead, developing new products and approaches based on their competitive strengths.
Organizational theorist Geoffrey Moore described discontinuous innovations as those that force us to modify our behavior or modify other products and services we rely on.32 But, he added, “truly discontinuous innovations are new products or services that require the end user and the marketplace to dramatically change their past behavior, with the promise of gaining equally dramatic new benefits.”33 During this period, fintech innovations changed the markets for established financial products but, for several reasons, they would not prove to be “truly discontinuous.”
The early movers in the fintech space had shaken up the industry by using new information sources and technology to deliver lending products in a way that was highly automated. From the perspective of the small business owner, the customer experience was significantly better, particularly in terms of speed. But in other important ways, there had been little real innovation in the actual products. With many of the offerings characterized by high prices and low transparency, small businesses began raising concerns about bad actors in the market. Cracks in the fintech success story began to appear.
Challenges to Online Small Business Lenders
By 2017, the industry’s underlying issues had caught up to the nascent fintech companies. Rosy predictions about the future of online small business lending were on the decline. This was due, in large part, to a growing realization that many of the innovations brought by the new fintechs could be imitated by incumbent banks, as well as concerns over the advantages that large platform players could exercise if they chose to enter the market.
It started to become clear that both incumbents and disruptors had advantages and disadvantages, and that the winners would be the group that could most quickly and effectively address their shortcomings. Comparing the incumbent players (large banks like
JPMorgan Chase and Wells Fargo and smaller community banks) with the new fintech entrants, it became apparent that no one was the clear winner. Instead, it was a pretty mixed picture (Figure 7.3).
Figure 7.3 Incumbents and Disruptors: Advantages and Disadvantages
Source: Author’s analysis based on “The Brave 100: The Battle of Supremacy in Small Business Lending,” QED Investors and Oliver Wyman, 2015.
Existing banks had the large pools of customers that fintechs were struggling to find. The 2015 annual reports of OnDeck and Lending Club showed that sales and marketing efforts were among the largest operating expenses for both lenders, at about 24 percent and 40 percent of gross revenue, respectively.34 On a per-loan basis, average costs to acquire a customer were estimated to be $2,500 to $3,500 per loan.35 As a comparison, in 2017, regional New England lender Eastern Bank reported an average marketing cost of $500 per small business loan under $100,000.36
Banks also had access to low cost deposits, while online lenders were largely forced to rely on capital markets to fund loans. Yield-seeking individuals and hedge funds were early sources of capital, but they were expensive and soon dried up as the Federal Reserve began to raise interest rates and the real level of risk in some fintech loans became apparent.
Fintech, Small Business & the American Dream Page 11