Making Sense of the Evolving FinTech Lending Market

‍Making Sense of the Evolving FinTech Lending Market

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Written by Mike Luebbers. Mike was Chief Credit Officer at Bridge Bank from 2015 - 2018. He was then Chief Credit Officer at Lighter Capital from 2018 through 2020. Lighter Capital was a pioneer in creating revenue-based lending. Mike is currently an advisor and consultant to various non-bank lenders. LinkedIn

OUTLINE

Introduction

• Bad news: Availability of “highly-underwritten” debt is limited for most early-stage DTC eCommerce companies
• Good news: The number of fintech and non-bank providers of “programmatic” debt is constantly expanding

Purpose

• Understand the key fintech products available to DTC eCommerce companies
• Understand the underwriting process, and how it differs from “traditional” debt
• Pros and Cons related to these new products

Current Landscape

• Product Breadth: Pure-debt providers vs service providers who also offer debt
• Lender Focus: “general” small business lending vs eCommerce focus vs subscription focus
• Specific eCommerce Products: MCA, RBF, and Other Working Capital Products (Note on Government-backed programs)

Underwriting Process

• FinTech vs Traditional Debt
• Trade-off: Speed to close vs loan structure

Considerations

• Assessing the true cost of capital
• Lender reputation, depth of focus, and breadth of offering
• Lender monitoring and real-time credit limits
• What does taking a programmatic loan prevent you from doing?

Conclusion

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INTRODUCTION

In our “Surviving the Loan Underwriting Process” blog series we provided a roadmap to help eCommerce entrepreneurs navigate the debt capital raise process, including how and why to match different loan products with specific company cash needs, what key financial and business information to prepare to expedite the process, and how to impress prospective lenders to stand the best chance of getting approved for funding.

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For the purpose of that series, we focused on debt products that typically have the most onerous due diligence processes, including bank term loans, bank revolvers, venture debt, asset-based loan facilities, and mezzanine debt. However, for many early-stage and bootstrapped DTC eCommerce companies, these “highly-underwritten” loan products are not yet in reach, usually due to the companies’ lack of consistent profitability and/or brand recognition.

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So where can a startup eComm business turn for debt capital, beyond personal loans and credit cards?

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Fortunately, in recent years the number of fintech and other non-bank lenders has expanded considerably, with more lenders and novel forms of “programmatic” debt financing popping up each day to focus on the growing eCommerce and subscription-based markets.

☝️By programmatic, I really just mean that the underwriting process and deal structures tend to be more standardized.

PURPOSE

In this blog post, we focus on some of the more common types of non-bank lenders and loan products to help you make sense of this rapidly evolving debt landscape. We’ll walk you through what to expect during the underwriting process, and how this differs from the “traditional” underwriting process (for better and for worse). Lastly, we’ll provide you with some pros and cons related to these new loan products, including some trade-offs you’ll likely experience between “speed to close” and the loan terms offered.

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CURRENT LANDSCAPE

For years now, programmatic lenders of all stripes have known that there’s a huge debt market for small and medium-sized businesses (SMBs). The problem keeping most lenders from effectively tapping this market has been the sheer diversity of the business models and financial performance metrics, which makes it difficult to source and underwrite them with any kind of consistency and scale. However, in recent years more and more lenders are pioneering solutions to that core problem thanks to three interrelated market trends:

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     1. A general shift toward the online economy, both in terms of eCommerce and tech-enabled business productivity tools (e.g., online accounting, CRM, and sales and marketing tools);

     2. The proliferation of data and the maturation of the data gathering ecosystem, spurred by companies such as Shopify, Amazon, Stripe, Square, Plaid, Facebook, and Google; and

     3. The emergence of viable Machine Learning and Artificial Intelligence capabilities (ML and AI, respectively), which enables underwriters to quickly compile and analyze diverse online data sources to more accurately predict loan outcomes.

☝️Discussed in more detail below

☝️☝️There are a couple additional macro factor at play, namely the increased regulatory burden placed on banks after the Great Recession (and the lack of regulations on non-bank lenders), as well as a huge inflow of capital into the lending space, as investors look for new ways to boost yields and diversify portfolios.

As these market trends continue to take hold, we’re also seeing a blurring of the line between debt and equity. There are an increasing number of fintech and non-bank lenders who position themselves as a hybrid between investor and lender. They focus on unique and flexible loan products that don’t dilute ownership but do offer higher potential yields to their investors by tying repayment to a percentage of their borrowers’ future revenue (more on this below). Many of these lenders also provide management insights and networking opportunities to their borrowers, similar to the role played by VCs, incubators, and accelerators.

