What’s Next for Small Business Lending?
The last few weeks have led to a lot of thinking about what comes next – for our families, our friends, for our local communities, and for our country. A chief concern during this uncertain and unstable time is what will the economic impact of the COVID-19 health crisis be for Small and Medium sized Businesses (SMBs). This is a concern that is near and dear to my heart. Like many Americans, my life revolves around SMBs: over half my career has been directly focused on lending to SMBs, my weekends consist of frequenting local businesses with friends (shout out to Pop’s SeaBar, Rebellion DC, and Dupont Market), I work for a SMB, and my dad is a fractional CFO for multiple SMBs. What comes next will be different, and it’s worth exploring how banks and lenders will be positioned and ready to support SMBs – and create value – on the back side of this recession.
In the short term, businesses are likely to be propped up by a combination of support functions and forces:
Direct government support through personal stimulus checks and forgivable loans to SMBs (the details are just now coming into focus)
Indirect government support through the expansion of SBA lending
Landlords/creditors with limited options - would you foreclose on a property if there is no way of filling a vacancy for at least 6 months?
This support will help many businesses survive the current environment. Some will still fail. Those that survive will have serious questions about the future outlook for their business. It is also important to remember that this support will not last forever. A return to a semblance of normalcy will require businesses to find other avenues for support, and for many that support must be an infusion of cash (debt or equity) to keep the business moving.
How will banks and lenders help?
Small Business underwriting is traditionally a very conservative practice. Loan lead times are the most common challenge for borrowers at large and small banks[1], most banks use similar ratio analysis methods, and <1% of banks view underwriting as a top 3 competitive advantage[2]. This led to 54% of businesses not receiving the financing they seek for loans less than $250,000, even in a previously strong economy! [1] The “perfect” borrower is an unrealistic standard. Let’s be honest, the 25-year-old business with a track record of 10% increase in annual sales, 30% net margins, and a Debt Service Coverage Ratio over 3 doesn’t exist. If they do, they certainly don’t need financing.
These standards will become particularly antiquated after this recession. The typical data sources used for underwriting will be riddled with question marks. Did customers receive payment holidays? Did the lender choose not to report missed payments? Are all negatively trending cash balances a sign of future risk? How are year-over-year revenue trends evaluated? The potential list of questions will be long and varied.
So what needs to happen? Here are a few of my early thoughts:
Underwrite the business on two time periods – pre and post COVID-19. The first serves as a demonstrated baseline for long term performance. The second provides insight into what was lost and therefore must return for the business to reach its desired performance.
“Character” must have greater influence in the 5 C’s of Credit, but not in traditional ways. Often, credit history is a proxy for a business’s Character. If credit history data is flawed, Character could take the form of the owner’s dedication to the business, its employees, and its reputation. Did the business prioritize maintaining cash balances over employee salaries? Did the business exhaust all options to remain operable, or did they fold early? If the owner was willing to risk personal failure for the benefit of the business’s stakeholders, rather than make monetary metric-based decisions, then they should score high on Character. Those borrowers have the drive to re-establish the business, find success, and most importantly for banks, pay back their loans.
Many businesses will have to compile and submit expense documentation to participate in new government backed loan programs. For future loan applications, banks could have businesses submit these documentation packages instead of a portion of the traditional documents gathered for loan applications. This lowers the burden on business owners during the application process while still providing banks with a detailed view of business expenses. If we are lucky the government will create standardized loan documentation forms and processes, which then presents an opportunity for automated financial spreading and analysis.
Prioritize loan decisioning speeds. The re-introduction of “normal” economic activity will create a first mover’s opportunity for highly impacted industries. Faster decisions leads to faster funding, increasing the business’s chances of early success and improving the quality of the bank’s loan.
If banks are part of the solution, then they must adapt. Those that successfully adapt, and meet customers needs in difficult times, are likely to create long term loyal and profitable relationships. Most folks in the industry will have ideas on how to solve this – I know I do. We’ve helped SMB lenders craft credit policies for new products, optimize current policies, and provided strategic advice to lenders in an ever evolving market. It’s early, and every situation is different, but we at AQN would love to hear how people are thinking through this and to share our view. Diversity of opinion and ideas will help create the best solutions.
Every job an SMB creates or maintains is one less person without a paycheck. That’s one less person with no means to buy food for their families, one less person without a way to pay rent or their debts, one less person trying to find work and normalcy after these unprecedented times. There is a cost to not helping these businesses, and that must be factored into what comes next.
Let’s be part of the solution.
[1] https://www.fedsmallbusiness.org/medialibrary/fedsmallbusiness/files/2019/sbcs-employer-firms-report.pdf
[2] https://www.fdic.gov/bank/historical/sbls/full-survey.pdf