ONLINE BUSINESS LENDING: ROLE & RELEVANCE TO SMALL BUSINESS AND LOCAL BANKS. February 14, CHRISTOPHE D. CHOQUART IOU Financial, Inc.

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1 ONLINE BUSINESS LENDING: ROLE & RELEVANCE TO SMALL BUSINESS AND LOCAL BANKS February 14, 2017 CHRISTOPHE D. CHOQUART IOU Financial, Inc. 1

2 1. SMALL BUSINESS ACCESSING CAPITAL Access to working capital is a critical concern for small businesses in the USA, as a great number of them are challenged to find adequate financing to sustain or grow their businesses. For the purpose of this paper, small business can be defined as owner-managed, 1-20 employees, annual revenues up to $1 million and over 1 year in business. Alternative lending/lenders is referred as online lending/lenders. Online means convenience and ease of application, a key success factor for the industry. Prior to the credit crisis of 2008, most small business owners leveraged home equity loans, large credit card limits and personal lines of credit to sustain and grow their businesses. The financial meltdown shrunk or eliminated many of these capital sources, while the credit window at banks was closed to most businesses. To this day, banks tend to stay away from most micro-loans (<$150,000). These loans are simply not profitable for banks as they are expensive to underwrite and compliance costs are high. This dynamic was the genesis for new non-bank market entrants to provide small businesses access to capital. Small Business loans originating with either direct or peer-to-peer lenders are generally a much higher cost than their previous counterparts (lines of credit or home equity lines). However, this new alternative lending access to capital is much easier for small business owners to obtain, with no collateral required, less paperwork and fast funding (hours and days vs. weeks or months). While 76% of business loan applications are below $250k, about 60% of the demand is for loans below $100,000. The online lending industry has simply responded to this demand for small loans, making its mark by: Focusing on innovative technology Speeding up the underwriting process Lessening documentation requirements Collecting data to improve risk pricing 2

3 2. ONLINE LENDERS Because of the void left by banks and the ease by which small business owners can now apply and receive capital, the online lending industry has matured and should continue to grow. Growth Praxis projects a US market for business lending through online platforms to reach about $206Bn by Online lenders offer three advantages over regular bank loans: Their application process is simple and requires little to no paper work They provide loans quickly, usually within one to three days They do not require collateral aside from a personal guarantee from the owner The online lending industry initially offered loans up to $150,000 with terms ranging from 6 to 12 months. More recent trends have shown loan amounts and terms increasing in a quest for market share gain. However, most small business owners seek loans below $100,000 to fund their working capital or investment needs (source: HBS: state of small business lending ). The alternative/on-line lending market is composed of three lender types: a. DIRECT LENDERS: these companies originate loans funded with their own capital. Cost of capital for these lenders runs from a lowest reported of 5.5% to the high teens. Direct lenders may sell some or all of their loan portfolio to third-party investors, while others will retain the loans on their balance sheet. The decision to either sell or retain ownership of the loan is usually linked to economic return and ongoing access to liquidity. Loan products offered to small businesses include simple interest term loans (no prepayment penalties) and lines of credit (High cost). Repayments are mostly made on a daily basis although weekly payments can now be available. Leading direct lenders are Ondeck, IOU Financial, Funding Circle. 3

