Debt: The Seven Stages of a Fintech Lender
Getting into fintech lending is easy. Anyone can just give away money. Money is just a type of information. It travels at the speed of light. You don’t have to ship anything. No warehouses needed (not physical ones anyway).
But it’s hard to do it at scale because you are gonna have to figure out how to raise all that cash for the portfolio.
For me, it’s been a journey. I’ve never taken a finance or econ class. I got my degree in Philosophy. Nevertheless, I’ve started three lending companies. Looking back, I wish someone had given me a blueprint for the financial back-end. How do lenders get all the money to fund their portfolios? This is not obvious at all.
So I just thought I would put together a list of the ways that lenders raise capital. In particular, I have become familiar with how to do it in emerging markets where the capital markets are a bit less mature.
This is a non-exhaustive menu — in relative order of stage. Startups usually start at the top of this list and work their way down as they become larger (often overlapping along the way).
- Equity
This is the easiest one right after you start. If you are lucky (or unlucky) enough to raise venture capital, you can pour that into the loan book. Startups raise their seed round and immediately start lending the VC cash to their borrowers.
The problem with this is that you can quickly run out of money. This happened to Branch. In 2015, we had about 5 employees working out of a small office in San Francisco. We raised $1.4M in June. We weren’t paying ourselves barely anything at all. By December, we essentially had zero dollars because we lent it out to Kenyan customers.
Bottom Line: Do this to get started, but not for long. Develop the discipline early in your history not to lend out equity. It’s dangerous and unsustainable!
2. Venture Debt
After equity, Venture debt is the next natural step for any startup. Venture debtors offer credit in exchange for the right to some of your equity. They typically do so by asking for “warrants”. Warrants give venture debt providers the right to purchase your stock at some point in the future at an agreed upon price — basically the same thing as stock options. Venture debt is like debt on training wheels. It can help extend your runway and be there for you on a rainy day. However, VD is expensive and can be dangerous. If things go sideways, VD providers engineer all sorts of ways they can mess with your company…
Bottom Line: If you are a lender, you should do this. It can help extend the runway and build an organizational track record of borrowing. Just don’t do it too much.
3. Bank line of Credit
One of the main functions of a bank is to lend to small businesses right? Lending startups are small businesses, so this feels like a natural fit. The truth is, banks still haven’t figured out fintech in emerging markets. They view fintech lenders through an extreme lens. Fintechs are either 1) totally crazy or 2) straight up competition. As with most things, the truth lies somewhere in between. Anyway, I’ve been in a number of borrowing conversations with banks over the years. It usually goes something like this:
Me: Can we have a line of credit?
Banker: Yeah sure, we love you guys. You are on the cutting edge.
Me: Great, let’s do it.
Banker: Let me talk to the risk person, just a minute.
Me: OK (waiting)
Banker: OK, we can give you a loan. Do you have any land?
Me: No, we are just an app.
Banker: You have a factory?
Me: No, but I can offer you my colleague as collateral.
Banker: Let’s keep in touch. (secretly vows to never talk to you again)
Me: OK. (secretly vows to never talk to you again)
Bottom Line: This is an appealing, but rather fake option. Until you have massive collateral, banks in emerging markets are largely unwilling to lend to fintechs at the moment…
4. Commercial Paper / Bonds
Another expensive option here. Commercial paper (CP) are essentially unrated bonds. In the first few years of any startup, you are unlikely to be “rated” — in any sense of the word. Alas, there is hope. Many countries in Africa/LatAm/Asia have active private commercial paper markets. Even startups issue CP. This has been extremely helpful for Branch. What you need to do is engage a local investment bank to underwrite the company and issue a prospectus to local investors. Often, investment banks are connected to a loose network of high-networth investors (HNIs) who buy short term corporate debt. Before you get a rating, there is less money to be raised. After you get a (bond) rating, the sky’s the limit.
Bottom Line: You absolutely should do this. However, it’s risky to go the unrated route for too long because the terms are worse and the investor network will be smaller. A smaller network involves greater “refinancing risk” when it’s time to increase the size of the portfolio.
5. Whole Loan Sales
This is an exciting new trend. Hedge funds around the world have been starting to buy loans from fintech lenders over the last fews years. How does this work? The fintech lender makes a loan as normal using its own capital. Then, it near instantly “sells” this loan to a fund who has previously agreed to purchase loans of a certain type. Increasingly, this is being done using APIs and involves no manual work.
Why would you want to do this? The main constraint of us non-bank lenders is capital. You can’t just grow your book exponentially — it can be quite risky to pursue double digit month-over-month growth. Selling loans enables you to get that risk off your balance sheet and make revenue at the same time.
Bottom Line: This should be part of the game plan for any fintech lender. However, you don’t want to make this your entire business because you don’t necessarily “own the customer”. Also, the margins are rather low.
6. Receivables Financing
Have you heard of a “warehouse facility”? This is a metaphor used to describe what is otherwise known as receivables financing. Basically, you put the loans you make into a “warehouse” and you consider the future repayments to be the “receivables”. You find a lender willing to lend money to the warehouse using the future repayments as collateral. To make this happen, you need an entity — an SPV for instance — that legally separates the loans from the rest of the company. That way, in case something happens to the company, the entity can persist and the collateral won’t be captured by other creditors. In other words, the office landlord won’t be competing with the wholesale lender in case of bankruptcy.
Bottom Line: This all sounds like a bunch of legal mumbo-jumbo. But it becomes really important at scale. The fact that the warehouse is “bankruptcy remote” is no minor detail. It can allow the facility to scale to a much greater size than the equity of a company could ever guarantee. It takes a while to set this one up — probably like 18 months — because of all the back-end tagging required to truly get loans into a separate legal entity.
7. Deposits
Eventually, most lenders need to become banks to continue to grow. Why? Banks have access to deposits which dramatically lower the cost of capital. Furthermore, a deposit base is much more stable than any wholesale credit source.
Bottom Line: Any non-bank lender, after 5–7 years, should start thinking about becoming a bank. It’s just hard to think of any generationally important non-bank lender. In the world of microfinance, all the big NGOs eventually became banks — Grameen for instance. I am sure there are some major counter-examples, but not many. Right now, we are in the process. So far, it hasn’t been easy, but it’s the only path to greatness IMHO.
