Future of Fintech

April 13, 2021

The Future of B2B Lending Fintech

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This week’s Future of Fintech is on the future of B2B lending fintech, covering why many of the previous B2B lenders failed, what's changed, how shifting regulations will impact this space, if B2B lenders are competing with VC financing, and more.

Future of Fintech is hosted by Immad Akhund, founder and CEO of Mercury, and Sheel Mohnot, Partner at Better Tomorrow Ventures.

Guests for this week include:

Highlights from Future of Fintech: B2B Lending

This interview has been lightly edited for length and clarity.

    What's different in the new wave of B2B lending, led by companies like Clearbanc and Chapchase?

    ANDREW (Clearbanc CEO): We had wave one of online lending, making the traditional offline lending and underwriting process more accessible by bringing it online. That was great from a distribution standpoint, but the products weren't that different. They still had to underwrite and validate assets. And for small businesses, the product structures typically required a personal guarantee. That limited what we could do.

    At Clearbanc, we've focused on online businesses. For the first time, those businesses can scale infinitely with the right type of capital. Offline businesses always raised traditional debt, and online businesses always raised equity. We've tried to design a financial instrument that sits between debt and equity, and uses online business data to project what revenue could look like, and gets paid back out of a revenue share.

    Part of it is the type of customers that we focus on. Part of it is a product structure that allows us to not have to focus on assets, and instead focus on more of an equity-like structure and risk profile for the founders.

    What types of expenses are good to use debt for versus equity?

    MIGUEL (Capchase CEO): Things that are going to have returns in less than 12 months may make sense to finance with debt, because it's a relatively quick return. Things that have much longer returns make sense to finance with equity. You can have the big pools of cash that you're betting on the moonshots and don't expect you can get back quickly.

    JASON (SalesRabbit CFO): Debt does a good job of leveraging realized value or assets inside of your business. The longer you're trying to leverage something, or use something to get capital or build towards R&D, I think it's much more difficult. If you've got assets to point to on your balance sheet, it's much easier to access debt, and it's probably a safer bet to use debt in those circumstances versus filing some of the equity needs that are not quite realized value.

    Are modern lending companies similar to banks because they have capital requirements? Or is it a different ball game?

    NELLIE (SciFi VC Partner): There are drastically different amounts of underwriting data. You can now count on much better underwriting data, which enables new companies to be more targeted and stronger. The earlier players in the B2B lending were more horizontal. Now there is more vertical fragmentation.

    They are emerging to finance anything from contracts to inventory; that can significantly change the economics of the business. If you think through the important components of the lending business, you have your cost of capital, your cost of user acquisition, and your underwriting costs. If you know your segment in great detail, you can target your user acquisition and control your underwriting a lot better to significantly improve those economics. This has largely been enabled by all the data available.

    The second point is that one can approach the lending business from the perspective of just the cost of capital, which is a race to ever-compressing margins. That race is never over. One way to differentiate on a lending product is actually on product. You want to embed further into the business and make yourself indispensable. Knowing your customer provides a whole suite of unique advantages from underwriting to additional revenue streams. That takes you out of just lending revenue and into any fintech revenue where you can own the full FinOps stack and build on that.

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    Does it really come down to cost of capital, cost of UA, underwriting and long-term value add?

    ANDREW: There's a reason why somebody would raise money from Sequoia, or Andreessen Horowitz, or Y Combinator over anyone else. It comes down to, can we actually give people access to advice and insights about their business? Can we give access to a network?

    Now we're plugged into 25,000 e-commerce businesses. We see what works for e-commerce. We see where they should be deploying their capital. We see what doesn't work, and we can start to build a playbook that says, "When you get to this scale in this category with these types of products, these are the channels you should be using. This is where you should be selling. This is where you should be advertising. This is where your margin profile should be, and if it's not, here's how you should negotiate with your suppliers." We're starting to use the capital and the data as a way to start the relationship, but we think about our business model evolving to a point where the reason people work with Clearbanc is for the value-add. The capital just fuels that transaction, that relationship, and that exchange of information.

