Small Business Lending —A primer
Now that Small Business Lending has effectively been nationalized, as have Corporate Lending (Fed’s support of corporate debt for COVID-19), the Mortgage Market (Great Recession) & Student Lending (Also practical impact of Great Recession) in the past 10 years, the issues in the market and some of the myths of the market have been laid bare through the challenges of the Payroll Protection Program.
Who Small Businesses really are, how they get access to capital and who is providing it to them are surprising.
Despite the statistic that over half of Americans are employed by Small Businesses, there actually is no singular criterion for defining a Small Business in the United States. The PPP legislation defines a Small Business as any business (including non-profits) that employ less than 500 people, a very broad cut-off that includes publicly-traded companies, major professional sports teams and franchises of large multinational corporations. Generally the federal criteria varies by industry. And though a figure north of 30 million is cited as the number of US businesses, the number establishments that employ others is approximately 6.5 million. Why the disparity? After excluding a million that employee more than 500, the remaining balance are sole-proprietors; independent contractors, Uber drivers, independent consultants and the like who work for themselves. And within the 6.5 million small businesses that employ others, the numbers skew dramatically to single location firms, generally with less than 20 employees, of which there are 5.4 million. It tends to be this segment, restaurants, independent retailers, barbershops, salons and dry cleaners that drives our perception of what a small business is.
And when we talk about what these businesses need, even in benign environments, access to capital as always the #1 need, whether for unexpected problems, managing through seasonality or funding business expansion. And if you engage in any event that discusses small businesses, most of the attention goes to the SBA, a cabinet-level Federal agency, and its programs.
But the reality is that the SBA is largely irrelevant for small businesses in all but rural ares and has been for a long time. Its delivery varies by state. In New York for example, SBA centers are operated by community colleges & universities, walled off from commercial corridors in towns and cities. For example, in Upper Manhattan the SBA’s office is staffed by two people in an upper floor of a building in the middle of the Columbia University campus. By contrast, the City of New York operates a Business Solutions Center with more than five full-time staff in a storefront on 125th street, funded by Community Development Block Grants from the department of Housing and Urban Development & Workforce Investment Act funds from the Department of Labor. Guess who does more to serve businesses in the area?
The SBA plays a critical role helping business recover from disasters when they can provide low-interest loans, but otherwise, the flagship loan of the SBA is the 7(a) loan program with loans up to $5MM, which guarantees a majority of the principal for the lender. Every bank and credit union offers them to gain credits under the Community Reinvestment Act, while selling through more lucrative services such as merchant processing, but the 7(a) program has significant drawbacks both in its scope and requirements. The program is capped by congress and generally lends only $40B per year. Though this may sound significant, at an average loan size of $425,000, the flagship lending program that sucks all of the oxygen out of the dialogue for 6.5 million businesses only serves 34,000, or less than 1.5% of small businesses. This is plenty for every large diversified institution, credit union or community bank to have plenty of case studies for their marketing campaigns & for niche players in the market like Live Oak & Celtic Bank to operate a nice business with some national scale but it doesn’t change the fact that SBA-backed lending is inaccessible, rare & irrelevant in mainstream of the economy.
And who receives these loans? Certainly not many of the 5.4 million employing less than 20, but predominantly the 1.1 million employing between 20 & 500 employees, who would likely otherwise qualify for a bank loan if the 7(a) program if it didn’t exist, albeit at less generous terms. Sure these are “small businesses,” but generally these are businesses with scale and at the upper ends of the market. Part of the reason for it are the extremely onerous requirements, including at least two years in business, well-documented business performance, a detailed business plan and most importantly collateral, which boxes out the vast majority of small business who don’t own their operating their location.
Venture Capital — particularly as a result of TV shows like Shark Tank — also gets a lot of attention, but it is also a niche product only for a very small segment of the market and it is VERY expensive. Venture Capital tends to go only to tech or life sciences companies with highly educated founders, many of whom themselves came from large companies and have connections with their investors or banks. With an annual size of $180B, the vast majority of venture capital goes to later-stage companies that don’t qualify as small businesses under any definition.
All of this presents a significant quandary for both business owners — many who have not been in business long, have credit issues, co-mingle their personal and business finances & lack collateral — and lenders who have to manage both repayment and high business failure risk.
The first way to work around the problem is to solve for collateral. Small businesses can get access to funds secured by outstanding invoices or equipment at reasonable terms. The purchase of nearly any large product, whether for commercial or personal purpose at this case can be financed at good terms, if the buyer is willing to pay full price. And factoring, subject to review of the counter-party and the rates involved, is both a cost saver in terms of outsourcing the accounts receivable function & cash flow management.