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In addition, there are eCommerce marketplace companies, payment processors, business productivity software companies, and other tech-enabled service providers who are now offering debt products as a logical offshoot of their core products and services. The obvious examples are Amazon, Shopify, Stripe, Square, and PayPal, each of which have small business loan products available to their customers, but there’s also an increasing number of emerging fintechs that combine business productivity apps with lending products, such as Settle (bill pay) and Brex (spend management).

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Lastly, there are lenders who are generalists in the small business lending space (e.g., OnDeck and BlueVine) and others that are focused specifically on eCommerce (e.g., Wayflyer, Settle, Ampla) and/or subscription-based businesses (e.g., Capchase, Lighter Capital, Pipe). There are also non-tech lenders and credit funds that provide traditional small business term loans, including Small Business Investment Companies (SBICs) that are government-backed and underwrite and structure loans based on specific SBA requirements.

☝️Not sure I'd consider those as "programmatic" lenders since they need to adhere to a certain underwriting standard in order to maintain their SBA guarantees.

Common eCommerce Loan Products

It’s difficult to quickly summarize the number of fintech loan products in the market today, as there’s constant innovation taking place in terms of new funding and repayment options, as well as novel underwriting approaches meant to increase the speed with which new borrowers are funded while expanding the credit box to include small businesses previously considered too risky to fund.

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Having said that, perhaps the two areas that have seen the most attention in the fintech lending space have been integrated business credit cards and revenue-based financing, both of which are available to eCommerce companies, primarily for the purpose of funding marketing and inventory spend.

☝️For our purposes, we're including Merchant Cash Advances or MCAs as part of revenue-based financing, as they essentially function the same way.  More on the distinction below.

Credit cards obviously aren’t novel, though many of the new entrants in the space offer a combination of cards, banking, and expense management apps (e.g., Brex, Ramp, Divvy, and Mercury). These providers often offer larger credit lines than traditional providers, with interesting options like extended repayment terms and other perks, and without relying on personal credit. However, the size of the credit limit is typically influenced by how much cash you maintain, so these may be better loan opportunities for VC-backed eComm businesses versus bootstrapped companies.

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As for revenue-based financing, there are two primary types in the market today: Merchant Cash Advances (MCA) and Revenue-Based Financing (RBF). With both products, the provider advances the borrower a set amount of money and borrowers pay back that amount plus a fee over time by giving the provider a specific percentage of their future gross sales. Although the two products function similarly, there are some key differences:

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• MCAs are typically smaller in size (low six figures), repay within a few months, and require daily repayment by hooking directly into borrowers’ Shopify or bank accounts. The underwriting process is very quick, with some providers advancing funds within hours of application. MCA providers will typically start small and increase borrower credit limits over time, assuming satisfactory payment performance and increasing sales, so borrowers can essentially repay and redraw funds over an extended period. Pricing for MCAs is typically very high (APR can be north of 50%!), which is generally why providers can afford to make credit decisions so quickly.

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• RBFs are typically larger in size (high six to low seven figures), repay over 2-4 years, and require monthly repayment. RBFs are used primarily in the SaaS world, but providers have started to expand into eCommerce, particularly around subscription-based DTC models. Because the facilities are larger and longer-term, RBF underwriting tends to be more in-depth and can take a few weeks. Providers such as Lighter Capital and Pipe will typically allow borrowers to draw the funds over a period of time from original approval, but longer-term advances and facility increases usually require an additional round of underwriting. Pricing for RBFs is more reasonable than MCAs (APR in the 15-30% range), which again correlates with the time to underwrite.

☝️For more details on Credit Cards, MCAs, and RBF, please refer to the Bainbridge Field Guide to DTC Capital.

In addition to revenue-based financing, there are also some fintech lenders who provide more traditional term loans and short-term working capital products to eCommerce companies. For example, Amazon Lending offers its sellers a term loan with standard monthly principal and interest payments, and Settle offers a short-term working capital loan that allows borrowers to repay in 30-day increments in return for a flat fee. 

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UNDERWRITING PROCESS

The key difference between fintech and “traditional” underwriting is speed. As noted previously, many fintechs differentiate themselves by offering funds within weeks, days, and sometimes hours, whereas traditional debt providers can sometimes take over a month to complete their due diligence process.

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So how can fintechs complete the underwriting process so quickly?

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Well, on one level the answer is pretty obvious: Fintechs invest heavily in developing proprietary technology to automate the underwriting process, specifically related to (1) process automation that allows human underwriters to more efficiently compile and analyze borrower financial information, and/or (2) complex underwriting algorithms that reduce or eliminate the need for human underwriters and credit approvers.