    JASON: A lot of people are looking for a relationship. That's why a lot of banks and a lot of lenders in general will take a hard stance that you can't fully automate lending at a certain level. Certainly at multimillion dollar loans, people want to know who they're working with. Entrepreneurs resonate with different products. They also resonate with different people and are able to leverage or use certain parts of their business as collateral.

    Are people raising too much money from VCs? Should they be looking for debt or alternative capital marketplaces/platforms?

    MIGUEL: Is there really too much money? Depends. VC money is perfect for certain stages. In some of the stages, it's not that appropriate. At the beginning when there's this idea, a deck, and early customers, there's not anything that would sustain any type of funding that's not VC. A VC is what's needed to get the ball rolling. But then there comes a time, and I'm speaking for SaaS specifically, when revenue starts to compound. There comes a time when the actual AR, in regards to burn, operating and acquisition costs, starts to become pretty substantial.

    The companies are not tapping into that AR to fund the growth now. Sure, it is a way, and they continue to IPO, but the opportunity cost of not using the AR is high. And it gets even higher. These companies are growing at 5-10%, per month, at least. That pool of capital they could be tapping into, to grow, now just gets higher every month. So just using VC all the way, it ends up being highly diluted, and it ends up putting those funds in the bucket of funders that own less than 15% of the company exit. We have examples of companies that created huge outcomes for almost everybody, but the founders.

    How did you go about getting your own debt? What have you learned from working in capital markets?

    ANDREW: We probably pitched 250-300 people. Nobody believed that this would work because they just thought, "What are the assets that are collateralized?" And we said, "It's the future revenue of the business." That was a complete mindfuck for most institutional investors, even the savvier institutional investors. We were fortunate that we actually started in microbusinesses. We started in Gig Economy, Uber drivers, Airbnb hosts, before we tapped into the ecommerce market.

    We had the opportunity to test and learn on small dollar figures with relatively quick turnaround, so it built some history. And then we started doing ecommerce as part of a larger business. It was a nightmare to begin with. We found some great partners with CoVenture and Upper90 in the early days that helped us build these dedicated funds.

    You have to continue to go back to the equity markets as your business scales successfully, regardless of whether that's the right time for you to go raise equity. It's ironic because we realized that we were going to go down that path. We would end up diluting ourselves, our employees and our early shareholders significantly through the journey. Instead we set up these fully funded vehicles without equity contribution. It took us a lot of work to do that. And we ended up paying a very high cost of capital at the beginning, but now we've got fully committed funds. Not different from the way you would raise a venture fund from LPs, other than that we're promising a fixed income return.

    Don't you find that the fully committed funds are much higher cost of capital than a warehouse facility from a big bank would be?

    ANDREW: Yes absolutely. It is much higher costs, but we wanted the certainty, and we didn't want the risk of having a bank, in an event like COVID, pulling things.

    MIGUEL: When we raised our first round, we needed funding from equity. I would recommend this approach to early stage fintech founders: at the beginning, find pools of capital that are flexible. We raised from a few family offices and we basically tripled the size of our equity with that.

    Then we started learning more about the product that we were selling. Then we went to capital markets, and then we raised our first facility. That was painful because the incentives for equity investors and debt investors are totally different. An equity investor puts in money and the upside isn't cut. They can make a hundred X returns, a thousand X returns. All the conversations revolve around how big can this get, and how great of a company can this be.

    As Andrew mentioned, there are a ton of clauses. That means that these facilities can be pulled, if things change in the markets. So it is complex in this specific talent to run these operations. When you're raising a great facility you have to put some first loss capital. You don't get a high advance rate, meaning that you need to put more of your equity into every deal. There are very few ways in which you can fund fintech operations with very little equity.

    So every lender wants the fintech company to put some equity in every deal. In some specific industries, there's a lot of comparable information, so it's much easier. This journey is much short-term and much quicker. There are ways in which you can automatically sell everything from the balance sheet without putting any dollar, like overthrow agreements where the fintech company just originates. And then there's a specialty vehicle that buys the whole thing.