4 b. PEER-TO-PEER (P2P) LENDERS: these marketplace lenders match loan requests with investor s return/risk tolerances. P2P platforms may partially fund these loans, or may act only as intermediaries to bring borrowers and investors together. P2P lending traditionally has been associated with personal loans, but has recently included small business loans as well. Lending Club and Prosper are leaders in this segment. c. MERCHANT CASH ADVANCERS (MCA): these funders offer to buy future credit card or bank receivables at a discount. These advances are not loans and can be very expensive, often bundled with credit card payment services. Most credit card processors offer Merchant Cash Advance in order to win new business from Banks merchant services clients. Since these are classified as an advance and not a loan, they are generally not subjected to usury compliance. In either case, online lenders provide speedy access to capital to small businesses across the spectrum of credit profiles, access that is typically not available from banks. Online lenders allow business owners to apply using on-line platforms with data-driven insights and advanced algorithms based on hundreds of data points including cash flow, personal and business credit, and even social media and consumer reviews. Because of this technology, online lenders can pre-qualify loans in seconds and approve them as quickly as a few hours. This is the key reason why online lenders have been gaining momentum: they make loan application easy and convenient. 3. QUALIFYING FOR FUNDING Most online lenders offer small business owners the flexibility of applying for a loan online. This paperless application allows to instantaneously screen each borrower for credit history (personal and business soft credit inquiry in the USA) as well as hundreds of relevant indicators (social network, reviews, location, industry ), the end result being a precise risk profiling assessment and optimal loan pricing. Leading online lenders have developed proprietary risk scoring algorithms. Once a business qualifies for funding (passes credit), additional information is then required: Borrower(s) must own a majority of their business The business has been in existence for over a year At least 10 deposits must be made on the business bank account Annual revenues of at least $100,000, well split over 12 months A minimum FICO score can be required (usually 600) Belong to an accepted industry (regular cash-flow vs. seasonal business These additional qualitative elements are gathered online as well to be reviewed by the loan officer and discussed with the borrower. Whenever a borrower fails to meet a criteria, he/she can be referred to specialized online lenders that can find the optimal solution, if any applies. 4

5 4. CASH-FLOW IS KEY FOR FUNDING Once a loan applicant fully qualifies for a loan, a processor scrutinizes the business cash flow through bank statements (3-6 month history), verifies owner s identity through the most recent tax return, driver s license and other outside databases. The banks statements are processed to assess cash flow requirements (minimum average daily balance, maximum NSF, negative days, number of deposits, cash-flow trend, anomalies) and to calculate the optimal loan amount. Online lenders do not look at either the equity or the profit level. The online lender s ability to be paid back is essentially assessed by the borrower s credit strength, solidity and trend of recent business cash-flows. Bank statements also show all outstanding loans, data that is used to calculate the maximum loan amount. Finally, online lenders will usually ask the borrower s permission to use 1/3 rd party services such as Decision Logic to verify bank statements accuracy. At all steps of the application do online lenders verify against fraud risk. Once cash-flow requirements are validated, the loan application then goes to a credit underwriter who will revisit the loan rationale and further investigate the business solidity. The underwriter will understand and verify the industry type, the use of funds, check for cash-flow anomaly, outstanding debt, and borrower s identity. Once fully satisfied, the loan amount will be determined and a loan offer is made to the borrower. Once accepted, a live closing phone call set-up to explain the loan product directly to the business owner. The latter then has several days to accept the funds. The whole process, from initial application to funding can take from 24h up to 78h depending on application completeness and borrower s availability. A small business owner who applies early in the morning, can have the funds wired same day. 5. DETERMINING THE LOAN AMOUNT It is often the case when a borrower is seeking a certain loan amount to be offered a portion of it. Good online lending practices take into consideration a combination of credit history and cashflow to ensure the business does not over-extend its debt. Disciplined online lenders usually impose key limits on total debt so that no borrower ever puts his/her enterprise at risk of defaulting. Each online lender possesses its own formula while 10% of annual revenues is generally considered as optimal loan amount. Good businesses with healthy cash-flow can get more. Responsible online lenders advise small business owners on debt load and how it can impact cash flow. The daily payments. Another important consideration applies to repayment cash flows. Some lenders enforce a monthly payment date, other cash advance companies take a percentage of daily credit card receipts. For merchants with uneven cash flows, the monthly repayment amount can look like a mountain of cash. Leading online lenders have a policy of collecting small automatic payments directly from customer checking accounts, daily or weekly, converting that monthly mountain into small molehills, a much less painful way to pay back a short-term loan. 5

