Blog Post

Servicing SME Customers Through Embedded Lending

SMEs (especially the very small ones) are a massive market; they represent  over 99% of businesses, almost three quarters of which are actually single-employee entities. As common as they are, these companies often face unique challenges in attaining operational funding to meet seasonal shortfalls, overcome supply chain hiccups, expansion, and other ongoing challenges.

Their requests are sometimes rejected by banks — or the process is too lengthy and complicated to help in the short term — due to the inherent nature of small business:

1.    Lack of collateral – Risk and thus price to the SME increases when there are no assets to secure any financing facilities. This can be due to a variety of factors, such as small quantities of equipment or real estate, or the fact that a service-based firm may simply have no need for many physical assets of redeemable value.

2.    Perceived as being of greater risk than larger companies - Due to their size and possibly niche products or services, with the corresponding risk to revenue streams. This perception can make it difficult for startups and other young or small-scale companies to secure financing.

3.    Insufficient credit history – If they have not borrowed often, newer or independently funded SMEs often have limited easily accessible credit histories, which can make it difficult to assess trends and financial stability.

4.    Lack of financial expertise - SMEs often lack the financial expertise required to build and present a strong financial model. This can make it difficult for them to secure financing from lenders who may require detailed financial projections and business plans. This reality may also make it difficult for them to understand the “fine print” on loan agreements.

5.    No history of consistent cash flow - This can make it difficult for SMEs to demonstrate their ability to repay a loan. Without easy access to data indicating a strong track record of generating revenue and controlling expenses, some lenders may view SMEs as too risky to lend to.

A two-sided conundrum

To be clear: banks are not to blame here; they need to be conservative when dealing with higher-risk entities as their capital reserves must be increased commensurate with the increased risk. Likewise, the SME is often not doing anything wrong; it is the nature of their business to simultaneously need periodic funding urgently while lacking the usual assurances that a loan will be repaid on time. 

Banks: No longer the only game in town

SMEs most often prefer to turn to their bank — the one holding their account and with whom they have a relationship. Their reasoning is simple: In addition to the bank being a familiar, known entity, their account’s financial details should provide some insight into the risk level of the requested loan. The problem is that even with this advantage, the traditional model requires significant data, paperwork, and time. As such, many SMEs do opt to try alternative sources:

·    Credit cards —often the personal credit cards of directors or shareholders, leveraging their own generous credit limits earned over time.
·    Peer-to-peer (P2P) lending — Also known as “social lending” or “crowd lending,” this is an emerging financial technology that connects borrowers directly to lenders, cutting out the financial institution as the middleman.
·    Third-parties, friends and family, or other investors – This approach does not have a set structure, can be expensive or uncomfortable to manage, and dilutes equity holding of existing shareholders.

Each of these approaches is usually expensive and deployed only as a last resort.

In the meantime, to fill this vacuum, neo-banks and fintech startups are trying to get in on the action, with innovative, customer-first, user-friendly design and functionality. However, many do not have the financial backing to make their offerings as affordable as can an established bank.

What are the options?

To maintain their dominance, and to attract new customers while keeping existing ones, banks need to expand their menu of financial products. These include:  

·    General-use operational (typically short-term, unsecured) or longer-term (secured) expansion loans – Operational loans can be used for a variety of purposes such as paying bills or purchasing inventory, as well as to weather seasonal dips or unexpected expenses. They often do not indicate inherent instability, but rather a temporary “cash flow crunch” that may hinder regular business activities. Longer-term expansion loans are secured loans that can be used for larger expenses such as expanding the business with new locations, staff, and/or products, and the associated large equipment purchases to support these activities. These are very often positive indicators of a flourishing business, and loans are more easily secured with collateral.

·    Asset financing - A type of financing that allows SMEs to purchase assets such as factory or office equipment, with those specific purchases serving as collateral, the key advantage being that it provides SMEs with funds specifically for the equipment they need to accelerate revenue-driving business without having to pay for it all up front.

·    Inventory or stock financing – Similar to asset financing, this loan allows SMEs to purchase inventory or stock, the sale of which is used to return the principal plus interest. The key advantage of these is that SMEs get access to the inventory they need to sell their products without having to pay for it all upfront; both the inventory itself — and the motivation of the company to sell it for its own profit — reduce risk.

·    Invoice financing - Invoice financing is a type of financing that allows SMEs to borrow money against their accounts receivable. The advantage of invoice financing is that it provides SMEs with access to cash quickly and easily without having to wait for their own customers to pay their invoices. Here the key advantage is that the lender is essentially purchasing those invoices at a discount, which almost eliminates risk (a remnant of which remains in collection). The cost is, ideally, covered by the SME’s new business opportunities (or simply the ability to continue to generate revenue).

·    Lines of credit, and other revolving credit products such as overdrafts and credit cards - Lines of credit and other revolving credit products provide SMEs with access to cash when they need it without having to go through the process of applying for a new loan each time. A key advantage with these is that the agreements provide SMEs with flexibility and convenience for numerous financings, requiring only a single application process.

Putting the menu on the table is not enough

While there is incredible value to offering a long catalog of options like those above, it’s not enough to simply offer these products. If the application and approval are a long, manual, and painful process, both the borrower and the lender suffer from the heavy cost in time and overhead in the interaction.

But it’s not always possible to do this quickly; banks prefer a consistent, predictable business model to use as the basis of their risk assessment. When compared to large businesses, SME lending is often a lower priority for banks because their overhead in dealing with unique, one-off, “let me explain how our business works” processes cost them more than the profit margin on the loan’s interest.

In parallel, from the SME’s perspective, they expect a digital experience that’s re-imagined and streamlined, taking a fraction of the time compared to the traditional approach. As mentioned at the start, if the funds arrive too late, the company may have challenges in functioning at all. 

The Solution? Embedded Lending

Most larger banks do offer these products, using their traditional approach. However, creating an app-based implementation for each, using automated, algorithmic assessment tools to radically slash time is a serious decision. For a bank’s IT department, building these frameworks for each of these offerings would be a significant distraction, requiring a dedicated, stand-alone team.  Alternatively, banks can accelerate access to these products by integrating an embedded lending solution with a fintech partner where the partner brings:

1.    The technical expertise for development, connecting via APIs with minimal implementation work by the bank

2.    Well-proven building blocks to deploy as needed, rather than re-inventing the wheel for each product or feature

3.    A super-intuitive, user-experience focus, typical of young, dynamic startups

4.    Streamlined risk-assessment tools that combine both internal and external sources, virtually in real-time

5.    Knowledge of security and compliance issues — many of which are frequently updated and in flux by regulators.

There is no reason for a bank to tackle this challenge on their own when looking to create a modernized, faster, automated system for a loan process that saves time for both their team and their clients, while maintaining or even reducing risk. A veteran fintech partner can integrate an embedded solution into the bank’s app (or help create a new one). Select one who has “seen it all” and can avoid the delays pitfalls or experimentation in the hope of optimization as they learn the ropes for each new banking partner.
Their proven, flexible, and bullet-proof platform should provide quick time-to-market and minimal stress on the bank's IT team.

Want to learn more on our embedded lending solution, head to our platform page.