Fintech, Small Business & the American Dream

by Karen G Mills

  Start-Ups Versus Ongoing Businesses

  Access to capital is also an issue for younger, less established firms. In 2016, about half the firms less than two years old (considered “start-ups” by the Fed survey) applied for outside financing, compared to 42 percent of firms more than five years old.7 These start-up businesses had a more difficult time getting loans. Fifty-eight percent reported facing issues with credit access in 2016 compared to just 39 percent of firms over five years old. While almost half of the firms more than five years of age received all of the financing for which they applied, this was true for only about one-third of the firms less than five years old (Figure 5.3).

  Figure 5.3 Total Financing Received by Age of Firm

  Percentage of applicants

  Source: “2016 Small Business Credit Survey: Report on Startup Firms,” Federal Reserve Banks, August 2017.

  Banks rely on the creditworthiness of small business owners themselves in their lending decisions, which is even more of an issue for start-ups. According to the Fed survey, 92 percent of small firms less than two years old rely on the credit score of the owner to acquire outside financing, compared to 84 percent of firms more than five years old. These frictions in small-dollar lending and lending to new businesses were likely a contributing factor to pressures on start-ups after the Great Recession—a matter that continues to be of significant concern for job creation and the dynamism of the U.S. economy.

  Why Small Businesses Seek Financing

  We have analyzed the supply forces at work in the small business lending market, but what about the demand side? What do small businesses want, why are they seeking financing, and what kinds of products will meet their needs? Recall that there are four main types of small businesses and that, for example, Main Street firms have different growth objectives than new tech start-ups. Even inside a category, small business needs can differ. In Chapter 2, we introduced you to Gelato Fiasco, an ice cream shop with big expansion plans, and Tony from the next door Big Top Deli, who was satisfied with his single location. As a result, their business plans would require different types of capital, in different amounts, with different durations, and for different purposes.

  One might think that the most common reason to take out a small business loan would be to start a business. Because of lenders’ resistance, new entrepreneurs who get loans rely heavily on leveraging personal assets by taking out home equity loans or lines of credit. Even more often, they draw down savings, take on credit card debt, or ask for money from friends and family.8 Over two-thirds of businesses less than two years old were started using funds from one or more personal sources.9 Venture capital is important for a certain segment of start-ups with high-growth potential that need larger sums of money and high-risk investors, but it is barely on the radar of most other types of new firms as a source of funding.

  As we discussed earlier, in this book we focus on small businesses that are seeking loans, rather than equity capital. We are looking primarily at the needs of the Main Street firms, suppliers, and sole proprietors. Among these businesses seeking loans, the most common reason is to expand—whether to open a new location, hire more people at an existing location, or perhaps buy a new machine to expand production (Figure 5.4).

  Figure 5.4 Small Businesses Use Loans to Grow Their Businesses

  Percentage of total small businesses surveyed

  Source: “2017 Small Business Credit Survey: Report on Employer Firms,” Federal Reserve Banks, May 2018.

  Note: These percentages add up to more than 100 percent, as many small businesses state more than one use for the loan proceeds.

  The second most common reason small businesses seek loans is for operating expenses. Recall that small businesses have bumpy cash flows and often do not have a clear picture of their future cash needs. They also have cash buffers of, on average, less than one month. Therefore, many small businesses rely on a loan or line of credit to weather the uneven monthly or seasonal fluctuations. Linda Pagan, the owner of a successful millinery shop in Manhattan, found the slow periods in her business dramatically challenging, calling them the “trifecta of terror.”10 (See box). Linda and her hat shop are not alone in facing the anxiety associated with cash fluctuations. The small business owner’s need for liquidity and capital to survive rough patches is fertile ground for the game-changing breakthroughs that technology can provide. In Chapter 8, we will explore some of these possibilities.

  Small Village Shop in the Big City

  Linda Pagan has owned The Hat Shop in New York City for almost 24 years. Based in SoHo in lower Manhattan, she provides specialty made-to-order hats for grand occasions, and for the everyday purpose of keeping the head warm in winter and protected from the sun in the summer. Linda believes in using local suppliers, usually other small businesses. Her feather provider is based in Queens, the fourth-generation company that makes her hats’ ribbons and silk flowers is on 37th Street, and a basement studio on Grand Street blocks the hats.

  Linda is a champion of the small businesses in her community. In 2009, the influx of large stores in SoHo spurred her to organize her block to form an association of independent business owners. In 2016, the area was designated the Sullivan-Thompson Historic District by the Greenwich Village Society of Historic Preservation, focused on maintaining the block’s unique owner-operated small businesses and historic flavor.

