Banks have failed small businesses time and time again. Here’s how to save them.

The past, present, and future of small business financing.

Quick note: We do lots of research for new ideas at Neighborhood Studios. In 2022 we began publicly sharing our research. We’ll pursue some of these ideas, but many we won’t. Either way we want more founders to build products to make our day-to-day lives better. If you are working on ideas around this problem, we’d love to chat — goodstuffnearby@neighborhoodstudios.com.

What’s your dream job?

Some of you might say CEO of a major corporation, or maybe a professional athlete. My dad’s dream job, though, was to run a butcher shop.

Niche, I know. He ran one location that was always super successful, but never had the upfront money or financial backing to open a second location.

His story is not unique. One of the biggest hurdles local businesses face is a lack of realistic and practical financing options.

Looking at their options, it’s understandable why these businesses struggle to get funded. Banks are an option, but they tend to stay relatively conservative with their funding to small businesses. Venture Capital from Silicon Valley is alluring, but venture capitalists only invest in businesses with exponential growth potential — not local businesses.

What we’re left with is the middle — the no-man zone — a wide swath of the American economy that is left underfunded, undernetworked, and underappreciated. Henri Pierre-Jacques at Harlem Capital articulates it well in this thread:

Who is working on this problem? How can we unlock the potential of small businesses in the U.S. and throughout the world?

Let’s look into the history of small business financing, the layout of companies working on this today, and examine what might be the next innovative model funding small businesses throughout the world.

Shameless plug. Neighborhood Studios is a hyperlocal startup studio. If you are a founder currently working in any of these areas or if any of this really grabs you, we’d love to talk with you — goodstuffnearby@neighborhoodstudios.com.

Definitions

Before we dive into the history of small business financing, we wanted to look at the financing options available to small businesses today.

We’ll start off pretty basic, so everyone is on the same page and then get to current options.

At a high-level, a business can either finance itself through equity or debt.

On the equity side, typical investors either include venture capital, high-net-worth angel investors, or the general public via equity-based crowdfunding (still relatively nascent — legal in the U.S. after the JOBS Act passed in 2012).

On the debt side, banks and alternative lenders have gotten creative with the various ways they can loan you money. Here’s a breakdown:

Loans:

• Traditional loan: Also called a term loan, these are traditional loans you would think of. Lenders give you an upfront amount of capital in exchange for fixed repayments (with interest) over a fixed amount of time.
• SBA (Small Business Administration) loan: Traditional loan, but with favorable terms since it’s guaranteed by the government. There are few of these and they’re difficult to get. Additionally, the processes to get these are super clunky.
• Working capital loan: Just like traditional loans, but for a short period. These are used to fund everyday operations (payroll, rent, inventory) in case of a temporary funding shortage.
• Personal loans: You can also take out a personal loan for business use, but risking your personal finances should be a last resort. With a personal loan, your personal credit helps to determine the terms, but depending on the loan, your personal assets may have to be used as collateral.

Sort of loans:

• Business credit card: Just like a normal credit card, but for businesses. Often a higher credit limit than personal credit cards have.
• Line of credit: Like a business credit card, but can be used for things that you can’t use a credit card on (e.g., payroll). Unlike traditional loans, business credit cards & lines of credit only begin to accumulate interest when you actually make purchases.

The creative stuff:

• Inventory financing: Need inventory? Lenders will give you money to purchase inventory for quick resell. The inventory itself is used as collateral if you can’t pay the lender back.
• Invoice financing / invoice factoring: These are actually separate things, but it’s probably not worth getting into the semantics. At a high-level, these types of financing allow you to sell invoices (people promising to eventually pay you) for money today. If you’re interested in the semantics, you can learn more here.
• Purchase order financing: Similar to inventory / invoice financing, but with purchase order financing, you get upfront capital to help when you have a customer that has purchased a big order that you don’t have the money to fulfill. You fulfill the order, and then pay the lender back + interest.

Other loans you’re used to as a consumer:

• Equipment financing: Like an auto loan on the consumer side, businesses can finance the purchase of a big piece of equipment (e.g., manufacturing equipment, company vehicles). Lenders will help to facilitate the purchase in exchange for repayments + interest.
• Mortgages: Businesses could get mortgages for office space for example. Similar to equipment financing, lenders help you purchase the asset in exchange for repayments + interest.