    The end goal is, once you have really good information on how your product performs, what the losses are to the double digit, and so on, to securitize. You can just basically access institutional markets and access almost infinite pools of capital. Although the cost of scale, as I mentioned at the very beginning, is pretty much the same as a large warehouse facility from a big bank.

    On the backend, are capital sources a lot more readily available?

    ANDREW: Yeah, it is starting to shift. I think we've scaled quite quickly. We're pushing new frontiers of scales and sizes of institutions. But like Miguel was saying we're now getting this deal where we're starting to talk about private securitizations, public securitizations. And we've got the history and the data to be able to have those conversations.

    What’s the typical cost for a first debt facility?

    ANDREW: Our first one, we paid 12% and then our second one, we paid at 15%. So when they weren't equity holders. It would be hard to do a student lending product or even a consumer lending product with those kinds of yields. I think the reason we were able to support it was that we focus on funding high-growth businesses. We could cover that kind of cost of capital.

    MIGUEL: It's expensive, but it gets cheaper with scale and there are certain steps. You arranged your first grade facility at low teens, then you arrange the second facility between $150 and $200 million. That comes as mid-high single digits. And then once you reach scale on warehouse lending, then you're basically at the floor, which is around low-mid single digits.

    How crucial was it to have an easier regulatory framework to succeed in the B2B lending market?

    ANDREW: It was definitely important for us. We operate in five countries now and we're aiming to operate across Europe and Asia as well by the end of this year. We wanted a structure that we could translate globally, relatively quickly. Now, the structure of a merchant cash advance or revenue share agreement, has some nuance in every country. But in most countries they have a similar regulatory framework to the US or the UK. We think about this as if we're unlocking capital for entrepreneurs and founders to grow their businesses online, and people can build businesses anywhere in the world. As hard as it is for US-based founders to raise capital, it's an order of magnitude harder everywhere else in the world. If we were going to achieve our mission, we were going to need a global product from the beginning.

    MIGUEL: The key is an unregulated, or less regulated, product in disguise. What we did from the very beginning was understanding extremely clearly what regulatory framework we're going to operate under. We made sure that we had the blessings from the regulators.

    With all the competitors entering the space, where will there be differentiation long term? Product experience?

    ANDREW: Our goal here is not just to be a source of capital, but actually a bit of a partner and a sounding board and provide a roadmap of where to deploy that capital to get the maximum return. Which is why we've gotten deep on things like marketing financing, inventory financing, and which channels you should spend that marketing dollar on. Or which suppliers you're actually getting the proper supply chain from.

    The goal is to be much more of a financial partner beyond just the source of capital. Like, "Hey, here's some money, good luck." And use the data that we have from the businesses that we funded to help inform those decisions. That's the sort of compounding data advantage that we've been building now for years. So we can credibly say that if you're a pet food company doing $200,000 in monthly sales, here's what you should do next. That's been how we think about differentiation.

    MIGUEL: I think the differentiation comes from three points. The question is of speed, flexibility and value add.

    Fundraising always takes time. You have to prepare a bunch of documents and so on. Nobody wants to do that anymore. So, fintech needs to basically make the experience as painless as possible. It should take no less than a few minutes to get an answer. Put funding on autopilot, to the point that funders don't even need to think about, "Do I need to raise debt, do I need to raise equity?" It's totally prescriptive. The funders can just focus on what's going to make the company great, which is launching a product, developing a product, and then shipping that product, and distributing it to customers.

    Then the other point of flexibility. Cost of capital is only one of the aspects in which fintech should compete. The others are, what is this going to mean for the company, right? What kind of securities, what kind of guarantees, what kind of warrants is going to mean for the funder? So it should be as light as possible. The way to make it as light as possible is having the best data sets.

    On the value add side, you can get cash from anywhere in the market, you kick a rock and there's a million dollars under it. The value add comes from first of all, telling funders or allowing them to know what they are getting out of this capital. So if I take $200,000 now versus $300,000, what does that mean for the business? What is the ROI and where should I deploy it? Then, because of the data enabled through the funding, what other parts of the business can you put on autopilot? So again, the funder only focuses on developing and shipping products.

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    The Mercury Team