This story appeared in our March 2012 issue. Subscribe here.
When Robert Frohwein was driving along Silicon Valley's Sand Hill Road in search of venture capital, he could practically hear the laughter. The year was 2008, when venture firms were hesitant about any new investments, much less the kind of online lending company that Frohwein was pitching. Plus, he was based in Atlanta-hardly known as a center of digital innovation. What he did have going for him was a good idea: advancing money via the Internet to other online businesses in a matter of minutes.
"Traditional business lending is fundamentally broken," says Frohwein, founder of Kabbage.com. "It's only out there for folks who have sparkling credit histories, and the average businessperson does not have a sparkling credit history." Despite the generally difficult climate for new ventures, Kabbage.com ultimately managed to raise $26 million from the likes of BlueRun Ventures (an early investor in PayPal) and UPS.
The recession and its aftermath have been tough on business borrowers. The number of small-business loans plummeted from 13.5 million in 2007 to 4.2 million in 2010, according to federal banking statistics. The dollar value of those loans fell from $329.2 billion to $179.6 billion. Some of this is due to banks tightening lending requirements, and part of it is due to the reluctance of business owners to take on additional debt. Banks are also pressuring current borrowers; Bank of America has asked some of its small-business customers to settle credit-line balances all at once-or face payment schedules at higher rates.
As a nascent recovery slowly takes hold, the presumption is that both sides will loosen up a bit, which would mean a pickup in expansion plans and hiring. But the roadblocks to borrowing go well beyond the recent bad times. They reflect decades of operational neglect that make the traditional lending process slow, cumbersome, and expensive-as well as risk averse when it comes to unproven but promising business concepts. Entrepreneurs like Frohwein are realizing as much, and the result has been a growing interest in lending alternatives, many of them Internet-based, that bypass the tortuous delays and frequent turndowns by conventional banks.
Non-Bank Lending
is certainly not new. In the early American Republic, businesses were more likely to get credit from their suppliers, customers, or other merchants than from banks. In 1932, the federal Reconstruction Finance Corporation was created to help recapitalize businesses suffering from the Great Depression. The Small Business Administration, since its start in 1953, has provided federal loan guarantees for some 20 million businesses. The management of these loans, however, is typically handled by banks.
Even in decent economic times, smaller loans are not cost effective for banks. It's considered more profitable to lend large amounts to a small number of reliable customers, which is one reason applications for loans of less than $20,000 are routinely turned down. The 25 largest U.S. banks underwrote just 20 percent of SBA general business loans in 2010, down nearly a third from 2006-despite those banks holding 32 percent more in deposits.
Notwithstanding the squeeze on bank borrowing, other options are available, though banks still dominate. Their competitors include credit unions, which function much like a bank except they're owned and operated by their members; community-development financial institutions; microlenders (both nonprofit and for-profit) that focus on small loans and are sometimes aimed at specific kinds of borrowers (women, immigrants, minorities, and low-income entrepreneurs); peer-to-peer arrangements where credit applicants and prospective lenders are brought together by an online facilitator; and "crowd funding" sites in which individuals pool money in support of a business or project (independent movie productions are especially popular).
For many fledgling entrepreneurs, a few thousand dollars can make a big difference, allowing them to purchase a used pickup truck or restock a store, for instance. Accion USA, an offshoot of a global lending network, is one of the bigger names in microfinance, having originated more than 18,000 loans over the last 20 years. Loans average $5,100, and interest rates are in the 8 percent to 18 percent range. Self-Help, a nonprofit financial organization based in Durham, North Carolina, has provided financing totaling nearly $500 million for 3,300 small businesses-ranging from auto shops to day-care centers. "We're a little flea-sized compared with the entire lending universe, but there's been real growth in the industry, particularly as banks have become more cautious," says David Beck, the organization's policy director.
