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The growth of online small business lending

Startups are now bypassing banks and finding capital online

Martin Desmarais
The growth of online small business lending
We definitely think that the biggest competitor we have right now is just awareness. We just need to educate businesses. They all still think you just go to the bank. The banks still have a 150-year head start on us, but as far as potential to grow we still see there is a ton out there.” — Jon Parise, head of customer marketing, Kabbage (Photo: Photo: Courtesy of Boston Common Asset Management)

Many business media outlets have emphasized online lending as a rising trend. Banner Biz has highlighted it as something to watch in 2016 as well. But it’s worth taking a closer look at the online lending sector to consider how it is changing the small business landscape, and why.

Overall, 2015 was a stellar year for lending to small businesses, with the U.S. Small Business Administration reporting record numbers for its loan programs, and the traditional bank-backed loan industry up as well.

Karen Gordon Mills, Senior Fellow, Harvard Business School

The online lending industry has made enough of a ripple in recent years to put the watchdogs on it. Morgan Stanley, for example, released data showing that online lenders provided $7.9 billion in small business loans in 2015, a 68 percent increase from the year before. Morgan Stanley’s findings also showed, however, that online loans only represented 3.3 percent of the total small business loan market. In other words, there is plenty of room for growth, and that growth is anticipated — with estimates suggesting that online lending will reach 20 percent of the loan market by 2020 and that the market quickly could climb to $200 billion annually.

Karen Gordon Mills, a senior fellow at Harvard Business School has been a leading voice on the rise of online lending.

Lead author of the report, “The State of Small Business Lending: Credit Access During the Recovery and How Technology May Change the Game,” Mills emphasizes that it is easy to see why the sector has so much potential for small businesses as a main source for capital — because online lending gives access to the kind of loans banks don’t offer. Owing to the fact that it costs banks just as much to process a $1 million loan as a $100,000 loan — but they can reap a far greater return on the larger loan — most banks simply have cut out loans below $250,000 altogether. For small businesses, this presents a difficulty, as loans of $100,000 or less are the most common loans they seek. Online lenders have stepped in to fill the massive supply void in the market for low-dollar loans.

According to Mills, aside from the capital available, several other important factors have led to the rise in online lending: tech-based systems that provide easy-to-use online applications; a much faster decision-making process for online loans; more accurate credit ratings; and a focus on customer service.

Three lending models

Mills defines three models of online lending that have emerged so far.

The first is the practice of companies using their own money raised from institutional investors to provide loans and employing their own models to determine risk and credit-worthiness. Examples of companies doing this include OnDeck and Kabbage.

The second is peer-to-peer lending platforms that connect capital from institutional and retail investors with all borrowers, but in particular borrowers that might not be able to get bank approval. Examples of companies doing peer-to-peer lending include Lending Club, Prosper and Funding Circle.

The third is online marketplaces that connect borrowers with a range of traditional and alternative lenders, putting a loan application out to many possible sources, increasing the likelihood of approval. Examples of companies doing this include Biz2Credit and Fundera.

Like any tech-related sector, online lending continues to shift and innovate so that new models of doing business will likely emerge or evolve quickly.

Mike Rabil, vice president of partnerships, Funding Circle

Mike Rabil, vice president of partnerships at Funding Circle, which connects small businesses with loans ranging from $25,000–$500,000, says that education plays a large part in the industry, as it is still an emerging sector. For Funding Circle, which has lent $1.5 billion to about 12,000 businesses since it was founded in 2010, this means working with groups and organizations that support small businesses to let them know the online loan options available.

“Small business owners are everywhere, and they are constantly looking for capital, so we put a lot of time and resources into our partnerships to let them know that this exists,” Rabil says.

Even though this is online lending, Rabil sees a large value in retaining strong customer service in interactions with small business borrowers. Funding Circle provides each borrower with an account manager.

“It is very important for us to differentiate our company that way,” Rabil says. “A lot of online lenders are behind the online screen and there is not a human side to it. … We understand the value of having the human touch.”

Rabil believes the next several years are going to be very important for shaping the online lending industry.

Like many, he cites the concerns about the lack of regulations and policy over the industry; all wonder if and when the government will step in.

Opponents of regulation say that if the sector is restricted to soon, it will halt innovation that could provide for even more valuable services to small businesses. Those who call for online lending policy worry that if left unregulated, it could turn into the next subprime lending crisis.

Last summer, Funding Circle and about a dozen other online lending advocates launched the “Small Business Borrowers’ Bill of Rights” outlining some of the key rights that all small business borrowers deserve and asking online lending companies to agree to honor them. The rights ranged from transparent pricing and terms to inclusive credit access without discrimination.

“We are very focused on trying to build a better financial world,” Rabil says.

Speedy results

Jon Parise, head of customer marketing at Kabbage, points out that the speed at which borrowers can get loans through online lending cannot be overemphasized as a selling point. That speed is linked significantly to his company’s growth, he says.

Started in 2011, but with most of its growth in the last two years, Kabbage’s online loans function as a line of credit for borrowers, which they can keep coming back to for more money when they need it. The lines of credit range from $2,000 to $100,000. The company now does over $1 billion in loans annually.

“We really see this relationship not as a one-term loan, but a relationship that is going to last and grow with your business,” Parise says.

Like Funding Circle’s Rabil, Parise stressed that educating small businesses about the online loan options out there is necessary to grow the industry.

“We definitely think that the biggest competitor we have right now is just awareness. We need to educate businesses. They all still think you just go to the bank,” he says. “The banks still have a 150-year head start on us, but as far as potential to grow we still see there is a ton out there.”

Case Western Reserve University Professor Scott Shane, who writes about online lending and small business topics, also sees the great potential in the sector, but cautions that it is still very early and hard to predict what exactly will happen.

“The percentage of the market that we are talking about is very small right now,” Shane says, “but it is growing at tremendous rate.”

Perhaps the key unknown about online lending is how banks and traditional lenders will react as it starts to eat up more of their market. While many argue that there is enough to go around, Shane points out that banks are already starting to eye the space. Some have begun to partner with online lenders.

It is unlikely that low-dollar loans are ever going to spark great interest for traditional banks, but they can still get a hand in the game by floating money through existing online lenders.

The different technology used by various online lenders to judge the risk of a loan to small businesses is also becoming a hot commodity, as it is proving to be more precise and fine-toothed than the tools banks and traditional lenders use. Acquiring such technology could be one way into the market.