The Capital Needs of Small Businesses are Changing: Here’s How Lenders Should Respond

The following is sponsored content from LendingFront.

With Covid-19 on the minds of businesses and lenders alike,
conversations about the capital needs of small businesses have
revolved—with obvious justification—around the Paycheck
Protection Program (PPP) and other forms of relief provided under
the CARES Act.

Yet the capital needs of many small businesses don’t begin and
end with the PPP.

Let’s start with a few facts

According to the U.S. Federal Reserve’s 2019 Small Business
Credit Survey:

  • 43% of small businesses sought external funding for their
    businesses in 2018
  • And more than half experienced a funding shortfall.

These funds—when small businesses can obtain them—are often
used to purchase inventory, replace equipment, finance expansion,
and hire new workers.

These needs will persist long after PPP lending has come to an
end, yet even in a strong economy, up to 80% of bank-originated
small business loan applications are rejected.

In the post Covid-19 environment, we can expect that percentage to
be even higher

That’s because the conventional underwriting criteria for
small business loans will no longer work. Traditionally, both bank-
and non-bank lenders have relied on four criteria for underwriting
small business loans:

  1. Tax/Financial Statements
  2. Credit Scores
  3. Collateral
  4. Owner Wealth

In a normal economy, these criteria are fine, but they’ll do
little to show the true state of a business in the post Covid-19
environment. 2019’s tax/financial statements will be all but
irrelevant. Credit scores will be damaged as a result of the
inability to make payments during a forced closure. Collateral will
have questionable value if bankruptcies spike. And owner wealth
will have been tapped in an effort to keep many businesses

Are we headed towards a capital drought?

With traditional underwriting criteria no longer useful, are we
headed toward a capital drought? We certainly don’t need to, but
the answer largely hinges upon lenders doing two things:

  1. Adopting new criteria that are more appropriate for the post
    Covid-19 environment
  2. Adopting new product structures that enable the lender to
    manage risk

New credit criteria include information such as:

  • Real-time Cash Flow
    Cash flow helps you gauge how quickly the business is recovering
    from Covid-19. Is it in irreversible decline? Is it struggling but
    stable? Has it gotten back to normal? Insight into real-time cash
    flow helps lenders make better decisions about who to lend to along
    with the terms of any offers.
  • Consumer Sentiment
    Customers who vote with their reviews also vote with their wallets.
    Examine reviews from Google, Yelp, and other sources to answer, Is
    this a business that customers love? Businesses that are
    well-regarded by customers stand a much better chance of recovering
    than those that had problems before the pandemic shut them

New product structures also enable lenders to deliver capital
efficiently while managing risk

Here’s how:

  • Shorter Terms
    First, lenders should emphasize shorter payback periods in the
    range of 6-12 months. Shorter terms get the lender paid back faster
    while enabling the business owner to show that he/she is
    creditworthy before seeking a larger amount of capital.
  • Daily ACH Payments
    Second, lenders should collect payments from the borrower on a
    daily—rather than monthly—basis. Monthly payments introduce
    unnecessary operational risk. Daily payments are smaller,
    consistent, and more predictable from the standpoint of the
    business’ cash flow.
  • Tie Payments to Performance
    Lastly, lenders should tie payment terms to current cash flow
    performance—and with visibility into cash flow, this is very easy
    to do.

A new economy needs new rules for lending

If the Great Recession taught us anything, it’s that
opportunities exist for lenders to increase their assets, gain
market share and, of course, to meet the capital needs of their
borrowers. In the post Covid-19 environment, lending is only as
risky as the information used to make decisions. With better
underwriting criteria and more appropriate product structures, the
most forward-thinking lenders will position themselves for success
and reap the rewards.

Photo by
David Emrich

The post
The Capital Needs of Small Businesses are Changing: Here’s How
Lenders Should Respond
appeared first on Finovate.