The cool stuff: We’ll dive into these more throughout the article

• Merchant cash advance: A merchant cash advance is an upfront loan in exchange for a fixed percent of future credit card sales, up to a certain limit. For instance, a lender may lend $100,000 in exchange for 10% of your daily credit card sales until $140,000 has been paid back. Since payback starts immediately and occurs daily, effective interest rates on this type of loan can get really high.
• Revenue-based financing: Revenue-based financing is super similar to a merchant cash advance, but with some small nuances. It operates under the same principles — an upfront amount of capital in exchange for a fixed percent of future revenue — but the main difference is that it’s targeted more for businesses seeking to grow, rather than businesses needing quick cash to keep operations going.

As we said, we’ll dive into these last two a little later.

But first, let’s take a look back at the history of small business financing to get a better perspective on where we’re at today.

History of small business financing

Phase 1 (pre-1960)
The establishment

In the beginning, God created the heaven, the earth, and the banking system.

While money lending actually only has origins back to Ancient Mesopotamia, the modern banking system began to really take form in the 17th century, with the development of fractional reserve banking and banknotes.

Pre-1960, banks had proliferated throughout the United States. The system for lending to small businesses, however, had its clear faults.

If you owned a small business, you would go to a local bank to apply for a loan, and over 80% of the time you would be rejected. There was a very high bar to get one of these loans, and even if you met the bar, approval and an ultimate payout could take several weeks, even months.

This isn’t just bad, it’s like prohibitively bad. If you were a small business, you were better off trying to borrow money from friends and family than even entertain the idea of working with a bank.

However, there were some good developments in this time:

• 1953: The Small Business Administration was founded in 1953 with the broad charter to help small businesses in the United States. One of their key pillars was to help finance small businesses in the U.S. (originally they lent themselves, now they just guarantee bank-backed loans).
• Late 1950s: By the late 1950s, credit scores had become widespread in the United States. This made it easier for banks to offer business credit cards, since they could quickly judge a business’s loan payback ability.

Phase 2 (1960-2005)
The proliferation of modern-day venture capital

Venture capital emerged as an asset class in the 1960s and 1970s, with the development of the limited-partnership model and the formation of some of the big west coast VC firms, such as Sequoia and Kleiner Perkins.

At a high-level, venture capital is a form of financing in which private investors pool their money to invest in promising startups.

However, modern day venture capital runs on the power law, a law that dictates that 80% of the returns come from 20% of the investments. Thus, venture capital investors need every investment to have the ability to pay back the entire fund.

With that in mind, venture capital was (and still is) only available to startups that have the potential to 10x their value, and not to the most common 95% of traditional small businesses.

Phase 3 (2006-2018)
The rise of online lending

With the commercialization of the internet in the early 2000s, the next big wave of startups kicked off a new era of digital-native online lenders.

These companies offered common bank lending products (lines of credit, traditional loans) to consumers and businesses, but offered two main advantages over banks:

• Higher acceptance rates: According to Forbes, a bank may require a credit score as high as 680, while online lenders may accept a credit score as low as 500. This unlocked another tier (or two) of businesses that couldn’t otherwise get a loan.
• Quicker acceptance processes: As opposed to traditional banks with approval processes that could take weeks or months, online lenders could automatically accept loans using advanced underwriting algorithms. While many of the online lenders today promise this instant qualification, in reality, many of them use a combination of digital techniques and in-person review before qualifying you for payout.

Some of the key winners from this phase were OnDeck (2006 — now public) and Kabbage (2008 — acquired by American Express), with other notable notable companies including:

• Kapitus (2006)
• Biz2Credit (2007)
• Fora Financial (2008)
• Yellowstone Capital (2009)
• Funding Circle (2010)
• Prospa (2012)
• Fundbox (2013)
• BlueVine (2013)
• Lendingkart (2014)

Quick side note — these businesses have faced a lot of regulatory scrutiny throughout their time, with some of them charging interest rates at levels made illegal for consumer loans or allowing the stacking of business loans.

If you haven’t heard of many of these companies above, that’s okay — they’re mostly targeted to small businesses. However, there are a couple players in this space that you have definitely heard of, namely Amazon, Square, PayPal, and Shopify.

All of these businesses have proprietary access to business data, via their point of sale systems like with Square or their E-commerce marketplaces like with Amazon. These companies realized the huge opportunity to lend to the businesses in their networks that were performing well. And this model has proven itself — for instance, it took PayPal a mere 5 years to reach a total of $10B in loans disbursed (with the aid of acquiring big merchant cash advance player Swift Financial).

