New Technology for Lending to Main Street
Delivering capital to the millions of restaurants, small retailers and local service businesses in America poses a unique challenge for the banking industry. Such businesses represent a huge market, their demand for capital is strong and they are an important (and vocal) part of their communities. Yet, serving this segment has historically been difficult as these businesses are often viewed as high risk with small revenue potential and banks typically have a hard time serving companies of this size in a cost-effective manner. Fortunately, advances in technology are changing the way we look at these companies, paving the way for increased lending and lower risk.
The greatest challenge in working with Main Street businesses is the lack of a truly efficient way to underwrite sub-$250,000 loans; this challenge becomes even more pronounced for loans under $100,000. The data predominately utilized to evaluate this segment – personal payment behavior – is not what is actually required to gain an accurate perspective of a business. Judging a business using the personal credit score of the business owner is highly inaccurate and results in a significant number of both false negatives (healthy businesses who are denied capital) and false positives (unhealthy businesses approved based on a high personal credit score).
What has always been needed, but was not available until recently, is a solution that utilizes the advances in data analytics and technology to remove the high cost and significant time requirement of doing business on Main Street. Lending to these small businesses is not a problem of credit and capital, but one of time and cost.
Move to Electronic Data
While a restaurant or an auto repair shop may be highly profitable with strong cash flow, the resources necessary to uncover this information often outweigh the potential revenue from a $20,000 or $30,000 loan. These businesses often lack strong financial records, many have thin credit files and the owners do not typically have the financial expertise or the time required to complete full loan packages. As a result, banks are often unable to see the true financial health of these businesses and instead are forced to judge them based on their credit history, both business and personal.
Judging a business based on its past payment behavior is far less accurate than assessing a business based on cash flow, which shows current business performance. Banks have had little choice other than to use the personal credit score of the business owner because it is more cost effective than performing a complete financial analysis on a hair salon seeking a $25,000 loan. Fortunately, trading off effective underwriting for efficient operations is no longer necessary as new developments in technology are making it possible to quickly understand the cash flow and true financial health of these small businesses.
Small businesses have shifted over the past ten years from being largely paper-based and disconnected enterprises to increasingly connected operations generating powerful electronic data about their businesses. These businesses have switched to online banking, more than half of their transactions are electronic, they generate information in their inventory systems, they use online accounting software, their tax information is available online and their customers are continuously talking about them in social media.
By leveraging these electronic data sources, it is now possible to instantly uncover the real-time financial health of a business – their cash flow, average bank balance, the daily number of transactions as well as monthly and yearly trends – which is incredibly powerful information that previously would have taken dozens of hours to uncover and analyze. It has been our experience that when you focus on these far more relevant and accurate metrics, there is no correlation between the personal credit score and the probability of successful repayment of a small business loan.
Technology can also be used to mitigate risk through new methods of servicing, such as systems that utilize automatic daily debit payments from borrowers via the Automated Clearing House (ACH). Monthly loan payments are a consumer-based concept from the days of lenders wanting to get repaid at the same time the borrower gets their paycheck. However, this is not necessary in today’s business environment where firms are generating revenue and expenses on a daily basis. An automated system that deducts payments on a daily basis is both convenient for the business owner and highly effective for the lender, who gets paid daily and can quickly identify negative trends such as missed payments far in advance of when a missed monthly payment would be noticed. A daily payment method also provides payment priority over lenders who collect monthly. Simply put, daily automated payments significantly reduce the risk often associated with Main Street businesses.
Advancements in technology have transformed how banks perform many functions. Five years ago, conducting transactions through mobile devices was unheard of. Now, it’s commonplace, as are debit cards, online banking and remote deposits. Similarly, advancements in technology have radically changed the way Main Street businesses pay their bills, offer daily discounts and communicate with their customers. Such advances enable a major leap forward in the way that business owners access and repay capital and in the way that banks meet their needs, increase revenue and reduce risk.
Mr. Jacobs is founder of New York City-based On Deck Capital, a provider of financing to small businesses. He can be reached at [email protected]. He will be presenting a more detailed presentation on this topic at the BAI Retail Delivery conference in Chicago on Oct. 12.