  But despite Linda’s knack for building a loyal customer base and the high quality of her hats, she dreads the slow months, usually January through March, when cash flow can get tight. She dubs this slow period the “trifecta of terror.” After Christmas, her shop experiences a seasonal drop in sales. At the same time, sales tax is due from the holiday season and by March, she has to buy inventory for the busy upcoming Kentucky Derby sales season.

  2016 was a particularly rough year for Linda. Money was tight and sales were down. Instead of dipping into her savings, Linda took out a loan from an online lender, OnDeck. The process was simple: Linda provided OnDeck with her bank statements and business documents, and quickly received a $30,000 loan. She ended up having the best Kentucky Derby sales in shop history, and promptly paid back the loan with $2,000 in interest.

  Customer-Product Fit—What Loan is Right?

  More than simply getting access to capital, it is also important to make sure that small businesses get financing that fits their needs. This means accessing the right product at the right price and duration. This customer-product fit is critical to a healthy small business credit market.

  For example, short-term loans that are repaid in a few months work well for seasonal businesses or for firms that need to purchase unusually large amounts of inventory for holidays or certain times of the year. Longer, multi-year term loans are a better fit to finance equipment or real estate purchases, since the purchase is typically made to increase long-term revenue, which will then be used to pay off the loan. If a short-term loan is used for an equipment purchase, it may come due before the business has increased its revenues enough to be able to pay it off. This could lead to a default on the loan, or a cycle of refinancing, each time paying additional fees to do so. Ensuring that each small business gets the right kind of loan is a win-win for both the borrower and the lender.

  The main types of financing available to small businesses today fall into a few distinct categories:

  Term loans are paid back on a set schedule. They are often used by small firms to buy equipment or real estate.

  Bank lines of credit are liquidity available for a business to draw down on an immediate basis to smooth out uneven cash flows.

  Merchant cash advances (MCAs) let businesses—usually retailers who take debit and credit card payments—get a lump sum cash advance. The lender is repaid by taking a percentage of the businesses’ future sales.

  Receivables financing allows a small business to sell or pledge some of its accounts receivables to a third party. In return, it gets immediate cash in an amount which represents a discou
nt on the total receivable. This discount compensates the third party for taking on the risk that it may not be able to collect the full amount of the receivable.

  Business credit cards are often the most accessible forms of financing, but they carry high interest rates and are not permanent financing, making them less than ideal for ongoing working capital needs or for large, one-time purchases that will not immediately generate revenue.

  SBA loans are an option for some applicants who cannot get financing from lenders without credit support. In these cases, the SBA partially guarantees a loan made by an authorized lender. The guarantee makes the loan a less risky prospect, since there is less exposure for the bank if the borrower defaults. This incentivizes lenders to provide financing. Since women and minority-owned businesses have a harder time than others do when it comes to accessing credit, it is not surprising that the SBA over-indexes in these kinds of loans.11

  How does a small business owner know what loan is right? In the past, the local banker who knew the small business owner helped make sure that there was customer-product fit. In the process of discussing the small business’s plans and prospects, the banker saw the financials, assessed the use of the loan proceeds, and made a judgment as to whether the endeavor would be a success. This interaction allowed the banker to make an informed credit decision and the customer got advice and counsel about the right loan product.

  As the presence of community bankers declines, who will take the responsibility for making sure there is customer-product fit? In a borrower-lender relationship, the interests of the parties should be aligned. It is not a good idea for a lender to give someone a loan that is so expensive that they can never pay it back, or one that has a timing mismatch. Maintaining optimal matching of the borrower to the loan that meets their needs is a challenge for the small business lending market of the future.

  Filling the Gap

  With a better sense of what small businesses want, we turn to the question of who will deliver it. As banks moved away from small-dollar loans and lending to small firms, entrepreneurs stepped in to fill at least some of the gap with creative solutions. Around 2010, new fintech entrants emerged in the small business lending segment, bringing a technology-driven approach to solving some of the market’s issues.

  The most visible initial innovation was a “digital first” approach where the process was done online, not in banks. The new lenders introduced a simpler credit application process and used algorithms to make quick and low-cost lending decisions. The new credit processes used more relevant and timely data from a small business’s own bank account and other financial activities to make more nuanced decisions about whether to offer credit.

  Most importantly, they created a better customer experience for the small business. Instead of Xeroxing a pile of paperwork, walking from bank to bank trying to get a loan, and waiting weeks for a response, small businesses could now apply online in minutes, have a response within minutes or hours, and have the money in their account within a day. These changes addressed some of the more painful frictions that had been plaguing the small business lending market.

  The innovators were met with an early positive response from small businesses. The Fed’s 2015 Small Business Credit Survey found that more than half of small businesses surveyed were dissatisfied with a difficult application process at their bank, while only one-fifth said the same about their online lender. Nearly half also expressed dissatisfaction with a long wait time for a credit decision from their bank, while again, only about one-fifth said the same about their online lender (Figure 5.5).

