By Marc Prosser – August 14, 2014

There has definitely been a boom in the small business finance space. Last week, I was approached by a company that enables small businesses to turn unpaid invoices into immediate cash. After doing a little research, I discovered that they had just received $17 million in venture capital funding. They are not the only company which is raising money to serve the borrowing / financing needs of the small business community. Here is a list of some companies that have recently raised significant amounts of money to tackle small business financing.

  • Fundation – Raised $2.7 million March 2013
  • Dealstruck – Raised $1.2 million January 2014
  • Bluevine – Raised $4 million March 2014
  • FundBox – Raised $17.5 million April 2014
  • Funding Circle – Raised $66 million July 2014
  • OnDeck – Raised $77 million March 2014
  • Fundera – Raised $3.4 million January 2014
  • Kabbage – Raised $50 million May 2014

What do these companies have in common besides recently raising money, and a lack of originality in choosing names?

  • They are as much technology companies as they are finance companies.
  • They are serving a market, small businesses, which has been neglected by banks for decades.

Are banks satisfying the need for small business credit?

What are the chances of a “real” small business getting a loan from a big bank? The answer isaround 19%, according to Rohit Arora of Biz2Credit. However, this number may overestimate the willingness big banks (those with over $12 billion in assets) to loan to small business. Many small businesses don’t even apply for loans, because they anticipate rejection. Small banks are much more willing to lend to small businesses, as about half of loan applications to small banks result in a loan offer. However, small banks use SBA loan guarantee programs heavily to limit the risk of these loans.

Why are banks reluctant to lend to small businesses? Is it because it is not a good investment, or are there other reasons?

According to former SBA Administrator’s Karen Mills article, Why small business lending is not recovering?, there are a few reasons why bank’s don’t want to serve this market.

  • The default rate on small business loans is more sensitive to economic conditions than loans to bigger companies. In a period of time when banks are being told to limit risk, it’s hard to add these riskier (although, not necessarily less profitable) loans.
  • Community and small banks don’t always have the tools or information resources to properly assess the risk of lending to very small businesses.
  • Diversity of small business borrowers makes it difficult to apply universal standards to loan underwriting. It also makes it harder for banks to re-sell these loans.
  • The processing costs for making these loans are high compared to the amount of revenues that they produce.

Do these same problems affect new entrants to this market?

  • Returns are more important volatility. As the new entrants are not regulated or funded like banks, they should have a higher tolerance for risk, provided there are good returns.
  • Access to online bookkeeping and bank statements are a treasure trove of information. The new entrants, which are technology driven, are able to access and electronically analyze a tremendous amount of information that would be cost prohibitive to do manually.
  • There now exists a sizable group of retail and institutional investors looking to invest in these small loans. Investors are much more open to investing in small loans in general, because Lending Club and Prosper have shown that lending small amounts can extremely profitable.
  • These new entrants have much lower processing costs than traditional lenders. These companies don’t have costly branches, and have highly automated everything from onboarding to collecting payments.

The new market entrants have major advantages over traditional banks in serving small businesses. How do I make money from the explosion in small business finance?

There are three ways which I see investing in this space:

1. Providing the money to finance these small business loans

In a past Forbes article, I discussed investing in a hedge fund that invests in these small business loans. Also, Funding Circle has has a fund that enables individual investors to invest in a portfolio of the loans generated through its platform. In both these cases, the funds are only open to sophisticated investors, and have minimums of $100,000 or more.

Unfortunately, there is no Lending Club or Prosper style marketplace for investors to invest in small business loans. (Although, it should be noted that Lending Club does offer small business loans to borrowers.)

2. Investing in the companies that make these loans

There is only one publicly traded company that specializes in providing small business loans. IOU Central. Never heard of them? You’re not alone. Shares of this company trade for under a buck. While one of the earliest players in the market, the company has had tremendous trouble growing. Not a great sign when one’s main competitor is experiencing rapid growth.

3. Investing in those that benefit from small businesses having more access to credit

There are two problems with this idea. One, the amount of credit that these companies are providing is still very, very small. OnDeck Capital, perhaps the largest non-bank online small business lender currently, is on track to do one billion dollars in lending this year. The market will have to radically grow before the trickle down impact is significant. Two, I am not sure where the money will go. Will these loans be used to hire employees, increase inventory, buy or lease real estate? I don’t know.

I am very excited about the expansion of small business lending, but I am still trying to find ways to invest in it.

To read the original article, click here.

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