As much as 50% of small businesses do not survive their first year of operation and an overwhelming majority are gone within 5 to 10 years.
It is not the lack of ideas or profitability or hard work or the dedication or sacrifice of the owners but the cause most common to business failures is their inability to finance working capital needs. This may sound trivial but it is catastrophic to those who have experienced it. Businesses fail not because they don’t make enough money but because they fail to generate sufficient cash or “liquidity” to pay their creditors.
Mind the gap
A business must be able to pay its creditors’ invoices if it is to remain solvent. To do so, its customers in turn must pay their invoices on time. In some industries this timing difference between cash outflows and inflows (between paying supplier invoices and getting paid by customers) can be inordinately long. This is the dangerous funding gap that can swallow any business no matter how profitable. There are two parts to it.
Pre-sale gap: a business when it buys raw materials or stock from suppliers cannot immediately sell it (except in the case of some retail stores), but must first process or convert these inputs to finished goods (e.g., buying wood to sell furniture), sell the finished goods and raise invoices.
Post-sale gap: Profit recorded in the books is meaningless unless it is represented by cash in the bank. For cash sales this part of the funding gap is zero but for sales on credit, unfortunately business customers delay paying up for whatever reason. The bigger the customer, the greater the delaying power.
The failure of banks
Providing financing to bridge the funding gap is a traditional business for banks. But banks fall way short of understanding the full extent of the opportunity and lend only to well established and stable businesses that can offer sufficient collateral to cover their risk.
Risk controls in general in large banks are skewed in favour of capital markets, where they take risks with securities and derivatives they don’t fully understand but hold back from lending to small businesses because they perceive this type of lending to be highly risky. To back up this frustrating contradiction they continuously complain about the impossibility of ascertaining the risks involved in lending to a small business without a credit history.
The problem here is that though banks and other traditional providers of working capital take too long to process loan applications and are unable to deviate from their traditional ways of credit assessing small business customers. In addition to reviewing past history they rely on the comfortable practice of securing collaterals. No alternative approaches, no workarounds, no lateral thinking.
Sensing the opportunity, some from outside the banking world are trying to crack the problem so that they can either make loans themselves or enable other lenders – including banks – to do so using innovative approaches to assess credit risk.
Companies such as OnDeck (ondeck.com) and Kabbage (kabbage.com) and CAN Capital (cancapital.com) have developed simple but effective policies and approaches. For example, to be considered for a loan – a business must be at least a year old with over $100K in revenues and the owner must have 500+ personal credit score. These lenders understand that the social and financial data available on the owner is crucial in ascertaining the risk profile of the business and not just its past history.
They will tell you that they look at hundreds of data points to assess a loan application something that banks don’t do. Kreditech (kreditech.com) a tech company based in Germany claims their technology “uses artificial intelligence and machine learning to process up to 20,000 data points per application” to enable precise credit checking of customers with thin files (little credit history). Kreditech offers its platform to lenders rather than advancing loans itself.
Markets don’t yet believe
While everyone likes the Fintech innovations and the jaw dropping 20,000 reference points for credit assessment the markets are not so enamoured by these technical advances and more focused on actual results and still sceptical.
Any bad news can be taken with a whole bag of salt leading the markets to believe that there could be something wrong about these unverifiable technical innovations and a few bad loans may be taken as a sign that the whole portfolio is a potential write-off. The markets punished Lending Club (lendingclub.com) recently when news of compliance irregularities on some of its loans came out resulting in the ouster of its founder and CEO. (Shares of other online lenders were also impacted by the news that institutional lenders are holding back and demanding higher returns for their money). At this early stage, institutional lenders / investors and the market as a whole are suffering from a form of controlled anxiety fearing that these alternative approaches may not stand the test of time and there could potentially be a credit catastrophe.
Digitisation is the difference
While risk assessment is the core engine of any lending business, pragmatic innovators are trying to focus on brining the whole lending process in to the twenty first century. The keys are full digitisation and speed of service. Two things that the banks have not been able to provide.
Innovative technology lenders are making the process fully online, easy and convenient for small businesses. OnDeck’s digital onboarding process is so smooth that Chase has partnered with it to use its technology in lending to small business.
Other innovators are digitising established financing channels. Buying invoices or factoring has been around for some time. Lenders “buy” invoices from businesses advancing them the money (for a fee – usually a percentage) saving the wait to get those invoices paid and the cost involved in pursuing customers to pay up. Now technology is helping automate and organise this process making it easier for companies to submit invoices directly from their accounting systems and for lenders to risk assess them accurately and quickly. FastPay (www.gofastpay.com), for example, enables its clients to upload their invoices directly to the company’s invoice portal from QuickBooks or other small business accounting platforms and provides a clear pricing structure for discounting the invoices. It is itself a small company and focuses on sectors that it is familiar with (such as media) – so that it is able to more accurately assess client risk and speed up the delivery process.
Getting it right
Lending is one of the oldest professions and the one of the most profitable. Risk is important but even with the plethora of digital data floating around us in real-time, the process of risk assessment is still a difficult one. Despite the claims of the new technology firms, the use of thousands of alternative data points represents an innovation that is still unproven. The key for online lenders is to target opportunity pools that have not been fully exploited (such as the small business sector) and make it easy, quick, and transparent for borrowers through full-process-digitisation while at the same time testing and building the toolset for more informed risk assessment.