April 25, 2016
Post the financial crisis in 2008, SMEs’ credit conditions had worsened, and credit has remained tight for the past several years. We saw a reduced number of banks focused on the small-business segment, increased regulatory scrutiny that caused banks to tighten lending standards and the need for more internal approvals. In short, SME loans became less attractive. In the recent past, we have seen that the trend is reversing. Banks and FinTech companies are getting interested in SME financing. For some banks, it has again become good business and they want to grow it. FinTech companies are targeting the gaps. According to a study, small businesses in the United States carry nearly $700 billion of small-dollar loans, borrowing over $200 billion each year. There are various ways of funding small-and-medium-sized businesses.
There are various method/models used today in this field to get the data to assess risk. Here are some of the ways in which SMEs get funded:
Companies like Square identify small businesses based on their processing history and provide cash advances, which the business owner agrees to repay with a cut of future sales. The processing data helps Square to determine which companies will benefit from the cash advance, and which ones are most likely to be able to quickly repay—mitigating risk.
The main advantage of this type of financing is that SMEs get loans just on the basis of their previous sales made. But an SME needs to provide adequate data which can enable further financing for the business.
There are some innovative invoice solutions offered by the B2B payment companies such as pre-financing of invoices, invoice discounting and SME financing. These B2B payment companies offer early payment discounts to the entire supply chain of the SME, using their cash or third-party cash. Some examples of such companies are Tualia, Kickpay and Invoice Interchange. Fundbox's cash flow optimization tool provides small businesses with credit-on-demand for their outstanding invoices, alleviating their cash flow gaps.
With invoice discounting, SMEs can improve their cash flow situation and will only have to pay the interest on the loan borrowed. But one of the cons of using invoice discounting is that when an SME gets involved with invoice discounting, the invoice becomes an asset of the finance company and hence cannot be used as collateral for further financing.
Some other prominent players working in this segment are C2FO, BTCjam, Bluevine and Magellan.
SBA loan programs are for helping startups and existing small businesses, with financing guaranteed for a variety of general business purposes. The guarantee represents the portion of the loan that SBA will repay to the lender if the company defaults on loan payments. Banks like Synovus Financial Corp. provide various SME financing products such as SBA loans (SBA 7(a), SBA 504, SBA Veterans Advantage Loans, SBA Export Working Capital Program), checking accounts, loans, treasury management, business credit cards, merchant services, employee benefits, investing & insurance. The bank has an increased focus on SBA lending (generated 65% increase in loan production during 2015, driven by talent acquisition as well as new product offerings and expected similar growth in 2016).
Some other banks providing SBA loans to SMEs are Wells Fargo, which serves around 3 million small-business owners across the United States; SunTrust Bank and Zions Bank, which is a consistent leader in the US’s SBA lending market and is known for its local decision-making.
The past two years have seen a growing number of partnerships with lending startups through which banks have focused on improving credit underwriting and working on building rewards/offers for SMEs. Banks like Celtic Bank has got into a partnership with alternative lenders such as Kabbage and Square Capital for providing bank loans to small businesses.
However, SME financing is not as profitable for banks as standardized loans which have mortgages as repayment in case of default. It also becomes difficult to underwrite these small companies and manage the books when the profitability on the lending side is low for banks. Hence, the approval rate for SME financing is very low in banks (around ~40%).
OnDeck Capital Inc., Kabbage Inc., Lending Club Inc. and other lending startups have launched products that not only help SME borrowers but also help in lowering operating costs through the use of technology. This model fits borrowers who want quick access to cash at good interest rates.
All of these startups have developed technology that pulls digital exhaust like customer reviews from Facebook & Twitter along with bank statements, credit scores and other traditional financial records into an algorithm that quickly and more accurately examines applicants and other data points for assessing the risk of a loan to an institution.
But such alternative lending platforms charge a very high interest on the loans provided to SMEs.
Some of the other major players in this segment are Accion, Rapid Advance and Funding Circle.
More than half of the small businesses in the US use a credit card for financing. The credit card has become a critical tool in expanding small business access to credits. Even at big banks, the credit card has become the default loan source for small businesses. Entrepreneurs are increasingly relying on credit cards to finance their businesses, especially early-stage companies as it provides instant financing easily.
For example, American Express offers merchant financing to small businesses that accept American Express cards.
All the above-given methods as mentioned above have their own pros and cons. The type of financing method availed by an SME depends on the necessity, type of firm and type of financing needed for the business. For an early-stage financing, alternative lenders such as OnDeck and Kabbage provide a good option as they provide instant financing. Invoice discounting is a better option for SMEs whose customers are other businesses and which have few invoices disputes and have customers who pay reasonably promptly (within 90 days). For businesses that want to expand and are seeking for loans, the first option is good as companies such as Square provide instant financing depending on the past sales.