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One particular area of rapid innovation is the use of ML and AI to not only speed up the underwriting process but also to improve the quality of the credit decisions, essentially by finding complicated patterns and connections in the business and financial information that most human underwriters are incapable of seeing. In theory, if lenders can crack the code from a risk perspective, then they can more accurately price and structure their loan offerings while hopefully expanding the number of borrowers that they can finance.

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In addition, there are a number of fintechs that have specialized domain expertise and/or access to vast databases of historical business and financial information with which to hone their underwriting skills. Easy examples would be in the marketing and advertising space (e.g., reviewing historical ad spend data from Google and Facebook to predict the impact on sales growth) and in the retail space (e.g., Amazon and Shopify using historical seller data to determine which products are likely to garner the highest customer loyalty).

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As noted above, this underwriting revolution has been made possible by the increasing availability of online financial data, data integrations, and data aggregators. Companies such as Shopify, Stripe, and Plaid, as well as online accounting software providers like Intuit and Xero, have made it possible for lenders to automate the data ingestion process to save a ton of time in the underwriting process, both in terms of simplifying the borrower application info requirement and accelerating the analysis phase by creating underwriting tools and models that pull directly from the underlying data.

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The reality is that most fintech lenders still rely on the three-stage approach to underwriting that we outlined in the Surviving the Loan Underwriting Process blog series (i.e., Discovery, Initial Analysis, and Due Diligence), but the key difference is that fintechs often require direct access to the prospective borrower’s banking, sales, and accounting software at the beginning of the application process, which essentially allows them to condense at least the first two stages into one round of analysis. 

☝️We’ll discuss some of the implications of this process requirement in the next section.

The underwriting trade-off between “speed” and “structure”

The second reason why fintechs can underwrite so quickly is a little less obvious, but has probably become clear to eCommerce entrepreneurs who have tried to compare multiple loan term sheets. If “speed to close” is on one side of the underwriting coin, then “loan structure” is on the flip side.

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As a refresher, there are three primary variables at play that impact a particular loan product’s standard underwriting process: (1) the expected repayment source, (2) the time horizon over which that repayment is expected to occur, and (3) the lender’s credit box. The lender’s credit box is really a function of risk, which can be separated into inherent risk (i.e., “probability of default” or PD) and residual risk (i.e., “loss given default” or LGD). The underwriting process is meant to uncover and assess a company’s inherent risk (i.e., the risk of material under-performance), after which the lender crafts a proposed loan structure that should adequately compensate the lender for the risk taken (i.e., pricing and, indirectly, loan term) while also limiting the risk of principal loss in the event of under-performance (e.g., loan amount, collateral, guarantees).

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So, back to the concept of “speed to close”, when fintechs decide to compete on that front, one way they do that is by structuring their loan offers more conservatively (i.e., lower amounts, shorter terms, and higher interest rates) to offset the potential that they’ve missed some inherent risk in their expedited underwriting process. A good example of this is comparing MCAs and RBFs. As we noted above, MCA providers tend to offer lower amounts, shorter repayment terms, and higher imputed interest rates relative to RBF lenders. Is it any surprise then that the RBF underwriting process is more in-depth and time-consuming than the MCA underwriting process? As an entrepreneur, how much value are you placing on speed to close versus loan structure?

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Of course, this example is somewhat simplistic, in two respects. First, MCA providers are often willing to take on more risk than RBF lenders regardless of the depth and accuracy of their underwriting processes, so it’s not always the case that an early-stage eCommerce entrepreneur will have the opportunity to choose between these two products. Second, most fintechs endeavor to speed up the underwriting process without sacrificing quality of risk assessment, and as noted above, the “have your cake and eat it too” goal of most VC-backed fintech lenders is to actually lower the loan loss prospects while maintaining pricing yield. Still, if you were to canvas the full fintech eCommerce landscape today, you’d likely see a fairly strong negative correlation between speed of underwriting and borrower-friendly loan structures.

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CONSIDERATIONS

In this final section, we spell out some of the items eCommerce entrepreneurs should take into account when deciding whether to take on programmatic debt and if so, what type.

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Assessing the True Cost of Capital

There are a lot of articles out there on this topic, particularly as more revenue-based loan products have become available in the market. Historically, all term loans and lines of credit would quote an APR (annual percentage rate) which represented your cost of capital and was fairly easy to understand, in part because the repayment schedule was determined in advance. With MCAs and RBFs, the total fee is determined in advance, but the repayment schedule is variable.