Kabbage.com Occupies a Niche
that might yet grow into a larger segment of the lending industry. The enterprise is an online counterpart to old-fashioned "factors"-lenders who advance a company working capital collateralized by its anticipated income, known as receivables. When Lisa Ackerman launched Luxe Life Ltd., a Chicago-based high-end consignment business (kind of an eBay for luxury items), she began making the rounds for $80,000 in seed money. Several banks turned her down flat ("They told me if I had come to them two years earlier, they would have written me a check," Ackerman says). She then scoured other sources, including Accion. "We wound up getting $2,500 out of them and another $2,500 later on," she explains, "but we had to put our car up as collateral, and the interest rate was 18 percent. I still had to jump through every single hoop, almost like a bank."
After managing to get her business started, Ackerman quickly ran into a cash squeeze and was told about Kabbage.com, which opened in early 2011. The company, like traditional factors, provides cash advances secured by accounts receivable. After filling out a few electronic forms, Ackerman was notified by e-mail a few hours later that she had been advanced $500. Her credit line is now $15,000, with payments automatically withdrawn from Luxe Life's PayPal account. The whole process is automated.
Like other Web-based lenders, Kabbage.com is given access to an applicant's credit scores, transaction history, website traffic, account activity on eBay and Amazon, payment disputes, and other metrics that determine a borrower's risk profile. None of this involves a visit to the bank or a credit committee. For each of the first two months, borrowers are charged from 2 percent to 10 percent of the original advance; after that it's 1 percent (customers typically repay the advance over six months).
Other online credit sites, such as Prosper.com, Lending Club, and Kickstarter, are variants on the model. Prosper has raised more than $75 million from several rounds of equity funding. It matches individual lenders to borrowers based on the lender/investor's appetite for return and tolerance for risk. Lending Club and Kickstarter both rely on online small investors who put money directly into a wide array of small businesses ranging from farmers' markets to music projects.
After the experience with lending by formula in the subprime scandal and the very high rates charged by payday lenders, some critics look askance at the interest charges, the automated lending formulas, default rates, and the relative lack of regulation of online lenders. On the other hand, the typical client of an online lender would not get bank credit at all, despite the fact that the vast majority are creditworthy.
"It amazes me that it works," says Richard Burnes, founding member of the venture-capital firm Charles River Ventures, which has helped fund a San Jose, California–based microlender, Progress Financial. "The traditional model was based on a local bank taking in a local deposit and then loaning to local people that they knew. But the banks have lost their local touch. This kind of model basically says that the new world is here."
A challenge for online microlenders is scale. Can lenders achieve volume without affecting service quality and profit? Scale requires automated loan-processing systems to accommodate all kinds of business borrowers, not just online businesses that are easy to track.
Chris Larsen, chief executive of Prosper.com, which is among the most successful peer-to-peer loan operations, says that a microlending business would only need a 1 percent or 2 percent market share to become a serious player. That, however, still amounts to $2 billion, and none of the microlenders are anywhere near that mark (Prosper has arranged loans totaling $235 million). "We're beyond the 'Will it work?' stage," Larsen says. "We've got all the components in place, and the results are working out really well. Now it's just a case of getting the name out there, and getting it beyond a niche."
What Larsen, Frohwein, and other young online entrepreneurs are really aiming for is a new form of banking, one that makes it easier for borrowers and provides small-scale investors with a chance to earn higher returns (up to 10 percent) than they would get from certificates of deposit. However, online microlenders are not likely to evolve into traditional banks-no ATMs or standard checking accounts. Nor is it clear whether they will offer more traditional commercial business loans with longer payback terms. As financial institutions that do not take deposits, they defy conventional categories. The government has yet to decide whether they should be regulated by the Securities and Exchange Commission or the new Consumer Financial Protection Bureau or another entity.
No doubt some bankers will try to compete with this new business model, but the question is whether they will be able to adjust their corporate culture and costly infrastructure. If not, don't be surprised to see banks snap up some of these fledgling companies.
