Navigating the Blue Ocean of Commercial Lending

The Lending Innovator is a monthly series, written by Canopy CEO, Matt Bivons

Many will argue that there’s already been a lot of innovation in lending. After all, some of the OG “fintech” players were lending companies. They have a point, but I argue that there are still key changes that need to be made to unlock the next revolution, which will be bigger than those before it.

Let’s take a step back to the 90s, when Nirvana, Guns and Roses, and the Foo Fighters were topping the charts and not even MySpace existed. Many of us probably weren’t thinking too much about B2C lending those days, but a major breakthrough was taking hold.

It came from Nigel Morris and Rich Fairbanks, who co-founded Capital One when they applied personalization to credit card offers through risk based pricing.

Before risk based pricing, banks would use somewhat of an insurance premium where they took a bell curve and said, here we have the most risky to the least risky set of borrowers. We're going to blend it to create one single rate.

Insert Oprah: You get 30% APR. You get 30% APR. Everyone gets 30% APR!

Great for banks’ risk management; however, it obviously locked a lot of people out of the market and was a highly impersonalized approach to lending.

From FICO to Risk-Based Pricing

Let’s take a closer look at this and why it was such a pivotal moment.?

Before Morris and Fairbanks came along, lending decisions took all of the buying, spending, and repayment habits into account to combine them into one risk score, but only looked 30 days back and lacked forward-thinking.

Through the invention of risk-based pricing, loans became more personalized. Risk-based pricing is a lending strategy that involves setting interest rates and loan terms based on the perceived risk of default by the borrower.

Lenders use a variety of factors, including but not limited to a borrower's FICO score, to assess the likelihood of default and determine the interest rate and loan terms. Risk-based pricing takes into account a broader range of factors to determine the borrower's risk level. These include the borrower's employment history, income, debt-to-income ratio, and other financial indicators.

Boiling Risk Down to a Single Number was a Major Unlock

Over the last 70 years or so, the consumer has been iterated on, again and again. At the same time, B2B lending has been slower to iterate. A lot of that had to deal with what’s going on behind the scenes. It wasn’t until recently that loan management and servicing software has begun changing to meet the ever-evolving needs of consumers and businesses, reflecting their demands for customized, transparent, and safer credit and lending products.

The Next Wave of Lending: Taking Lessons From Consumer & Applying to Commercial

With all of this groundwork now laid, what can we take away? How do we translate what’s worked for consumer lending and apply it to the commercial lending space?

Let’s dig into a few trailblazers that have set examples.

Kabbage: Funding Business Lines of Credit

Kabbage from American Express was one of the first working capital (non-bank) lenders that broke through in 2009. They use an online platform and automated underwriting processes to assess the creditworthiness of small businesses and provide funding decisions quickly, often within minutes. Kabbage's loans, which are for anything from working capital to inventory management to equipment purchases, are typically short-term, with repayment terms ranging from 6 to 18 months.?

By leveraging alternative data sources and early application of machine learning, they were a pioneer in making small business loans more efficient and profitable. It has also served as a popular funding option for small businesses that may have difficulty obtaining traditional bank loans due to limited credit history, lack of collateral, or other reasons.?

Fundbox: Meeting Modern Business Owners Where They Are

Not only does Fundbox make it possible to get an application approved within 3 minutes and fund you next-day, business owners also don’t take a hit to their credit score for simply applying.?

They offer two primary types of financing, lines of credit and invoice financing. With both, small businesses can apply and get decisions in minutes. With lines of credit, they’re able to draw on funds by the next business day. With invoice financing, businesses can connect their accounting software or business bank account to Fundbox, and the company evaluates their invoiced receivables to provide funding against the value of those invoices. Once the invoices are paid, the funds are repaid to Fundbox along with fees. They’re also partnered with Stripe, making it possible for businesses to access cash in the platform they’re comfortable with using on a daily basis.

Pipe: Making Growth More Accessible and Fair

Capital growth has long been catalyzed by “who you know”, rather than the true health of your business. Pipe changes the game by making it possible for companies to trade their future revenue for up-front capital, without dilution.

Pipe is not a lender, but rather they offer a unique solution for businesses to access capital by "selling" their recurring revenue streams as an alternative to traditional debt-based financing.