  Figure 5.5Borrower Dissatisfaction by Lender Type Source: “2015 Small Business Credit Survey: Report on Employer Firms,” Federal Reserve Banks, March 2016.

  * * *

  The stage was set for a cycle of innovation in small business lending. Finally, after much time and frustration, small firms and those seeking small-dollar loans thought that they would soon have many alternatives to easily access capital that met their needs. Using technology, innovators would fill the gaps in small business lending in ways that were good for the borrower and the economy as a whole.

  Technology does have the power to solve some of the market frictions we have identified, and enable lending to more creditworthy borrowers at a lower cost and with a better customer experience. With the increased availability of data, lenders should be better able to identify the financial prospects of smaller companies, and because of automation of their systems, make small loans profitably. The resulting more efficient market should mean better matching of creditworthy small businesses with willing lenders, closing the small-dollar loan gap. Yet, as with many cycles of disruption, the story is not as simple as “they all lived happily ever after.”

  Part II of this book explores the cycle of fintech innovation that has begun to transform the small business lending market. After some early success, new fintech entrepreneurs faced powerful competition from large technology companies like Amazon, and banks and traditional lenders which refused to be counted out. For small businesses, the final outcomes are still evolving. Increased innovation has brought and will continue to deliver more products that meet their needs. In addition, artificial intelligence will enable new insights for both small business owners and their lenders, but will also bring risks as future markets operate under a regulatory system that has not caught up to the changes technology has brought. The next chapters explore what the small business lending environment of the future will look like, and who the winners and losers will be as the cycle evolves.

  Part II

  The New World of Fintech Innovation

  © The Author(s) 2018

  Karen G. MillsFintech, Small Business & the American Dreamhttps://doi.org/10.1007/978-3-030-03620-1_6

  6. The Fintech Innovation Cycle

  Karen G. Mills1

  (1)Harvard Business School, Harvard University, Boston, MA, USA

  Karen G. Mills

  Email: kmills@hbs.edu

  In 1947, Bell Labs developed a small device known as the transistor. This miniature piece of hardware could control the flow of electricity, either amplifying or switching it. Using the transistor, electronic devices like radios and computers could be built more cheaply and reliably—and smaller—than their predecessors that relied on vacuum tubes. The transistor formed the basis for the electronics industry, perhaps the most economically and culturally important sector in the world. Most often built using silicon, the transistor created Silicon Valley in both substance and name.

  But as important as the invention later became, it received little notice at first. Design and production problems had to be resolved. Potential had to be translated into concrete products. It was unclear how the innovation would go to market, and how large the market would be for it once it did. Ten years later, after a slow start, transistors had reached mainstream product markets and could be found in radios, hearing aids, clocks, phonographs, and more.1

  In the late 1950s, another transformative event occurred. Jack Kilby at Texas Instruments patented the integrated circuit, which placed transistors and other components onto a single chip. Engineers worked to cram more and more transistors onto a chip, boosting their functionality along the way. This led to further innovations through miniaturization, plummeting costs, and ever more powerful chips that enabled the creation of personal computers in the 1970s, and eventually led to today’s iPhones, Internet infrastructure, on-board automobile computers, and even pet tracking devices.

  Today, we rely on a chip that can hold hundreds of millions of transistors every time we pick up our smartphones or our computers. What began as a simple invention to direct electric currents eventually gave us the modern-day products and services that transform how we conduct many facets of our daily lives. Yet, in 1947 and in the early years after the initial discovery, the transformative nature of the transistor was unclear.

  While we are not necessarily predicting that innovations in fintech will be as transformative
as the transistor or integrated circuit, the change to online, data-driven lending is the start of a significant cycle of innovation in a market that has not, up until recently, seen much change. Fintech covers a broad array of new technologies, from blockchain to online mortgages, of which the changes in small business lending are just one part. The path of innovation in small business lending will be influenced by activity in other parts of financial services, including consumer lending, payments, and artificial intelligence. But it will ultimately follow its own distinct course.

  We are at the beginning of the fintech innovation cycle. The early innovations we have seen in online lending are like the phase of the transistor, opening the door to a new future in the way that small businesses access capital. What will be the “chip” that unleashes the full potential of these changes?

  The Innovation Life Cycle

  The creation of the transistor and its integration into the now ubiquitous chip is an example of how the innovation cycle works in action. An invention or fundamental change occurs in a market, and is at first adopted by just a few “first movers.” The use cases for the innovation are unclear and the players who go to market often take on substantial risk, with the potential for large market share if the innovation is commercially successful. As more entrepreneurs understand the innovation’s potential and translate it into new products and industries, the innovation becomes more widespread. Eventually, products become standardized and the market reaches a large scale with strong acceptance and usage. Then, new innovations come into play that compete with the old products, and thus begins the next innovation cycle.