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Small Business Finance: Combining Old-World & New-Age Methods

December 12, 2016, 07:00 AM

Innovations in technology, product and distribution are gradually transforming the small business financing marketplace. Legacy finance companies are increasingly faced with direct competition from new tech-driven entrants as both groups seek to fill the void left by banks following the global financial crisis. Both groups are vulnerable and only those that can combine old-world knowledge with new ways of thinking will be positioned to succeed.

Small businesses have no shortage of challenges, but one of the most persistent issues they face is continuous access to capital. In good times and bad, all small businesses encounter capital needs, ranging from short-term working capital demands to long-term strategic growth capital requirements. Even the most successful management teams can find themselves hamstrung by up-front cash outlays that stand in the way of achieving business objectives. 

Imagine the manufacturer that wins a large order from a new distributor: the company will typically face a short-term drain on cash and other resources from the purchase of raw materials, making payroll, investing in new equipment and other costs –- all before producing a final shipment. Upon shipment, the manufacturer will submit an invoice and that payment will be paid 60 or perhaps even 90 days later.

Historically, the manufacturer would look to bridge this gap in the cash conversion cycle through financial products like asset-based lending or factoring, generally provided by a bank or independent finance company. But since 2008, traditional sources of financing have dried up. Many independent finance companies were acquired by other financial institutions, or collapsed due to their poor portfolios and related funding constraints. Meanwhile banks, which remain subject to stricter regulation, have reduced their appetite for risk and left a sizable portion of the small business marketplace underserved.

The Equipment Leasing and Finance Foundation’s recent survey noted that banks continue to focus new financing efforts on companies with lower risk profiles. The share of bank lending to unprofitable companies has declined to 26% in 2015 from 53% in 2014 –- forcing less profitable businesses to seek alternative financing.

However, new developments are taking shape to provide efficient forms of financing for small businesses. These include interrelated innovations in three key areas: technology, product and distribution.

Innovations in data and technology enable faster, smarter ways to underwrite and serve small business relationships. For example, fax and overnight delivery have given way to optical character recognition software and application programming interfaces to streamline information exchange. Meanwhile, many innovative finance companies now use technology to automate workflows once handled in a manual, and often clumsy fashion. These innovators are streamlining the underwriting process, leaving manual intervention for managing exceptions.

These efficiencies enable finance companies to more cost-effectively underwrite small business relationships, and may even help to more objectively measure risk. To be sure, there is no substitute for real credit experience honed over many years, but the most successful finance companies are combining their credit-focused intellectual property with data science and technology resources to better harness their institutional knowledge.

The second key ingredient concerns innovations in the types of products available to small businesses. Perhaps no trend has been more impactful than the recent rise of unsecured financing that includes small business term loans distributed through partnering banks and merchant cash advances. It is tempting to dismiss these trends as high-priced alternatives for companies with less-than-stellar credit profiles, but the significant adoption of such products highlights important changes in consumption patterns and buying behavior that are gradually working their way into other small business financing solutions.

In the age of streaming, on-demand, and one-click purchasing, we are growing accustomed to more immediate satisfaction. Small businesses place a similar premium on speed and flexibility, and often eschew the lengthy underwriting processes and stiff terms in place at old-world lenders. Meanwhile, in a business where cash is fungible, the lines between working capital loans, equipment loans, and other products get blurred. Finance companies who embrace the role of “solutions provider” rather than “product specialist” will continue to gain share in the evolving marketplace for small business finance.

The final key ingredient is distribution. Trends in the retail industry are telling: internet retailers are continuing to displace big-box stores, and mobile purchases are growing at a faster rate than web purchases at online merchants. The market for small business financing is no different, with small businesses looking for a different buying experience when looking for capital –- one that is increasingly virtual and more efficient. Small businesses face an interesting paradox; financing is at once both difficult to obtain and yet the number of choices that exist are overwhelming. As a result, shopping for capital is a dizzying experience, one that is often opaque and fraught with intermediaries that may not have their best interest at heart.

Direct B2B marketing and strategic partnerships help finance companies stand out from the competition. The technology-enabled finance companies that are accessible to small businesses directly online benefit from more cost-effective customer acquisition.

In the case of equipment finance, integrated relationships with vendor partners represent another efficient means of distribution, helping leverage the vendors’ distribution footprint and aligning closely with the point of need.

Even banks, once thought to be competitors to independent finance companies, have become unexpected partners. Often unable to directly extend credit to small businesses, banks have become valuable referral partners, where the newer specialty finance companies are able to meet financing needs without threatening the broader banking relationship.

These strategic partnerships leverage brand, relationship and point-of-sale opportunities, enabling tech-enabled finance companies to stand out in a competitive marketplace.

Innovations in technology, product, and distribution will continue to cause disruption in the small business finance marketplace, while incumbent firms have the advantage of often having decades of credit experience in their executive ranks; their challenge is to adapt to the changing marketplace, overcoming organizational and cultural barriers to change.

Managers of newer entrants in the small business financing market, having started with a blank slate, are better able to mobilize their organizations, products and systems, to develop a purpose-built platform. However, they often lack seasoned credit experience gleaned from working through multiple business cycles. These organizations must find a way to add such experience to their organization, grounding it in their operations and algorithms.

For those few firms who can combine old-world and new-age methods, opportunities will abound in the marketplace for small business finance.

W. Bradford Armstrong
Principal | Lovell Minnick Partners
W. Bradford Armstrong joined the Philadelphia office of Lovell Minnick Partners (LMP) in 2009. Prior to joining LMP, he was part of the Financial Institutions Group at Bank of America Merrill Lynch, where he focused on M&A and capital raising transactions for the firm’s investment banking clients. Previously, Armstrong was an Assistant Vice President in Bank of America’s Finance Group. He began his career in a strategic advisory group within Wachovia Corporation.

Armstrong is currently a member of the boards of directors at Commercial Credit Inc. and LSQ Group Holding LLC, and previously served on the board of First Allied Holdings Inc. He received an M.B.A. with a concentration in Finance and Accounting from the Kellogg School of Management at Northwestern University and a Bachelor of Science in Business Administration from the Kenan-Flagler Business School at the University of North Carolina at Chapel Hill.
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