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For example, let’s assume you have two loan options, both for $100,000. In Option 1, you are required to repay $110,000 in exactly one year. In Option 2, you are also required to repay $110,000, but you pay monthly based on 10% of your gross sales. At first glance, you might be tempted to conclude that both options have the same cost of capital, since both loans require $10,000 in excess payments. However, if your revenues are expected to come in at $200,000 per month, then you’d end up paying back Option 2 in six months, which means your true cost of capital would be twice as much as for Option 1. What’s more, if your actual revenues outpace projections your cost of capital would be even higher.

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That’s not to say that MCAs or RBFs are inherently bad loan products. On the contrary, there are lots of situations where they’re perfectly acceptable and allow businesses access to debt capital much earlier in their life cycles. The point is that any loan with a fixed fee and variable repayment structure requires some extra calculations, and you’ll want to take care if and when you’re comparing interest rates with fees. And by the way, a good lender should be willing to provide you with APR estimates and cost of capital calculators to help you assess whether their loan is a good fit.

☝️Also, as the RBF market matures, more providers are offering structural features to ensure that there's a cap on how quickly a loan will be repaid.

Regardless of the loan product selected, your most critical step is ensuring that the proceeds will result in sufficient incremental cash flow to offset the cost of capital. This is finance 101, namely that there’s a positive IRR when you compare cash inflows and outflows. If the loan proceeds cannot generate positive net cash flow, then it’s not a good fit.

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Again, an example may help illustrate the point:

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• Let’s assume you’re considering an MCA for $120,000, which has a $10,000 flat fee and requires daily repayment based on 12% of future sales.

• You currently generate $300,000 in monthly sales and have a stable gross profit margin of 44%. You plan to spend the $120,000 on advertising over the next three months ($40,000 per month), and estimate the additional ad spend will add $100,000 in monthly sales and $44,000 in extra gross profit per month.

• On the surface, the investment seems to make sense: The MCA only costs $10,000 and you expect to generate $12,000 in incremental profits (i.e., $132,000 gross profit less $120,000 in ad spend).

• However, to be sure, you model out the cash inflows and outflows. You’re surprised and disappointed to discover that the 12% repayment rate means that you’ll repay the MCA in slightly less than three months. Worse yet, the daily payments are so high that you actually won’t be able to deploy the full $120,000 in proceeds on ad spend.

• In fact, because of the variable repayment schedule, you’d only be able to apply $80,000 of the MCA proceeds on ad spend, which in turn would generate only $8,000 in excess profits. When considering the $10,000 in MCA fees, the investment would actually result in $2,000 negative cash flow!

Lender Monitoring and Real-Time Credit Limits

Another key consideration is whether your loan is fully committed, that is, whether future advances are (1) available upon request (no questions asked), (2) subject to hitting performance milestones and/or financial covenants, or (3) at the sole discretion of the lender. In the prior section, we talked about how MCA providers can quickly close on new deals in part by structuring facilities with high fees and short repayment terms. In addition, many lenders limit their risk by offering borrowers credit limits that can be canceled or reduced unilaterally by the lender.

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For example, a lender may initially approve a short-term advance for up to $200,000 and state that you can request additional draws in future periods. However, similar to how an ABL facility works, those future draws are almost always subject to continued satisfactory performance, meaning that the lender is essentially re-underwriting you at each draw request. Other lenders may offer the ability to draw additional funds or debt tranches based on hitting specific financial milestones. In any event, if the proposed loan structure includes any undrawn capacity, you’ll want to understand what and how those draws are approved, so as to avoid a situation where funds you thought would be available to you are pulled at the last minute.

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Lender Reputation, Depth of Focus, and Breadth of Offering

As we’ve noted previously, the fintech lending market is constantly evolving, with new players entering the space each day. Many of these lenders are start-ups and not yet profitable, so their ability to withstand macroeconomic stresses may be questionable. For example, in April eCommerce funding platform Payability announced a 20% layoff due to global supply chain delays and shipping inflation that presumably impacted the cash payments flowing from their borrowers.

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While a lender’s financial condition might not directly affect its existing loans to borrowers, it could impact their ability to offer additional funds at the same terms as initially offered, if at all. Since most fintech providers require upfront and real-time access to their borrowers’ financial information, borrowers should understand how those start-ups ensure data privacy. From this perspective, the larger players in the eComm lending space, such as Shopify and Amazon, may offer a higher level of security and stability.

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In addition, you should consider whether the lender’s depth of industry knowledge aligns with the DTC eCommerce market. For example, most RBF lenders built their underwriting models around the SaaS market, so they tend to think about eCommerce subscription businesses with that mindset. Company founders could end up educating their lender about their specific business model and subscriber base, and could see some pullback from lenders if/when the market performs differently than planned.

