Fintech Rewrites The Rules For SME Funding — And Everybody Wins
The impact of SMEs (small to medium sized enterprises) on the world’s economy is quite surprising. When we see information about the size of country economies, we perhaps have an impression of large companies driving them. While this is true to an extent, the contribution that “small guys” make is significant.
SME’s are small to medium sized businesses. Some countries add a micro category as well, generally where there are fewer than 10 employees. Each country defines each category in terms of the number of employees and annual turnover. So, for example, in the EU, SME refers to enterprises with up to 250 employees. In the USA this number is 500, and in China it can be up to 3000, depending on the industry.
It’s perhaps useful to look at the impact of SMEs in the USA, which is the world’s largest economy in 2017:
- 99.7% of employer firms in the USA are SMEs
- SMEs account for over half of US non-farm GDP, make up 98 percent of all US exporters and bring in 34 percent of US export revenue
- Small firms employ nearly half of the private sector workforce, ie 60 million people, and they contribute 72% of the total payroll
- Small businesses create 2 out of every 3 net new jobs.
- Small businesses support innovation: They produce 13 times more patents per employee than larger firms and employ more than 40 percent of high technology workers in America.
The numbers are very similar for other countries:
- China is the second largest economy. 97% of all companies in China are SMEs and their contribution to GDP is 59%
- Japan is third. 99.7% of all companies are SMEs and they employ 70% of the workforce. SMEs supply most of the components for products produced by large corporations — they are the backbone of the Japanese economy.
- In OECD (high income) countries, 95% of companies are SMEs and they generate 60–70% of the employment.
- In emerging economies, formal SMEs contribute up to 60% of total employment and up to 40% of GDP. According to a World Bank report, 600 million jobs are needed by 2030 to absorb the growing global workforce, mainly in Asia and Sub-Saharan Africa. Formal SMEs create 4 out of 5 new formal jobs and are therefore critical to meeting this target. It is estimated that, in addition to the 30 million formal SMEs, there are another 350 million micro and informal SMEs in emerging markets. If they could be brought into the formal sector, they could have a significant impact on job creation and on the economy.
On a global level, 9 of every 10 business is an SME. SMEs provide 60% of overall employment and contribute 50% of global gross value add.
A South African study highlighted that the number of people employed grows in relation to the turnover of the enterprise and in relation to the length of time that the SME survives. While this might sound logical, it gets to the nub of the SME issue. Growth and survival of SMEs are critical.
As for any enterprise, growth and survival of SMEs are primarily dependent on access to finance. Yet study after study and report after report indicate that a major difficulty faced by SME’s is lack of access to finance.
According to the World Bank:
- More than 50% of formal SMEs in emerging markets lack access to finance. This number grows to about 70% if micro and informal SMEs are added.
- The total credit gap for formal SMEs is estimated at US$1.2 trillion, and more than double that if the informal SMEs are added.
The Oliver Wyman report in 2014 corroborated this number. It estimated that the total unmet demand for credit by all formal and informal SMEs was $3.5 trillion, a third of it in OECD countries and the balance in emerging economies.
This funding gap represents a threat to economic growth around the world.
Why Can’t SME’s Access Finance?
SME face major difficulties in getting business loans from traditional financial institutions/banks.
According to the UK Government SME Business Barometer, SMEs requested finance for working capital or cash flow, acquiring equipment or vehicles, improving buildings or buying land. 46% of them had difficulties in raising this finance from the first institution they approached (and this number grew to 68% for micro businesses).
- Reliance on banks, especially community banks
Traditionally, SMEs rely on bank overdrafts, lines of credit and loans to gain access to finance. About 48% of SMEs in the US have a major bank as their primary source of finance, with another 34% relying on regional or community banks. This arrangement may be appropriate for start-ups but not for growth and maturity. It also made SMEs particularly vulnerable to the 2008 global financial crisis — and many of them remain vulnerable. A Harvard Business School paper makes the comment:
“Access to bank credit for small businesses was in steady decline prior to the crisis, was hit hard during the crisis, and has continued to decline in the recovery as banks focus on more profitable market segments.”