6 The daily and weekly payments are calibrated according to the business cash-flow. They are also the reason why online lenders prefer small businesses with regular deposits (at least 10 per month). A construction company s cash-flow is often not a good match for daily or weekly debt repayments. No matter the considerations, loans from alternative lenders should always be reviewed carefully so that a merchant understands the costs and terms completely. The business cash flow should never incur stress by any incremental debt amount. 5. THE COST OF ONLINE LENDING vs. CONVENIENCE OF EASY APPLICATION Traditional banks lend in majority to the most credit-worthy businesses (FICO at 750 and above), with some form of collateral. The online lenders however not requiring collateral, charge a much higher interest rate and may apply loan guarantee fees. Therefore the total loan cost (including fees) is usually much higher than for a traditional collateralized bank loan. The application and underwriting process at a bank is structured to mitigate nearly all loss risk and in-turn may take weeks and months to finalize. This is justified from a bank s risk point of view. However, this may freeze many good, viable small businesses out of the running for bank loans, and delay business opportunities for those who are bankable. Contrary to traditional banks, online lenders incur a high cost of capital, ranging from % range depending on its source. Online lenders cannot access deposits as a source of funding and can be subject to heavy restrictions and covenants by private institutional funders (hedge funds) or from a revolving credit facility. There is however a rationale for banks to want to fund loans underwritten through alternative lenders platforms. (See last section about partnership opportunities). There is little argument that the underwriting and vetting process traditional banks take is far more robust and mitigates risk to a greater degree. In order for online lenders to ensure they generate an appropriate yield, they must factor: Their cost of capital The risk score of the merchant Loan term servicing costs (operations, sales costs, customer acquisition costs, etc.) These variables drive pricing of the loan. Unlike collateralized loans, the online lender cannot build in the asset value of the collateral to reduce risk pricing. Online lending is done on a noncollateralized note basis; lending without collateral increases the cost to cover defaults across the portfolio. 6

7 6. APR vs. TOTAL COST OF CAPITAL APRs are rarely disclosed for online business loans. Most small business owners (and some experienced bankers) may even have a hard time telling what a 23% APR is on $25,000 borrowed over 10 months. Business owners should look at total cost vs. the expected return on investment. If a merchant borrows $25,000 to purchase inventory which they plan to sell for $50,000 within 6 months, then paying $32,000 for it (factor rate of 1.28x), would net $18,000, a 36% gross profit margin. Note that the notion of factor rate (total reimbursement amount divided by initial loan amount) is the most widely ratio used by the online industry to communicate with business borrowers on their loan cost. The factor rate includes all financial costs incurred by the small business borrower (i.e. Interests and fees). Alternative working capital loans allow business owners to be opportunistic and seize growth projects at any time. Opportunity cost of money is a real factor explaining the success of higher cost online lending. Small businesses with good business models and healthy cash flows can grow faster with capital from online lenders. Businesses that borrow money for lower-roi needs (i.e. hiring, day-to-day working capital, etc.) must be very diligent in how they borrow. The following chart shows how customers at a leading online lender put their loans to work. As you can see, the bulk of loan money goes to high- ROI/growth activities (equipment purchase and business expansion). BUSINESS LOANS USE OF FUNDS Expand 18% Purchase equipment 47% Temporary cash-flow 16% Purchase/Build Inventory 14% Other 5% Total 100% Once again, the opportunity cost of not getting a timely loan is a key risk factor that small business owners need to look at when evaluating their financing options. Waiting weeks or months for lower cost funds can make sense in some cases, but can also mean businesses irremediably delay their growth curve or miss opportunities which could far outweigh the difference in total costs. 7

8 7. ONLINE LENDING AND LOCAL BANKS? If you are a seasoned lender, you need to ask yourself the following questions: Do you think that your small business customers have trouble accessing capital to grow? Do you work with seasonal businesses that cannot complete projects in their off season? Do you sometimes need to pay off a UCC lien or taxes prior to obtaining an SBA loan? Do you entertain regular requests from small business owners for small loans? If the answer is yes, there is a way for your bank to answer these clients needs while generating a non-recourse fee income and other ancillary revenues. How? By partnering with a leading alternative lender through a plug & play proprietary solution that allows your bank to qualify merchants for small loans ($150,000 and less) and get them funded in as little as 24h-48h. Small business owners needing a rapid loan do not usually have time to shop around. Instead, they would love if their bank could lead them to a convenient solution. Who is better placed to provide such help? Any bank looking to grow with small businesses have the opportunity to work with online lenders top provide a much needed service to many entrepreneurs across America. With very limited upfront costs, your bank can deliver credit online via a cost effective innovative loan platform that will enable to reach, retain and grow entrepreneurial small business clients. a. The New Product Due to smaller scale operations and high human capital costs, local banks must prioritize businesses enjoying optimal risk/profit relationships. Such choice may explain why larger collateral loans are usually favored over smaller, no collateral loans. Small loans are not profitable, mostly due to compliance requirements and cost to produce. This does not mean smaller no collateral loans are not viable products for local banks. This is especially true when some leading online lenders are now making their online plug & play service solutions available to banks. Using innovative and cost effective online loan platforms, local banks now have the opportunity to offer a new product and reach a new clientele of small business entrepreneurs. They can offer small loans at no direct cost in exchange for substantial non-interest income and possibly cross selling opportunities (merchant services/working capital bundling, wealth management, personal & business banking). 8

