Banks have failed small businesses time and time again. Here’s how to save them.

March 8, 2023Posted inIndustry Deep Dive
Reading Time: 8 minutes

Original version posted on November 22nd, 2022 on Medium.

One of the biggest hurdles local businesses face is a lack of realistic and practical financing options.

Looking at their options, it’s understandable why these businesses struggle to get funded.

Banks are an option, but they tend to stay relatively conservative with their funding to small businesses. Venture Capital from Silicon Valley is alluring, but venture capitalists only invest in businesses with exponential growth potential — not local businesses.

What we’re left with is the middle — the no-man zone — a wide swath of the American economy that is left underfunded, undernetworked, and underappreciated.

Who is working on this problem? How can we unlock the potential of small businesses in the U.S. and throughout the world?

Let’s look into the history of small business financing, the layout of companies working on this today, and examine what might be the next innovative model funding small businesses throughout the world.

Definitions

Before we dive into the history of small business financing, we wanted to look at the financing options available to small businesses today.

At a high-level, a business can either finance itself through equity or debt.

On the equity side, typical investors either include venture capital, high-net-worth angel investors, or the general public via equity-based crowdfunding (still relatively nascent — legal in the U.S. after the JOBS Act passed in 2012).

On the debt side, banks and alternative lenders have gotten creative with the various ways they can loan you money. Here’s a breakdown:

  • Loans: Lenders give you an upfront amount of capital in exchange for fixed repayments (with interest) over a fixed amount of time. You can get them for long periods (term loans) or short periods (working capital loans), from banks or backed by the government (SBA loans), or get them tied to your name (personal loan).
  • Sort of loans: You can also get a business credit card or a line of credit, which are types of debt. A business credit card is just like a normal credit card, but for businesses. Often a higher credit limit than personal credit cards have. A line of credit is like a business credit card, but can be used for things that you can’t use a credit card on (e.g., payroll). Unlike traditional loans, business credit cards & lines of credit only begin to accumulate interest when you actually make purchases.
  • The creative stuff: Inventory financing, invoice financing, invoice factoring, and purchase order financing are all clever ways that banks / other financial institutions lend to businesses. They all use different methods of collateral (e.g., inventory / invoices / purchase orders).
  • Other loans you’re used to as a consumer: The main ones here are equipment financing (e.g., like an auto loan for a big piece of business equipment) and mortgages (e.g., for office / manufacturing space).
  • The cool stuff: We’ll dive into these more throughout the article
    • Merchant cash advance: A merchant cash advance is an upfront loan in exchange for a fixed percent of future credit card sales, up to a certain limit. For instance, a lender may lend $100,000 in exchange for 10% of your daily credit card sales until $140,000 has been paid back. Since payback starts immediately and occurs daily, effective interest rates on this type of loan can get really high.
    • Revenue-based financing: Revenue-based financing is super similar to a merchant cash advance, but with some small nuances. It operates under the same principles — an upfront amount of capital in exchange for a fixed percent of future revenue — but the main difference is that it’s targeted more for businesses seeking to grow, rather than businesses needing quick cash to keep operations going.

As we said, we’ll dive into these last two a little later.

But first, let’s take a look back at the history of small business financing to get a better perspective on where we’re at today.

History of small business financing

Phase 1 (pre-1960)
The establishment

In the beginning, God created the heaven, the earth, and the banking system.

While money lending actually only has origins back to Ancient Mesopotamia, the modern banking system began to really take form in the 17th century, with the development of fractional reserve banking and banknotes.

Pre-1960, banks had proliferated throughout the United States. The system for lending to small businesses, however, had its clear faults.

If you owned a small business, you would go to a local bank to apply for a loan, and over 80% of the time you would be rejected. There was a very high bar to get one of these loans, and even if you met the bar, approval and an ultimate payout could take several weeks, even months.

This isn’t just bad, it’s like prohibitively bad. If you were a small business, you were better off trying to borrow money from friends and family than even entertain the idea of working with a bank.

Phase 2 (1960-2005)
The proliferation of modern-day venture capital

Venture capital emerged as an asset class in the 1960s and 1970s, with the development of the limited-partnership model and the formation of some of the big west coast VC firms, such as Sequoia and Kleiner Perkins.

At a high-level, venture capital is a form of financing in which private investors pool their money to invest in promising startups.

However, modern day venture capital runs on the power law, a law that dictates that 80% of the returns come from 20% of the investments. Thus, venture capital investors need every investment to have the ability to pay back the entire fund.

With that in mind, venture capital was (and still is) only available to startups that have the potential to 10x their value, and not to the most common 95% of traditional small businesses.

Phase 3 (2006-2018)
The rise of online lending

With the commercialization of the internet in the early 2000s, the next big wave of startups kicked off a new era of digital-native online lenders.

