A new period of small business financing is here and it's by entrepreneurs, for entrepreneurs. After years of traditional lenders overlooking emerging companies, entrepreneurs are tackling financing and lending with the intention of serving other entrepreneurs--and as a result, have introduced new financial products tailored to small business needs. While in some cases these alternative lenders may be rightly critiqued for their high rates, it's definitely better for entrepreneurs and small business owners to live in a world with higher cost financing options than with no options at all.
Over the past few years, with increased regulations and more conservative lending standards, traditional banks have offered significantly fewer loans to small business owners. According to the New York Fed, it takes an average of 24 working hours or more to research and apply for loans, ultimately amounting to half a week's worth of effort. That's a significant barrier for business owners who are already working around the clock to balance managing a business with their personal expenses. And of course, many people don't even bother applying for loans, perhaps because 82 percent of applicants are rejected.
Since applying for loans is so onerous for small business owners and other self-employed professionals, it's created an underserved market in financing, leading to the innovation we see today. These lenders have stepped in to provide faster and smarter financing, giving more options to their entrepreneurial brethren and those who are trying to strike out on their own with a great small business plan.
These companies aren't blindly handing out money. They've changed underwriting models: using algorithms, connecting to online platforms and marketplaces and leveraging untraditional sources of big data--like social media--to quickly perform cash flow analysis and assess an applicant's eligibility for a loan. Thanks to these new approaches to the old lending problem, small businesses can access financing in a streamlined way that takes days--even minutes--instead of months, and in turn, eliminates one of the most common barriers to securing capital.
It's my belief that while the pricing and terms of these alternative loans should be clearly communicated upfront, small business owners can and should do their own due diligence when making their financing decisions. Debt is serious and those seeking loans must ask themselves these questions: "How much risk is there if I default?" "Can I live with myself if I do?"
I know from personal experience that where you raise money from matters. Before my company, FreshBooks, raised its first round of venture capital, we received funds and loans from friends and family while trying to convince traditional banks to help with financing. When we reached $5 million in revenues for the first time and applied for additional financing, the bank refused to offer us more than $25,000--simply because they did not understand our business. The lesson learned: financing needs to fit the business model, and not all structures work at all times.
If a graphic designer wants to take a loan at a high rate because it's good for his or her business, that's his or her decision. If a consultant is working on his or her third venture with a series of past failures, the loan rate should probably be higher. Some borrowers will make mistakes along the way, but it's much better for the economy if these professionals at least have the opportunity to finance their businesses.
So where is it all going? While there are some valid concerns about alternative loans, as people get more familiar with these new financial products and more data is collected, the lending algorithms used will only improve. Over time, better algorithms and more competition will drive down lending costs to their risk-appropriate lending levels and more people will apply for small business loans. If their application is denied, at least the time and cost of trying won't have been as hard on the business owner.
Because these new lenders are designing previously unseen products and services and are willing to take risks, large financial institutions will ultimately adjust how they do business too. We're already seeing some of that evolution today: JPMorgan Chase launched an online small business platform in April in partnership with OnDeck, and Scotiabank recently announced a collaboration with Kabbage. Through these partnerships, small business owners can integrate a more efficient, responsive lending process with their existing bank accounts. Big picture, I see this as great progress all around.
Traditional financing may not have been built for small business owners but innovation by entrepreneurs is giving small business owners financing options they've never had before. And while they might still have to fight every day to make it work, that's what comes with taking a risk and building a business. In the end, the outlook for both small businesses and our economy is made stronger by permitting owners to make informed business decisions and offering them more lending choices.
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