- Regulatory pressure for high collateral or equity
Part of this continuing difficulty is that risk-averse regulators are putting pressure on banks, who then increase capital requirements for loans above the levels that SMEs can deal with. Banks want enhanced collateral or traditional equity and SMEs can’t meet these requirements.
- Banks’ reluctance to process small loans
A major issue for SMEs is that banks do not regard them as profitable enough. A typical loan request for an SME is less than $100,000. The problem is that, for a bank, the transaction cost for a $100,000 loan is comparable to a $1million loan, with a fraction of the return. Transaction costs are pushed up as banks try to assess the risk attached to the loan. SMEs are heterogeneous, so there is no template to apply. Many SMEs have patchy financial records, and there is no public record of their performance. Community banks have relied on relationships built up over time as a basis for risk assessment and loan decisions, but this cannot be automated to assess creditworthiness. This has been exacerbated as community and regional banks have been absorbed into the major banks.
- Time and effort required for loan applications
The time and cost involved in applying for finance has also been exorbitant. A Federal Reserve survey found that SMEs spend an average of 25 hours putting together the necessary paperwork, must approach multiple institutions and then must wait for weeks for decisions.
- Unfair criteria in decision making
One of the shortcuts that banks have taken, has been to make decisions for business loans based on the personal credit profile of the owner. This in no way reflects the health of the business. In addition, owners often personally financed the start-up of their businesses, and their own credit profiles have therefore declined.
In China, big banks tend give all SMEs a “D” credit rating, regardless of their innovativeness or market competitiveness.
As a result, it is estimated that up to 70% of SMEs don’t even try to use formal lending facilities, while another 15% are underfunded when they do apply.
- Lack of knowledge of other solutions
One of the solutions for SME access to funds has been through so-called supply chain financing. This can the form of collateral or some form of guarantee from a large buyer, which then allows the SME, as the supplier, access to funds. Another form is where a lender takes over the SME’s debtors or accounts receivable. This is also called invoice financing. Cash flows that have been captured by unpaid bills are released to the business. According to research undertaken by Lloyds, less than a third of SMEs are even aware of these options.
While lack of finance is not the only reason for business failure, it certainly is a major one. In the US, 500,000 new businesses get started each month. Sadly, a larger number shutdown. The statistic is that 70% survive for 2 years, 50% for 5 years, a third for 10 years and only 25% longer than 15 years.
Alternatinative Finance As The Solution For SMEs
The real answer to SME access to funding may come from technology and the Fintech industry.
Online lenders are disrupting the small business lending market. They provide easy online applications and loan agreements, most taking less than 30 minutes rather than the traditional 25 hours to complete. Decisions are made in hours and money is in the borrower’s account in a few days. All of this is in stark contrast to the traditional bank approach!
Algorithms are applied to large data sets to evaluate, make decisions and manage small business loans. Data from nontraditional sources, such as shopping patterns or social media usage is added to traditional financial data to assess creditworthiness. Much of the focus is on current cash flow — sometimes just based on card processing statements. This is particularly helpful for individuals and SMEs who cannot be “scored” by traditional systems because they lack financial records or credit histories.
Some preliminary reports are showing that the default risk in these transactions is half that of banks. Zopa, the first peer-to-peer lending company and one of the earliest fintech companies, is said to have a default rate of 0.005%. Better data seems to lead to more accurate risk profiling.
There are concerns about these methods and questions about how they should be regulated, but they are gaining traction and becoming an attractive investment option.
What Is P2P Lending And How Does It Work?
Peer to peer (P2P) lending is a simple concept. An online platform connects people who want to borrow money with those who want to lend money, cutting out the middle man, usually a bank. In some cases, these are loans between individuals (P2P). In other cases, loans are made to SMEs (P2B).
Borrowers have access to a wide range of lenders and a new pool of capital. Even if they sometimes pay higher interest rates, they generally have greater transparency, better repayment terms and better customer service. They are also able to get unsecured loans.