These companies offered common bank lending products (lines of credit, traditional loans) to consumers and businesses, but offered two main advantages over banks:

  • Higher acceptance rates: According to Forbes, a bank may require a credit score as high as 680, while online lenders may accept a credit score as low as 500. This unlocked another tier (or two) of businesses that couldn’t otherwise get a loan.
  • Quicker acceptance processes: As opposed to traditional banks with approval processes that could take weeks or months, online lenders could automatically accept loans using advanced underwriting algorithms.

Some of the more notable companies from this phase were OnDeck (2006 — now public and acquired) and Kabbage (2008 — acquired by American Express), with other notable notable companies including: Biz2Credit (2007), Funding Circle (2010), Prospa (2012), Fundbox (2013), BlueVine (2013), and Lendingkart (2014).

If you haven’t heard of many of these companies above, that’s okay — they’re mostly targeted to small businesses. However, there are a couple players in this space that you have definitely heard of, namely Amazon, Square, PayPal, and Shopify.

All of these businesses have proprietary access to business data, via their point of sale systems like with Square or their E-commerce marketplaces like with Amazon. These companies realized the huge opportunity to lend to the businesses in their networks that were performing well. And this model has proven itself — for instance, it took PayPal a mere 5 years to reach a total of $10B in loans disbursed.

Phase 4 (2019-present)
Modern revenue-based financing

Pipe, founded in 2019, was the fastest fintech company ever to reach a $2B valuation, achieving the status roughly a year after its launch.

Their model was pretty simple. They gave subscription businesses (like SaaS startups) upfront capital in exchange for a percentage of their future revenue. Companies would receive a lump sum to help grow their businesses, and give a percent of their revenue every month back to the lending provider, up to a certain cap. Additionally, similar to CircleUp founded in 2012 with their Helio loan model, Pipe would use your historical business data as inputs into their model to determine the financing terms.

Does this sound familiar? If so, it’s because we’ve talked about this model before.

While they were not the first company doing this, Pipe led the wave of companies offering revenue-based financing (also known as Cash Flow-Based Financing or Royalty-Based Financing). While revenue-based financing had a structure similar to that popularized by merchant cash advance companies in the 2000s, revenue-based financing aimed to not be a financing option of last resort. Instead, it focused on growth companies, allowing the financing to also have more moderate fees.

This type of financing is often called “founder-friendly financing” for several understandable reasons. First, it’s not-dilutive, so you don’t have to give away ownership of your business. Second, it has a cap, so you’re not paying your lenders out forever like with equity. And finally, payback is based on a fixed percent of revenue, not a fixed amount, so if your business struggles, your payback amount per month goes down.

Ultimately, the key to this financing is in how powerful some of the marketing elements surrounding it are:

  1. It’s simple. There’s no confusing interest or annual percentage rates (APR). If we loan you $100,000, you pay us back 10% of monthly revenue, up to $140,000. My 8-year old cousin could understand that.
  2. The lender appears on your side. You pay more when you do well and pay less when you’re struggling. The lender wins when you win, and loses when you lose.
  3. The lender’s upside is capped. You’re never worried about having to give away and arm and a leg like with equity. You know how much you’re paying back the lender.

Pipe wasn’t the first company to offer revenue-based financing for subscription businesses, but their success led to a ton of follow-on attempts.

Let’s dig into the current market layout.

Small business financing market layout

First, there’s the Pipe-like companies that are doing revenue-based financing. Most have started post-2019 and a lot of them have raised significant money off the Pipe tailwinds. Here are the categories we see the most often:

Revenue-based financing companies

Other lenders

So what’s next in small business financing?

At Neighborhood Studios, we are always looking for novel approaches to solving problems in spaces. Here are the approaches we think are interesting (some that are being attempted, some that are not), in and around the small business financing space.

  • Boopos, founded in 2020, is a recent promising attempt to improve SBA loans. Surprisingly, a lot of SBA loans are actually used to acquire small businesses, not fund them. Boopos works on this issue by offering fast, upfront capital to acquire businesses with revenue-based financing payback. What else could be improved with the clunky SBA process?
  • Bonside, founded in 2020, is working on a revenue-based financing marketplace to connect investors with brick-and-mortar businesses. While most revenue-based financing companies are working with online businesses, Bonside appears to be taking the opposite approach. Could there be a product that does this for other types of businesses, like Bonside is doing with brick-and-mortar businesses?
  • SeedBlink, founded in late 2019, is promoting co-investing in deals with their venture investing team. This way, you get access to investment opportunities with the added social benefits knowing that others are investing. Could there be a product that allows investors to co-invest in SMBs alongside established lenders?
  • FranShares, founded in 2020, is working to create an asset class out of franchise returns. They’re marketing “passive income” with access to this class starting at $500. Is this an untapped market need?
  • Pin, founded in 2020, is building an easy way to launch “investment clubs” to invest in startups in your “community” (broadly defined). They’ve been funded by top investors such as Initialized. Could this be the key mechanism to fund small local businesses?

What do you think is next?

Last updated on March 26, 2023