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Lastly, depending on where your business is in its life cycle, you may see more or less value in the fintech lender’s breadth of product and service offerings, both debt and non-debt. For example, a lot of lenders offer value-add management insights and analytics which may be of interest to start-up entrepreneurs who haven’t yet built out their management teams. In some cases, these value-add services might warrant paying a premium on the debt capital.

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What does taking programmatic debt prevent you from doing?

Finally, it’s very important to realize that it’s not always possible to take on multiple forms of debt capital at the same time, meaning there’s an opportunity cost to taking one form of debt over another. For example, most secured lenders require that they have a first position security interest in all of your business assets, so if you’ve already taken on $250,000 from one provider, another lender may require that those funds be repaid before they consider giving you money.

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There are two main reasons for this. First, lenders want to be sure that they’re first in line to collect proceeds in the event a borrower starts to underperform. A first-position security interest means that a secured lender is afforded the legal right to foreclose on your assets in the event of a breach of your loan documents, before any other secured lenders, unsecured creditors, vendors, suppliers, and equity investors. Second, a large part of the underwriting process is determining how much debt capacity a borrower can reasonably handle, so a new lender will take into consideration a borrower’s existing debt before deciding on what amount to offer.

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It’s also important to note that most secured lenders won’t allow borrowers to have MCA debt on their balance sheet, either before or after granting a loan. Even though MCAs aren’t technically loans and don’t typically require a collateral position, other lenders don’t like the fact that they take their payments off the top. It’s very difficult for a senior lender to control or block those payments in an event of default, such that in practice MCAs almost have a de facto senior position.

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Lastly, keep in mind that a lot of loan products have prepayment language that can make it difficult to switch from one loan product to another. If you want to retain flexibility and/or think you’ll outgrow your current lender before the loan’s maturity date (either from a risk perspective or from a loan capacity size), you’ll want to carefully review and negotiate the prepayment clauses.

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CONCLUSION

At this point, hopefully you have a clear understanding of the fintech landscape, and what options may make sense for your company! Here are the key takeaways:

• The fintech landscape is constantly shifting, but more lenders are focused on eCommerce and subscription-based services due to general market shifts toward the online economy, wider availability of business data and data integration providers, and the emergence of ML and AI.

• An increasing number of non-traditional lenders are entering the space, including eCommerce marketplace companies, payment processors, and business productivity software companies.

• Two areas experiencing significant growth are integrated business credit cards and revenue-based financing, including both MCAs and RBFs. Many of the providers are offering integrated solutions, combining business process tools with debt capital.

• MCAs and RBFs have a role to play in financing eCommerce companies, although entrepreneurs should understand how the variable repayment structure can impact the cost of capital calculations and company cash flow. For additional loan product info, please review the Bainbridge Field Guide to DTC Capital for more details.

• Fintech underwriting processes are considerably quicker than highly-underwritten forms of debt capital, though it’s important to keep in mind that the speed to close often impacts the type of deal terms you’re likely to receive, i.e., shorter terms, smaller amounts, and potentially higher rates.

• The most important point to remember when assessing debt capital options is the true cost of capital. If the cost of the loan proceeds exceeds your expected incremental cash flow gains, then the loan is not a good fit! Be particularly careful when assessing revenue-based payment structures, as the speed of the repayment could impact your ability to fully-deploy the loan proceeds.

• Keep in mind that many fintech providers will offer credit lines that may not be fully-committed, meaning that the lender may be able to unilaterally reduce or eliminate undrawn capacity. If the proposed loan facility includes undrawn amounts, be sure to discuss the funding pre-requisites with your lender.

• When selecting a lender, do some research on their market reputation, depth of industry knowledge, and breadth of product offerings (both debt and non-debt). Remember that many fintechs are start-ups too, so you’ll want to understand to what extent you’re depending on them to continue providing new debt and/or other business services and analytics.

• Lastly, taking debt capital isn’t like an all-you-can-eat buffet. Most lenders require a senior collateral position and limit other forms of debt, so if you think you may outgrow your lender before your loan matures, be sure to understand if and how you can pay off that loan early.

If you are struggling to answer the tough questions about your business, Bainbridge can help. Our platform is a finance and data team in a box that aggregates your data and provides the tools and expert help needed for you to get the best capital, understand profitable customer acquisition, understand your retention, and maximize profitability. Our tools are used by founders and team leaders at fast growing DTC brands and we’d love to learn more about your business and challenges. Please book time with us!

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