Phase 4 (2019-present)
Modern revenue-based financing

Pipe, founded in 2019, was the fastest fintech company ever to reach a $2B valuation, achieving the status roughly a year after its launch.

Their model was pretty simple. They gave subscription businesses (like SaaS startups) upfront capital in exchange for a percentage of their future revenue. Companies would receive a lump sum to help grow their businesses, and give a percent of their revenue every month back to the lending provider, up to a certain cap. Additionally, similar to CircleUp founded in 2012 with their Helio loan model, Pipe would use your historical business data as inputs into their model to determine the financing terms.

Does this sound familiar? If so, it’s because we’ve talked about this model before.

While they were not the first company doing this, Pipe led the wave of companies offering revenue-based financing (also known as Cash Flow-Based Financing or Royalty-Based Financing). While revenue-based financing had a structure similar to that popularized by merchant cash advance companies in the 2000s, revenue-based financing aimed to not be a financing option of last resort. Instead, it focused on growth companies, allowing the financing to also have more moderate fees.

This type of financing is often called “founder-friendly financing” for several understandable reasons. First, it’s not-dilutive, so you don’t have to give away ownership of your business. Second, it has a cap, so you’re not paying your lenders out forever like with equity. And finally, payback is based on a fixed percent of revenue, not a fixed amount, so if your business struggles, your payback amount per month goes down.

Ultimately, the key to this financing, we think, is in how powerful some of the marketing elements surrounding it are:

1. It’s simple. There’s no confusing interest or annual percentage rates (APR). If we loan you $100,000, you pay us back 10% of monthly revenue, up to $140,000. My 8-year old cousin could understand that.
2. The lender appears on your side. You pay more when you do well and pay less when you’re struggling. The lender wins when you win, and loses when you lose.
3. The lender’s upside is capped. You’re never worried about having to give away and arm and a leg like with equity. You know how much you’re paying back the lender.

Pipe wasn’t the first company to offer revenue-based financing for subscription businesses, but their success led to a ton of follow-on attempts.

Let’s dig into the current market layout.

Small business financing market layout

First, there’s the Pipe-like companies that are doing revenue-based financing. Most have started post-2019 and a lot of them have raised significant money off the Pipe tailwinds. Here are the categories we see the most often:

Revenue-based financing companies
Subscription / SaaS: Companies that offer revenue-based financing to subscription companies or SaaS companies

• Major examples include Pipe, Capchase, Liquidity Capital, re:cap, Lighter Capital, TIMIA Capital, Founderpath, Arc Technologies, Element SaaS Finance, and Vitt

E-commerce: Companies that offer revenue-based financing to e-commerce businesses

• Major examples include Clearco, Wayflyer, Velocity, Jenfi, FlapKap, RITMO, Booste, and Choco Up

Vertical-specific: Companies that offer revenue-based financing in certain verticals

• Major examples include real estate (Nophin, Futurerent, Nectar), app developers (Braavo Capital), cannabis (Magnolia Partners, Peppermint), or entertainment (RIPE Capital, Music Royalty Lending)

General: Some companies offer revenue-based financing pretty generally to all of these types of businesses (SaaS, e-commerce, app developers, etc.)

• Major examples include Uncapped, Boopos, GetVantage, Klub, Outfund, Remagine, Corl, Flow Capital, Unlimitd and Fairplay

Aside from revenue-based financing, there are companies that are offering other ways for businesses to get funded. Some of these are direct lenders themselves and some are marketplaces.

Other lenders
Banks: Typical small business lenders

• Major examples include Bank of America, JPMorgan Chase, Citibank, and Wells Fargo

Broad online lenders: These are the companies we talked about in the wave of new online-first lenders. They generally offer a broad array of debt products (e.g., traditional loan, line of credit, merchant cash advance)

• Major examples include OnDeck, Kabbage, Funding Circle, Kapitus, Biz2Credit, Fora Financial, Yellowstone Capital, Prospa, Fundbox, BlueVine, Lendingkart

Point solution online lenders: These companies typically offer one type of financial product.

