Business Lending

Sound Bites From Underwriting – The Risk of Imperfect Merchants

When you’re funding a business, does the risk begin and end with the business? Or does the character of the owners play a role? Can you judge the business on weak financials if your product is geared towards weak financials to begin with? And can you trust unaudited internally prepared financial statements?

At the Factoring Conference during a portfolio warning signs panel, Michael Bagley, VP at Action Capital Corporation, spoke about the risk of internally prepared financials:

“The issue is from a financial standpoint, are they breaking even? That gives you some ability they can function, but one thing that jumps out at you is the payables. It really seems pretty simple. But if you’re in an industry where there’s a critical vendor, or you’ve got a critical supplier, or you’ve got subcontractors and the payables are stretched beyond what is logical past terms, well, that’s a huge warning sign in the underwriting, but it didn’t always show up in underwriting, right, because these were internal financials and 90% of the time and they’re garbage, right?

They’re created by the user so that you at some level have to create or mitigate that by creating procedures that allow you to chase down what are your critical expenses associated with customers. So, for example, in the government space, it would be a subcontractor not getting paid. In manufacturing, it could be a critical vendor that you see on the aging. But if you see that their insurance company had not been paid a couple months, it may not be as big a deal.”

Emma Hart, the COO of Sallyport Commercial Finance, on where the risk lies:

“[…] More than anything I would say even beyond the collateral, it’s the integrity of the client that you’re dealing with. Because in my experience, it’s people that pay you back, not businesses.”

Hart again, on judging a customer’s financial situation:

“[…] quite often, that’s the reason they’re factoring, is because their AP is a mess and you can see the AP is a mess and you raise it in the underwriting, you know. Is anybody suing you? What are you gonna do about it? And they’re like ‘Oh, I’m gonna use the money that you provide to me to sort out my AP.’ ‘Okay then.'”

Melissa Baines, Risk Manager of Republic Business Credit, LLC, on a deal going too smoothly:

“We had a situation where I believe they were doing the parking lot striping, the painting on a parking lot. And it was one invoice. It was a dealership. A car dealership was the account debtor. The account executive who was helping out with the take-on sent out the verification letter. The no-offset verification letter came right back. No issues. And our CEO at that time— Again, going back to the gut feeling, just it was too easy— There weren’t even any questions asked. “What is this?” It was just “Sure. Send it over. I’ll sign it.” And he did and we got it back. And so, our CEO called and talked to him. And he said, “Yeah, yeah, yeah, it’s fine. It’s fine.” It still didn’t feel right. So, we called the dealership main line, got the receptionist. She answered the phone. She said, “Who signed it? Okay. Hold on.” Ended up somebody from the accounting department got on the phone and said, “That’s not real. You’re not the first person to call, you know, and then we’ll call you back.” And then ultimately, the owner of the dealership called back and said, “We will take care of this. It will not happen again, but it is not a real invoice. And please do not fund that to that client.” So, you know, don’t ever give up on that gut instinct. There was nothing that said it wasn’t real to begin with, but thank goodness for [employee’s name]. She just had that gut feeling. It wasn’t right. It was too easy. And here you go.”

This is one of several excerpts from this panel that we plan to post under the Sound Bites From Underwriting tagline.

Are Small Business Borrowers Bank-Loyal to a Fault?

Applying for a small business loan is easier than it’s ever been. Online lenders have streamlined the process, brought it all online and whittled down approval times. Still, the majority of small business owners still think a bank is the only place to get a loan. They’re four times more likely to seek funding from banks than any other source; more than 80 percent of funding applications go to traditional financial institutions.

Big banks’ small business loan approval rates have dropped sharply thanks to tightened regulations and compliance costs post-Great Recession. Because the transaction costs on a $100,000 loan are roughly the same as a $1,000,000 loan, banks are passing right over small business owners seeking smaller amounts. And since the majority of small businesses want loans smaller than $100,000, they’re not being served by the institutions they turn to first.

Small Business Borrowers Turn to Banks First, But They’re Not as Loyal as They Seem

While it would seem that small business borrowers are loyal to a fault, a Lendio survey of 50,000 business owners found that 74 percent of them would move their account to a new bank if the new bank offered them a loan.

Business owners may be keeping their deposits at banks and turning there first when they set out to obtain funding, but when push comes to shove, they want the easiest path to accessing the capital that will keep their businesses afloat or help them to grow and scale.

Banks Realize They Can’t Rely on Customer Loyalty Alone

Banks have shifted some of their focus back to the small business loan market in the last couple of years. In this space where online lenders have made the process of applying for a loan much more customer-friendly, banks have realized that in order to remain competitive, become more effective and profitable, and ultimately retain customers, they must take a page from the book of online lending.

As little as two years ago, banks were closed off to the idea of outsourcing in the online lending space, while lending firms were armed with technology and ready to compete. Banks have caught on to the idea that investing in a fintech partnership is a quicker, less-expensive way to build technology and create a better customer experience without completely reinventing the wheel, allowing them to serve more of the small business borrowers they’ve been turning away. Now both parties are seeing the value in joining forces.

Recent partnerships in areas such as merchant services, researching, underwriting and accounting software have paved the way for more collaboration between banks and online lenders. Last year we saw banks begin to explore new strategies for converging with online lenders through licensing deals and partnerships, and this year we’ll see even more collaboration in the marketplace.

Partnerships, like JPMorgan Chase’s team-up with online lenders OnDeck and LiftFund, allow banks to leverage technology while expanding their loan offerings and revenue. ScotiaBank, Santander and ING have collaborated with online lender Kabbage to license its technology platform for automating a more efficient underwriting process and to provide more comprehensive lending solutions.

Bank-Alternative Lending Partnerships Are a Win-Win-Win

For banks, the benefits of an alternative lending partnership lie not only in cost savings and tech advances, but also in building and maintaining those loyal customer relationships that have served them for decades. Banks will be able to capture a new generation of customers while also retaining more of their existing customers’ deposits by providing them a better, more streamlined loan application and approval process.

And in such partnerships, online lenders and marketplaces win big too, with access to some of the built-in advantages of a bank: an existing customer base with a high level of trust, risk management experience, access to key data and the ability to offer low-cost capital.

Bank-fintech partnerships offer both parties the opportunity to improve processes and reduce costs. And more importantly, they offer those bank-loyal small business borrowers more options, more efficiently when they turn to the banking institutions they know. When banks and online lenders collaborate to serve small business owners, it’s a win-win-win.