Lenders bypass the banks, have no major infrastructure costs and can achieve higher yields. They can also diversify by investing small amounts into several loans. There is some development into the secondary market where small loans can be bundled together and sold.
There are various models in online lending to SMEs:
- Lenders use their own balance sheet; they raise capital from institutional investors and then use their own risk models to decide on loans. Generally, daily fixed amounts are deducted directly from the borrower’s bank account to recover the loan
- Peer-to-peer platforms connect institutional and retail investors with borrowers. Investors sometimes use the tech platforms together with offline marketing, to cherry-pick borrowers
- “Lender-agnostic marketplaces” are platforms where borrowers can compare and select offerings from various lenders. Both borrowers and lenders save on search costs. The marketplace charges a small fee if the borrower gets funded via the platform
The global P2P lending market is expected to grow at a CAGR of 53% between 2016 and 2020. Morgan Stanley expects this to command $150 billion to $490 billion globally by 2020, and suggests that P2P could well reinvent banking.
WishFinance: An Up-To-Date Example Of A Fintech Solution For SMEs
WishFinance is a good example of how innovative Fintech companies have become in providing solutions for SMEs.
WishFinance is a balance-sheet lender — it attracts funding from hedge funds and financial institutions to provide loans to SMEs. It aims to launch its business in Singapore in December 2017.
Other lenders in this space include Biz2Credit, SoFi and Fundrise. Competitors also include OnDeck Capital, Kabbage and PayPal WC.
WishFinance has targeted small merchants (convenience stores, restaurants, small retailers and the like) who have been in business for at least 12 months and who have cashless turnover. They will lend to SMEs where customers pay with credit cards or other electronic forms of payment. Loans range from the equivalent of $750 to about $750 000, repayable over 3–36 months at 24% APR (an interest rate significantly lower than the competitors).
Some of their unique features include:
- Proprietary software to evaluate applications. They use real-time transaction data, data about the company and open market data about the industry and the economic landscape (a total of 85 variables are included in their algorithm). This system includes machine learning so will become even more efficient over time. The system can handle hundreds of applications simultaneously, and provide answers within 24 hours.
- Loans are recovered through direct access to POS transactions. Every time a customer makes a payment, 2–5% is deducted to repay the loan. This reduces risk for the lender and makes it seamless for the borrower.
- All loans are insured against possible bankruptcy.
- POS data providers and the insurer share in the revenue.
- All transactions will be stored on the Ethereum blockchain, to ensure that the company itself is transparent and borrowers can track their own repayment progress. (No personal or commercial data will be provided.) This will be backed up with monitoring tools to effect Cryptographic Audits.
- Wish Finance will diversify its portfolio into Hong Kong, South Korea, Benelux (Belgium, Netherlands and Luxembourg), and Scandinavia (Denmark, Norway and Sweden) and across a variety of merchant industries
Accessing finance has never been easier for SMEs. Technology provides high yields and mitigates risk for lenders. It seems to be a win-win solution.
SMEs are a critical part of ensuring the success of world economies through job creation, innovation and contribution to GDP. However, survival and growth of SMEs is at risk because of the difficulties they face in accessing finance through traditional financial institutions. The total unmet demand for credit by all formal and informal SMEs is estimated at $3.5 trillion, a third of it in OECD countries and the balance in emerging economies. This funding gap represents a threat to economic growth around the world.
Fintech companies have seen the opportunity and stepped into this gap. They provide alternative options for loans. Most of these are online peer-to-peer (P2P) or peer-to-business (P2B) lending platforms that are fast, cost efficient, transparent and customer friendly. SMEs can get unsecured loans at reasonable rates and terms. Lenders can get good yields and manage risk. New Fintech companies are introducing innovative products.
The global P2P lending market is expected to grow at a CAGR of 53% between 2016 and 2020. Some say that it is reinventing banking!
All in all, this seems like a winning solution for SMEs.
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