• Line of credit (Oxyzo, Ampla, Floryn)
• Merchant cash advance (Swift Financial, 365 Business Finance, Snap Advances)
• Invoice factoring / financing (Tradeshift, Factris, FundThrough)
• Revenue-based financing (entire section above)
• Lots of other point solution companies

Platforms to connect startups with funders: These platforms connect venture-scale startups to funders, such as angel investors, venture capitalists, or regular investors (crowdfunding)

• Connect startups to Angels / VCs: Major examples include AngelList, Hum Capital, Trica, SeedBlink, Pin, and Connectd
• Connect startups to people (“Crowdfunding”): Major examples include OurCrowd, Wefunder, FundersClub, SeedInvest, and Gust

Platforms to connect local businesses with funders: These platforms connect non-venture-scale startups to funders. More focus on local businesses

• Major examples include MainVest, Micro Connect, Honeycomb Credit, Localstake, Bonside, FranShares

Texture of the problem

There are several components of this problem as small businesses seek funding:

• Traditional financing options are expensive: When businesses can’t get a bank loan, they turn to online lenders, who target this tier of riskier businesses. To be compensated for this level of risk, they charge interest rates that can exceed 100%+ APR — levels made illegal to lend to individual consumers.
• Speed to get funding: It could take weeks to get funded after a traditional bank loan application. Online players use time-to-funding as a differentiator, with some citing less than 48 hours to get funding.
• Capital isn’t everything: Money is nice for expansion, but isn’t everything. There are a ton of reasons a business may not expand, such as talent and being spread too thin.
• Lack of awareness: There is still relatively low awareness to alternative online lenders. Many business owners don’t know of the financing options at their disposal, or may not have the time to sort out the good options from the bad.

Novelty

At Neighborhood Studios, we celebrate novel ideas to tackle these problems in all their forms. Here are the current attempts that we find particularly novel.

Almost all of the revenue-based financing companies that have risen to prominence were founded in the last 3 years. So in a way, all of these are still exploring a relatively novel product.

Aside from traditional revenue-based financing, here are some of the other novel products, ideas, and companies in this space today:

• Boopos, founded in 2020, is a recent promising attempt to improve SBA loans. Surprisingly, a lot of SBA loans are actually used to acquire small businesses, not fund them. Boopos works on this issue by offering fast, upfront capital to acquire businesses with revenue-based financing payback.
• Bonside, founded in 2020, is working on a revenue-based financing marketplace to connect investors with brick-and-mortar businesses. While most revenue-based financing companies are working with online businesses, Bonside appears to be taking the opposite approach.
• SeedBlink, founded in late 2019, is promoting “co-investing” in deals with their venture investing team. This way, you get access to investment opportunities with the added social benefits knowing that others are investing.
• FranShares, founded in 2020, is working to create an asset class out of franchise returns. They’re marketing “passive income” with access to this class starting at $500.
• Pin, founded in 2020, is building an easy way to launch “investment clubs” to invest in startups in your “community” (broadly defined). They’ve been funded by top investors such as Initialized.

So what’s next in small business financing?

As a startup studio, we are always looking for what’s next in various hyperlocal spaces. Here are the parts of the problem we think are promising to explore:

• Other revenue-based financing models: Pipe and other similar companies have popularized revenue-based financing for online / subscription businesses. Could there be a product that does this for other types of businesses, like Bonside is doing with brick-and-mortar businesses?
• Co-investing: Could there be a product that allows investors to co-invest in SMBs alongside established lenders? Inspiration for this is SeedBlink and this model, which lets you invest in what Republican / Democratic lawmakers invest in.
• Opendoor for commercial mortgages: Opendoor does instant offer marketplace for buying and selling houses. Could a similar model be done with much more complicated commercial mortgages?
• Modern SBA agents: SBA loans have clunky processes. Could there be a product that makes it easier for small businesses to access these types of loans? Similar to Boopos with acquisition loans.
• Group buying: The Convoy offers group-buying services for small businesses. Could pooling small businesses in a way like this be a wedge to offer lending options to them?

If you are a founder currently working in any of these areas or if any of this really grabs you, we’d love to talk with you at Neighborhood Studios — goodstuffnearby@neighborhoodstudios.com.

Only neighborhoods can save us! And you can take that straight to the bank.

About Neighborhood Studios

Neighborhood Studios is a venture studio that partners with tenacious founders to build hyperlocal startups from the ground up.

If you are building a business in any hyperlocal space or if any of this really grabs you, we want to hear from you. Drop us a note at goodstuffnearby@neighborhoodstudios.com.

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Only neighborhoods can save us!