Banks have traditionally shied away from lending to small businesses, and this has created a lucrative gap for a new type of lending institution catering to a sector that is reckoned to generate up to 45% of GDP and employ more than half the formal labour force.
While no one was looking, these institutions have found a way to make lending to small business profitable. Banks have approached the small business sector with trepidation because of the perceived risks of default. Their credit approval processes are seen as cumbersome and approval often takes months. Credit approval requires cart-loads of documents, including financial statements, cash flow forecasts and – of course, personal sureties and collateral.
As Moneyweb previously reported, SA Reserve Bank figures show that despite steadily rising personal debt levels, 34.5% of total bank credit in 2018 went to households. Less than 1% went to construction. Banks have moved away from their traditional function of lending to the ‘real’ economy, such as construction and manufacturing. A paper on finance and human rights prepared by the Centre for Human Rights at the University of Pretoria and the Institute for Economic Justice shows that most bank lending involves the recycling of already existing assets, rather than loans to new businesses. Clearly, a new approach is needed.
Most entrepreneurs pour their life savings into their businesses, and lack the kind of net equity required for bank lending. Yet their businesses are generating decent monthly cash flows which could be used to service debt for expansion or working capital.
The new lending institutions are sometimes called fintechs because of their use of technology to handle the onboarding, application and credit scoring processes involved. They have shredded the conventional banking model by making it possible to sign up in minutes and get loan approvals within 24-48 hours.
One of them is Merchant Capital, which started six years ago and has since lent more than R1 billion to over 5 000 clients. What’s attractive about its business model is that repayment is not term based, so the borrower can pay back in six months or six years and this doesn’t change the cost of the product, which is fixed and agreed upfront. Each time the business swipes a card through its point of sale terminal, a small percentage of that goes to the lender for repayment of the cash advance.
“We look at the entrepreneur’s previous monthly turnover, which we use as a proxy for future turnover allowing us to discount their future turnover in exchange for an upfront lump sum,” says Merchant Capital CEO Dov Girnun. “So, for example, if the cash flow projections show that the company will make R100 000 over the next 12 months, we would discount that and advance an amount of say R80 000.
“In our experience, small businesses use the funds for anything that will be additive to the growth of their business: to hire more employees, buy new equipment, refurbish their store or buy more stock. They can even use them for marketing. They don’t necessarily have to be elaborate plans, but each funding step is crucial to the next.”
Once 70% of the loan has been repaid, the borrower qualifies for a new loan on the same terms or better. Four out of five borrowers come back for second or third loans as their business expansion requires. The typical client is in the retail sector, with monthly turnover of R200 000 to R1 million. Most loans are repaid within 12 months. In 2018 Merchant Capital saw new client growth of 150%.
“Business expansion is a phased process, and banks don’t really understand this. Growing businesses need cash injections at various stages in their expansion, and our business model caters for that,” says Girnun.
The cash flow imperative
Another of the new generation lenders is Bridgement, which offers a similar easy-access loan facility to businesses. It says cash flow is one of the critical bottlenecks impacting businesses, and can affect the company’s ability to pay creditors, salaries, raw materials and other expenses – including tax.
Hence, the growing demand for this type of fast turnaround, uncomplicated lending.
Merchant Capital’s loan default rate is in the low single digits, which is lower than those of the major commercial banks. Standard Bank recognised the potential of this new approach and acquired a strategic equity stake in the company, which now offers its Merchant Capital Advance product to Standard Bank clients with a Standard Bank point of sale device. Rand Merchant Investment Holdings, which has substantial interests in OUTsurance, Discovery and MMI Holdings among others, bought a 25.1% stake in Merchant Capital in 2015.
Another fintech servicing the small business sector is Retail Capital, which offers a repayment model similar to Merchant Capital. Borrowers are required to have a card-based turnover of at least R30 000 a month and must have been trading for at least six months. The funding is unrestricted, which means business owners can use it for whatever needs they may have, such as working capital, stocking up for a busy period, advertising, remodelling, expansion, paying taxes and more. Roughly 80% of loan applications are approved, and 70% of successful applicants come back for additional loans. Once you have been approved as a client, loans can be approved in 24 hours.
Another fintech servicing the small business sector is Retail Capital, which offers unsecured funding and secured asset finance solutions with fixed or flexible repayment models. Since 2011, Retail Capital has provided over 15 000 SME business owners with more than R 2.5 billion in easily accessible funding solutions. Business owners are required to have a turnover of at least R30 000 a month and must have been trading for at least three months. The business funding offering is unrestricted, which means business owners can use it for whatever needs they may have, such as working capital, stocking up for a busy period, advertising, remodelling, expansion, paying taxes and more. The digital solution provides access to funding in 30 seconds, roughly 80% of loan applications are approved, and 70% of successful applicants come back for additional loans. Once you have been approved, loans can be approved in 24 hours.
Another fintech, JSE-listed Transaction Capital, focuses on the alternative financing and minibus taxi markets, and grew its headline earnings by 17% to R363 million in the half year to March 2019.
This segment of the lending market is unregulated, prompting the establishment of the South African SME Finance Association (Sasfa) in 2017 to self-regulate industry standards and ethics. Girnun says part of Sasfa’s mission is to educate entrepreneurs on the types of products now being offered to the market, and to ensure that they understand the mechanism of repayments and the benefits and risks.
Other members of Sasfa include Cash Flow Capital, Bridgement, Lulalend, FundingHub and AirAdvance, all of which offer variations on the type of lending described above.