March 5, 2014
As seen in the New York Times
Ivan Rincon’s products may have been skimpy, but he was convinced his growth prospects were not. Orchid Boutique, the online swimwear shop he founded six years ago in Miami with his wife, Mayra, was approaching $3 million in annual sales. It had been profitable since 2010, he said, with margins that ran between 10 and 15 percent. But the business was highly seasonal, leaving him scrambling for cash in the off-season when he needed to place orders.
Working with an executive coach in 2012, Mr. Rincon developed a plan to diversify the store’s offerings beyond swimwear and tap into promising markets like Australia and Europe. To execute the idea, he needed to stock up on jewelry and other accessories, and he needed to hire more employees — all of which would require money.
Mr. Rincon first sought a bank loan but was rejected for lack of collateral. Then he did what many small-business owners have done since the recession: He turned to a merchant cash advance provider, a type of nonbank lender that advances cash quickly in return for a share of future sales, extracted daily from the borrower’s credit card receipts.
In late 2012, Mr. Rincon got a merchant cash advance of $200,000, for which he agreed to pay $55,000. The lender took 15 percent of his sales daily until it had recouped the $255,000 — at an effective annual interest rate of more than 50 percent. Mr. Rincon paid off the advance last May with the proceeds from another merchant cash advance, this one for $70,000 at a 15 percent annual rate, not including other fees. In retrospect, Mr. Rincon said, taking the cash advances “wasn’t the healthiest thing to do for the business.”
Then he heard about Dealstruck, a year-old company based in San Diego. In October 2013, Mr. Rincon shared his financials with Dealstruck, and a few days later, he came away with a $250,000 loan that featured a three-year term, a 10 percent annual interest rate, and flexible terms that allow him to make more significant payments in busy months. “The terms are clear and include a set monthly fee and a reasonable payback time frame,” Mr. Rincon said.
Dealstruck is among a new crop of alternative lenders — including Fundation and Funding Circle — offering a middle path between banks, which lend primarily to the most creditworthy small businesses, and cash advance lenders, which thrive on subprime candidates. The new lenders, according to Sam Graziano, Fundation’s chief executive, focus on “midprime” businesses that “deserve a better product but don’t qualify for a bank.”
Alternative lending has filled a gap left by risk-averse banks: big banks approved less than a fifth of all requests for small-business loans they received in January, while small banks approved about half of such applications, according to a survey by Biz2Credit, an online platform that matches businesses and lenders. And that does not reflect the companies that are too discouraged to apply. By embracing technology to make small-business lending more efficient and profitable, the alternative lenders have opened opportunities for businesses. In January, according to Biz2Credit, alternative lenders approved roughly 64 percent of the loan requests they received.
“The Internet is doing to this industry what it’s done to every other industry — create efficiencies, competition and price transparency,” said Jared Hecht, chief executive of Fundera, another website that matches businesses with lenders.
The first wave of tech-based alternative lenders — companies like OnDeck and Kabbage, which opened in 2007 and 2011 — used innovative software and data metrics, including social media interactions and Yelp reviews, to assess the health of a business. OnDeck alone has underwritten more than $900 million in loans. And Kabbage, which targets online merchants, lent $200 million in 2013.
But these loans typically are similar to a cash advance, with a fixed amount or percent of sales deducted daily from the borrower’s bank account over several months. Given the short loan terms, a small-business borrower can end up paying 50 percent or more on an annualized basis without realizing it. Those rates, however, have made it easy for OnDeck and Kabbage to line up institutional investors looking to supply capital and take a piece of the action.
That has opened the door for the latest lending upstarts, which combine digital innovation and efficiency with true term loans akin to bank loans. Their rates are higher than those charged by banks but lower than those charged by the short-term alternative lenders and the merchant cash advance providers. It’s not about disintermediating the banks but the very high-yield lenders.
Dealstruck Inc. is a company can offer lower rates by targeting midprime or near-prime borrowers and by lending more substantial amounts for longer terms. Dealstruck, like Funding Circle, uses a peer-to-peer model, meaning wealthy investors put up the capital for individual loans, which the lenders say lowers their cost of capital by freeing them from raising money.
To secure the loans, these platforms typically require a personal guarantee or business assets as collateral. Along with lower rates, the new lenders offer some transparency to what has been an opaque and confusing market. “We are trying to price fairly for the business,” says a Dealstruck representative. “That doesn’t always mean cheap. But we will tell you what we are charging and why.”
Dealstruck’s interest rates range from 8 to 24 percent for loans of up to $250,000 that can stretch for three years. Funding Circle, a British lender that has expanded into the United States, charges 10 to 17 percent for loans of up to $500,000.
The peer-to-peer model is already established in consumer lending, with two companies, Lending Club and Prosper, making more than $4 billion in consumer loans. Now the market for peer-to-peer small-business loans is heating up. Lending Club plans to expand into the market this year. And Daric, a peer platform backed by a former Wells Fargo chief executive, opened recently.
Fundation, which is based in New York, offers terms friendly to small borrowers on par with the peer-to-peer lenders but relies on a partner, Garrison Investment Group, to underwrite the loans. “There’s a lot of room for a lot of different types of lenders,” Mr. Graziano said. Since opening last year, his company has made about 90 loans at rates ranging from 9 to 24 percent. The average loan is $175,000 with a three-year term.
One of those loans went to Lydia Aguinaldo, owner of Pines Home Health Care Services, in Broward County, Fla. Like Mr. Rincon, she had resorted to a high-interest loan from a merchant cash advance provider for her 13-year-old adult care business. She replaced that loan recently with a three-year, $250,000 loan from Fundation. The interest rate, 19 percent, is still high, she said, but it is much lower than what she had been paying.
The fresh competition is already forcing established players to adjust. In February, OnDeck announced it would begin offering loans of up to $250,000 with terms of 12 to 24 months and interest rates of 20 to 40 percent. Noah Breslow, OnDeck’s chief executive, said the move into more significant, longer-term loans reflects the growing accuracy of OnDeck’s lending model, now in its fourth generation, and market demand. “I don’t think we’ll ever get to a five-year bank loan, but we’ll continue to move upstream,” Mr. Breslow said.
Competitive scrum can only be good news for small businesses with big plans. Mr. Hecht of Fundera predicted a day when “there is a credit product out there for everyone.” He added, “We’re just at the beginning of this.”