It operates as a marketplace that connects businesses, particularly those with recurring revenue models such as subscription-based businesses, with institutional investors who are interested in purchasing a portion of their future revenue streams. This allows businesses to receive upfront cash for their recurring revenue, which they would otherwise collect over time. It's important to note that this is not a loan, but a mechanism for businesses to access capital by monetizing their future revenue streams.

Translating KYC to KYB

The term "Know Your Business" (KYB) is derived from the similar term "Know Your Customer" (KYC), which has been a standard practice in the banking industry since the 1990s to prevent financial crimes and protect against various risks.?

KYB is a term used to describe the process of verifying the identity and information of a business's customers, suppliers, or partners to reduce risk and ensure compliance with regulations.

Much like other types of loans, it’s evolved over the years as a response to the increasing need for parties on both sides of the loan to protect themselves from risks and now allows lenders to take a deeper look at businesses that were applying for loans. Previously, banks often relied solely on a business owner’s personal finance risk profile. Today banks can look at market dynamics and current economic factors for the specific business in need of fresh capital.?

Lending Innovation within the Factoring Industry

In recent years, lenders have looked at financing businesses that get paid for work at a later date from a somewhat rigid point of view.

The theory was, “I'm going to take this invoice that you're going to get paid for, and I'll give you 70 cents on the dollar for it. You might lose some money, but I’m taking the risk because I have to hope that you get paid back on this invoice.”

Turns out, this old way of lending wasn’t always a win-win in the long-run for the lender or the commercial borrower. It can be slow, manual, and led to high friction in the lender-borrower relationship, giving the business owners good reason to keep their eyes open for a better rate. Out of this struggle came a new, now highly competitive industry – factoring.

This is a type of lending that involves the purchase of a company's invoices by a third-party financial company called a factor. Essentially, the factor provides immediate cash to the company in exchange for its outstanding invoices. The factor then assumes responsibility for collecting the payment from the company's customers when the invoices become due.

Factoring is a popular form of financing for businesses that need to maintain a steady cash flow, but may experience delays in payment from their customers. Instead of waiting for payment on outstanding invoices, businesses can sell them to a factor at a discount in exchange for immediate cash. Factors typically charge a fee for their services, which is based on the amount of the invoice, the creditworthiness of the customer, and the terms of the invoice.

The factoring industry can be beneficial for small and medium-sized businesses that need to access working capital quickly and do not have the creditworthiness to secure traditional bank financing. However, it can still be more expensive than other types of financing.

Factoring is a great starting point, but there’s still lots of room for innovation.

Take GreenSky for example. They actually got their start in factoring, which helped them understand how to acquire merchants. They now provide point-of-sale financing solutions for home improvement projects and other industries such as healthcare and retail, acting as the facilitator and connecting borrowers with lenders and then managing the loan process.

The Future

Finance executives of the past believed that every consumer was the same, doled out a 30% APR across the board, and called it a day.

Now, we know better; it’s not all the same revenue. What learnings will we take from consumer lending for the next era of commercial lending?

Factoring will play a key role here, and is in many ways the B2B equivalent to risk based pricing for B2C lending. Take Kabbage for instance. The fintech lender offers secured loans for small businesses through invoice factoring, business cash advances, SBA loans and equipment loans. Unlike most online lenders, Kabbage can arrange accounts receivable factoring services for small businesses with substantial credit sales and are structured as either 6-month or 12 month installment loans.?

Thanks to these new tools, online lending is close to achieving real time funding for businesses. In addition to Kabbage, Ondeck Capital and Bluevine can also provide financing decisions almost immediately. While instant funding is more important for some businesses than others, cash flow crunches are avoidable if lending decisions and money movement happen in minutes or hours rather than days or weeks.?

Final Thoughts

The next decade of lending will look very different than the last. Given how much B2C lending has resulted in undifferentiated commodities, it’s time to turn the focus on the blue ocean of commercial lending.?

Canopy has the good fortune of being in the trenches with our partners and playing a role in helping them innovate. We see new policies and rules being applied to different B2B use cases every day, while new working capital products are launching to fill a massive void.?

Our partners, like Flexport and Novo are leveraging Canopy to be better lenders which ultimately creates better borrowers. This moment has similar characteristics to other critical inflection points in Fintech history. The timing is ripe for disruption. With better infrastructure, access to new data types and massive demand from SMBs and merchants, this vertical of lending is an operator's dream.

We can’t predict the future and no doubt there will be surprises along the way, but the signal is clear - and in the words of a16z, it’s time to build.

#lending #commerciallending #fintechinnovation