I knew it wouldn’t be long before someone figured out that lending to small business is a huge market. Of course the big banks already know this, but they are highly regulated and they have processes and procedures in place to make sure they make the fewest possible number of loans at the least possible risk. That means no startup can get a loan, and unprofitable companies don’t get them either. Typically, it takes three years for a new company to become bankable, and everything has to go right in the mean time.
It was ten years before I got an operating line of credit for the largest marketing company in Arizona. That was in the early 90s, and it hasn’t gotten easier. In fact, it has gotten harder; my line of credit (I still have it) is unsecured, which is practically unheard of these days. Unsecured means I didn’t have to put up hard collateral. In essence, it was a combination of a business loan to a service business with a long track record and a character loan to a person with a good reputation in the community.
Those are rare if not non-existent today. Usually a friendly “relationship manager” meets a small business at a networking meeting and says the bank would love to have you as a customer. As the entrepreneur, you think this means you are going to get the loan. But these people are only front men, and have no lending authority. Their job is to lead you into the bank and get you to fill out a shit ton of forms. Getting all the information together takes you time, and then the bank’s lending committee has to pass on your loan. Some of this is now done online; if you are already a customer of the bank and have enough deposits there, you may actually get a business loan in a reasonable amount of time. If you don’t, you will either get a turndown or the slow no.
But the need for operating lines of credit hasn’t gone away. Enter Square, the fin-tech company founded by Jack Dorsey when he was forced out of Twitter. Square Capital, which launched this week after a beta test, gives cash advances to companies in exchange for a flat fee. And it is not alone in the space.
The data company Venture Scanner tracks 177 startup companies in the lending business. Of that number, 85 of them have raised nearly $4.4 billion. The sweet spot is lending to businesses that have a hard time getting bank loans but don’t want to pay sky-high interest rates. Small businesses can spend months applying for bank loans that start at 6% to 8% interest, only to be denied. Or they can turn to lenders like factors and merchant cash advance shops that typically move faster but can charge the equivalent of 35% interest or more. There’s a big gap in between these two options that startup lenders hope to fill.
Because of low interest rates on more typical assets, hedge fund managers are racing to give money to these startups in hopes of getting a better return on their investments than they can in the traditional market. Reportedly Square is using its own funds, so it will bear most of the risk, but other fin-tech startups are taking money from hedge funds. They may live to regret that, as might the hedge fund managers.
This is a great service for businesses that need a quick cash advance at less than 22.9%, but will the numbers work for Square itself? Is this a long term disruption of the banking system?
Here’s how it works: you become a member of Square, the original credit card processing system. Then you make a request for Square Capital’s cash advance program. You can get a cash advance in a day, without filling out all the arduous forms that take banks months to analyze before they refuse you the loan. Square takes its payment from your credit card receipts — automatically. For you, the business owner, this is a Godsend. You don’t have to figure out how and when to repay the loan, you don’t have to budget for it (if you have fewer customers, you will automatically pay back less and take longer to pay off the loan), and you don’t have to worry that the bank will decide you should have paid off the entire thing by now and “call it,” putting you out of business. A homebuilder friend of mine was put out of business after three decades by a bank that called in his entire loan during the downturn. Of course he didn’t have enough cash on hand to repay the entire thing at once, and he’s now kaput.
I am rooting for Square. No industry needs upending as badly as the banking system. But the rate of small business failure can be alarming if you are the lender. Let’s all get on our hands and knees and pray for these new fin-tech startups. One or two of them have to make it.