So what does a lender do for a single-location business that rents their space and without collateral? To take this issue further, consider how you would lend to a new restaurant considering that 60% fail within their first year and 80% within the first five? Bear in mind that the underwriting process for a $500 million loan and a $50,000 requires effectively the same basic due dilligence; evaluating years of well-documented business performance to ensure that even in a time of economic distress that the business can make its loan payments? But what if the business doesn’t have the records of a publicly-traded company and hasn’t been around for years? And what do you do in certain industries with a high rate of business failure?
First, funders control risk by controlling term and you don’t allow their money to be out for more than a year at a time so they can continually re-underwrite the business and change the underwriting of the credit pool in aggregate relatively quickly. Secondly, they attempt to automate underwriting by using data providers and simple rules to knock out businesses based upon tenure, issues with cash flow management or other rules correlated with non-performance (e.g. industry or seasonality) — often by taking very expensive shortcuts. But recent innovations like utilizing Google Maps Street View & more updated searches are starting to replace expensive and time consuming site inspections to ensure the business is operating at the location on the application. Thirdly, it’s prudent to develop long-term relationships with businesses. Typically you can re-acquire business less expensively and a business owner who has paid you back once is more likely to do so again in the future. Lastly, funders can control the risk by intermediating business cash flow, first by taking repayment out of credit card processors before deposited in business checking accounts or more frequent loan repayment (weekly or daily) so issues can be spotted and resolved quickly. A good example of this is through an integration with a credit card processor to take a percentage of credit card sales, most commonly called a Merchant Cash Advance (MCA). Though MCA’s have gotten a bit of a bad name by being unregulated with unscrupulous entities taking advantage of lower barriers to entry & confession of judgement contracts to operate as expensive collection agencies with unsustainably high batch-split rates, the product itself can be very helpful to businesses if offered responsibly. AdvanceMe laid out these principles many years ago and since then, American Express, Square & Shopify have all offered similar constructs at reasonable rates.
But even when all reasonable precautions have been taken, lending unsecured (as opposed to a mortgage where a house is collateral) when failure rates are high (almost all businesses small business eventually fail whereas even in bad times less than 1% of consumers declare bankruptcy, pricing needs to account for the risk. For example a one-year loan from Wells Fargo that goes to their best business customers, still costs at least 15% for a loan under $35,000. It’s not wonder then that the average APR’s for two leading independent private Small Business lenders, Kabbage & OnDeck Capital have average APR’s in excess of 40% APR. It is for this reason that small business lenders charge by factor rate, or the amount of total repayments divided by the total principle. So for a $10,000 loan at over 40% APR, a business may only be paying a small origination fee and approximately $1,500 in interest payments. This is due to how long the money is actually outstanding (less than a year), and the impact of repaying a small amount each business day.
So what would I advise a business owner looking for capital:
Secure adequate funds for start-up and at least the first year of operations with plenty of contingency to avoid early bankruptcy or the most expensive products
Maintain good records with QuickBooks or another digital accounting software. Leading providers have integrations with lenders and the ability to otherwise export key documentation easily
Seek to factor or use equipment loans where feasible, particularly for equipment where the useful asset life is lengthy where financing costs to “lease” would need to be rolled over
When seeking an unsecured loan, try to find a low-interest merchant cash advance or similar product from your merchant processor (e.g. Square or AMEX)
Only use independent advances or loans for time-sensitive growth investments where the expected return is high. If renewing or refinancing, insist upon a discount for positive repayment history
Develop a relationship with your business banker and insist upon good service. This is especially important in dire times when disaster loans or PPP-like products become available. Furthermore, once ready for a bank loan (SBA or otherwise), you’re more likely to get the best service and ultimately approval. But be patient for a long & iterative process that may result in a decline. Don’t be afraid to move your banking relationship if necessary to get a loan as it may be necessary
Author disclosure & background: I gained much of the expertise supporting the article through multiple experiences working in the small business space. First I spent a year and a half as an internal consultant at the NYC Department of Small Businesses primarily improving the operations of the City’s Business Solutions Centers. Subsequently, I attended Columbia Business School where I was an officer in the Small Business Consulting Program where I had multiple clients & volunteered at both SBA & City Centers. Following graduation, I spent four years at CAN Capital (formerly AdvanceMe), a small business funder who offered Merchant Cash Advances and short-term daily remittance business loans. The loans were originated through WebBank, an FDIC-insured, Utah-chartered industrial bank.