(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 business.)
Banks are the principal source of outside capital for small businesses, but there have always been alternative forms of loan capital available, including credit unions, Community Development Financial Institutions (CDFIs), merchant cash advances, equipment leasing and factoring products.
“Alternative players have the potential to fundamentally change the way in which small businesses access capital”
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 funding for small businesses. The outstanding portfolio balance of online lenders has grown about 175 percent a year, compared to a decline of about 3 percent in the traditional banking sector. However, it still only represents less than $10 billion in outstanding loan capital.
Despite their small scale, these alternative players have the potential to fundamentally change the way in which small businesses access capital, creating greater competition, price transparency, and a better customer experience. Emerging online players are pushing innovation within the lending sector in the same ways in which other online upstarts such as Amazon.com changed retail and Square changed the small business payments business.
A few factors account for the rapid growth of the entrants. First, institutional debt and equity investors have been attracted by the relatively high rate of returns available by lending in this market. Traditional bank loans may yield a return of 5 to 7 percent, but many alternative lending platforms charge yields ranging from 30 to 120 percent of the loan value, depending on the size, term duration, and risk profile of the loan.
“Although the online small business lending market is in its infancy, there is already disagreement over the appropriate level of regulation”
The growth is also driven by ways in which alternative lenders are innovating in small business lending, particularly in terms of simplicity and convenience of the application process and speed of delivery of capital. For example, all of the biggest players emerging in the alternative lending space offer online and mobile applications, many of which can be completed in under 30 minutes. These are not just inquiries; these are actual loan agreements. This compares to the average of about 25 hours that small businesses spend on filling out paperwork at an average of three conventional banks before securing some form of credit, according to the Federal Reserve Bank of New York's Fall 2013 Small Business Credit Survey. Upon filling out an online application, owners can be approved in hours and have the money in their account in just days, whereas in the conventional banking model small business owners may not be approved for several weeks.
New Ways To Make Loan Decisions
By and large, emerging online alternative lenders make decisions on loans by using predictive modeling, data aggregation, and electronic payment technology to assess the health of a business. Traditional lenders generally focus on both the small business owners' personal credit history and key metrics about the borrower's business, such as industry-specific trends and number of employees. Alternative lenders use these indicators but also focus on current cash flow and performance of the small businesses using a broad array of traditional and nontraditional data sources.
The new lenders generally fall into three categories.
The first wave of tech-based alternative lenders included companies like OnDeck Capital and Kabbage and can be referred to as online balance sheet lenders. Their loans typically are short-term, less than nine months, and fund working capital and inventory purchases. Many of these loan products operate similarly to a merchant cash advance, with a fixed amount or percent of sales deducted daily from the borrower's bank account over several months. Given the short loan terms, the rate a small business borrower could pay on an annualized basis is a median of about 50 percent at OnDeck for a business term loan, but can range anywhere from 30 percent to 120 percent, with average loans of about $40,000.
Lending Club, Prosper, Funding Circle and Fundation are using a peer-to-peer (P2P) model. Backed by individual investors, these companies make loan decisions based on proprietary credit models and typically target mid-prime or near-prime borrowers. Interest rates range from 8 to 24 percent for loans of up to $250,000 that can stretch for three years. P2P platforms offer amortizing loans with fixed interest rates and three to five year maturities.
A third emerging online player in small business lending are lender-agnostic marketplaces, which create their own market where small business borrowers can comparison shop among a range of products from a variety of lenders--including community and regional banks, online balance sheet lenders, and others. Some of the most prominent of these players include Biz2Credit, Lendio, and Fundera. One of the more interesting factors of these marketplaces is that they mitigate one of the biggest problems borrowers and lenders face: search costs. Typically, these marketplaces earn revenue by charging a small fee on top of the loan if the borrower gets funded and accepts the terms of a loan from its platform.
Clearly new online entrants present a challenge to established players in the small business lending marketplace. They have been on the scene since 2007, but momentum has increased significantly in the last 12 to18 months. Lending Club recently filed for an IPO with a valuation of approximately $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 earliest stages of 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, despite having to deal with higher interest rates in some cases, could find more transparency in product and pricing options, lower search costs, and better speed and customer service.
The advantages of new entrepreneurial entrants could be tested if incumbent players decide to target the market gaps and new approaches themselves. Traditional large banks and credit card companies have access to three types of assets that could make them important players.
First they have millions of small business customers with information on activity within the business' accounts which can be valuable in a predictive model. Second, they have a built-in source of small businesses seeking loans. Finally, these banks have their own balance sheets off which to lend and don't have to raise high cost capital to compete.
All these factors could make them powerful competitors in the new marketplaces, but institutionally they need to be nimble and aggressively study the appeal of the new entrants and develop new capabilities.
The Role Of Regulation
Although the online small business lending market is in its infancy, there is already disagreement over the appropriate level of regulation.
Many view the new entrants as disruptors of an old and inefficient marketplace and caution against regulating too early or aggressively for fear of cutting off innovation that could get more capital to small businesses.
But, on the other side, there is already concern that, if left unchecked, small business lending could become the next subprime lending crisis. Traditional players, such as community banks, are weighing into the debate as well, fearing that stronger regulatory oversight in the wake of the recession is leaving them less competitive relative to new entrants that have to-date operated in largely unregulated markets.
The issues of transparency and disclosure are the most important considerations facing regulators, and can be broken down into several key questions. Are online lenders accurately and transparently disclosing terms of their loans to small business borrowers? How much information should online lenders be disclosing to regulators and policymakers? And should there be greater standardization, transparency or regulation of online loan brokers?
Additionally, there is the question of oversight and monitoring. Currently, the SEC partially regulates peer-to-peer lending, and state banking laws apply, but the online small business lending sector 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 perform this role?
Reason For Optimism
The financial crisis significantly changed the lending landscape in the United States for small businesses, both for owners and entrepreneurs and the institutions that lend to them. As we've seen, lending to small businesses through the traditional sources—both large and small banks—has yet to return to pre-recession levels.
This has created policy challenges for lawmakers and regulators, and also, I believe, economic challenges when it comes to the tepid job growth we have experienced in the years since the Great Recession. But as is often the case during transitional times, market opportunities emerge, and we're seeing alternative, online lenders step up to leverage those opportunities.
Looking ahead, there is reason for optimism when it comes to the future of small business lending. As technology and innovation continue to drive change in processes and decision making in this market, the ones with the most to gain are small businesses, and ultimately our nation's long-term economic growth and competitiveness.