9 b. The Partnership Existing partnerships between banks and online lenders can vary in complexity, from a soft referral to a full system integration (white-labeling), each requiring more or less complex third party management vetting. Banks may also want to retain certain high quality loans on their balance sheet while underwriting them through cost efficient online loan platforms. Most leading online lenders keep loans on their balance sheet, on a non-recourse basis whoever the originator is. While the bank would need to train, incentivize bankers and advertise the new loan service to ensure volume success, it can pursue various integration options: 1. Personal or business bankers acknowledge merchants request, either in the branch or on the phone. They offer a high level overview of basics of non-collateralized loan. The application can be made via , online or on the phone. The banker can monitor the loan process via a dedicated loan portal provided by the online lender. 2. A dedicated page is created on the bank s website to explain the non-collateral loan product and general requirements (year in business, cash flow requirement, restricted industries). Once the business owner decides to apply online from the bank s website, he is officially re-directed to the alternative lender s website. From then on, the alternative lender s loan officer is in touch with the merchant and gathers all required documents to process the loan. 3. Automated credit initiation and analysis of business clients bank statements to formalize credit pre-approval. The screening could match the alternative lender s underwriting criteria. Small business owners, once alerted on their ability to access fresh capital, can then proceed seek further qualification. At all times, the bank maintains all client data until client decides they want to pursue. Working with online lenders who are SSAE 16 certified is certainly recommended. 4. The bank acquires a license from an alternative lender (i.e.: SaaS business model) to fully integrate the loan platform or specific modules (online application and risk pricing; bank statements processing / underwriting / closing, etc.). The bank can process the loan internally and fund it. The combination of low cost of capital and low cost online lending technology sounds like a great business model for banks. Depending on the level of integration, the time to market of any partnership will vary greatly, depending on banks leadership implication in the third party vendor management process. Online lenders must be selected based on their resources to abide by vendor management processes and compliance with compliance regulation in general. for more detail. 9

10 c. The role of the Personal Banker? Who should be the banks first point of contact to help a prospect business owner looking for a small loan? Could a personal banker be in charge of small loans advice and walk a prospective borrower through an online loan application? Loan size and timing would probably matter in deciding who would handle such loan application. While a large C&I loan inquiry will usually be handled by an SBA lender, a small business loan request (below $150,000) could easily be handled by a personal banker or an assigned champion for the bank. The small business owner s personal financial assets can be handled by a personal banker who can as easily help with working capital funding. The small size of the loan and quick process make it an obvious match. Personal bankers know how to cross sell the bank s services and ought to be the best contact for small business owners. As mentioned before, for higher commercial and industrial loan amounts, online lenders quick process may prove critical in the event a SBA borrower had to pay off any government lien or taxes. Online lenders do offer short-term working capital to bridge SBA loans. Business loans from online lenders fill a critical capital need for small businesses. Banks need to comprehend how the alternative lending players can provide a credible opportunity for the banks to grow their customer base in a very profitable manner. What happens when a bank fails to help a small business owner secure funding? It risks losing business to big banks like Chase or Wells Fargo s own online lending platforms, both institutions using these innovative no-collateral business loans to cross sell all their services. Should your client retention strategy profit and include small business online lending? If you believe so and would like additional information about lending best practices and partnership options, please get in touch: CHRISTOPHE D. CHOQUART IOU Financial, Inc. VP - Strategic Partnerships P: cchoquart@ioufinancial.com 10