Helping Small Businesses Manage Cash Flow and Receivables

Helping Small Businesses Manage Cash Flow and Receivables

2 Executive Summary Table of Contents Executive Summary An unmet need Why the need is unmet What s at stake How new entrants are creating value How banks should respond The information advantage The relationship advantage Addressing the capability gaps Conclusion Banks have largely ignored small businesses need for cash flow and receivables management solutions. While several provide traditional cash management services largely as an offshoot of their commercial banking value proposition most do not have a solution for meeting their customers need for short term financing. While only 15 20% of small businesses have a small business loan, 60 70% value access to credit. The majority of these businesses seem to not want a traditional credit line or term loan. Rather, they describe the need for a line of credit that would be available to act as a reserve and buffer against occasional short term cash flow gaps. In most cases, the loan amount would be equal to between half and one month s revenues. For example, businesses with annual revenues of around $500,000 would seek credit lines of between $20,000 and $40,000. This unmet need exists largely because traditional small business lending models used by banks fail in this situation. This is driven by the high cost of manual underwriting and credit loss rates, the combination of which tends to make small business lending unprofitable. Banks are largely absent from the market for small-dollar loans for small businesses. The stakes are quite high. Oliver Wyman estimates that the total market for such cash flow and receivables management solutions represents annual profits of $2 B. Furthermore, 20% of small businesses would definitely or probably be willing to switch banks to access this solution, which represents a significant threat to a very lucrative banking profit pool. New entrants have seized upon this unmet customer need to create a lending model that is based on the simple but powerful insight that the data describing a business s cash flows can be a strong real time indicator of that business s creditworthiness. One source of data on a small business s cash flows can be its merchant services account (if it is a card-accepting merchant). Another source is the business s primary checking account (whether the business is, or is not, a merchant). These new entrants are effectively disintermediating banks. In this paper, we will profile the key developments associated with this new offering, and explore strategies that banks should undertake to counter this threat. We recommend a two pronged approach for banks: Leverage areas where you re differentiated Banks have privileged access to cash flow data and an in-person distribution channel (branches); new entrants rely on partnerships to replicate these benefits. Be honest in acknowledging what you need to build vs. buy/partner New entrants have developed better technology platforms for underwriting and servicing, and banks may also be able to leverage partners who offer this bundled with their core product, e.g. payments processing. Copyright 2015 Vantiv, LLC. All rights reserved.

3 An unmet need Banks have not done a good job serving small businesses in meeting their cash flow and receivables management needs. There are 2 products that banks can offer to meet this need: Payments management products, such as cash management, payroll services, lockbox, and cash vault. These products are reasonably prevalent, with 60 80% of banks offering one or more of these (see Figure 1). Short-term financing products, such as a line of credit to meet occasional cash flow shortfalls. These are all but absent in banks. Our research shows that only 15 20% of small businesses have an operating loan or an equipment loan or lease. It is true small businesses don t actually have many small business loans. However 60 70% of business owners say that access to credit is an important consideration to them when selecting a bank, and most of these businesses have a need for a receivables financing solution. Figure 2 shows that 50 75% of small businesses need credit, but less than 20% of them received it; the vast majority of whom didn t even think of applying for it. Figure 1 % OF BANKS OFFERING PRODUCT Merchant acquiring Credit card Debit card Wire transfers ACH Cash management Remote check deposit Lockbox Payroll services Account access authorization Corporate purchasing card Cash vault Mobile banking Escrow Source: Oliver Wyman Small Business Banking Study 2014 27% 45% 45% 64% 64% 64% 100% 100% 100% 91% 91% 82% 82% 82%

Small business owners 4 Figure 2 HAS YOUR BUSINESS APPLIED FOR A RECEIVABLE FINANCING ARRANGEMENT OR A LINE OF CREDIT IN THE PAST THREE YEARS?1 80% 70% 75% ⅓ ½ small businesses need credit and didn t or couldn t access it 60% 19% 50% 50% 3% 6% 47% 40% 30% 20% We estimate that between 50 and 75% of small businesses need credit 24% 10% 23% 0% Need credit Received credit Applied for credit and was denied Didn t apply because they didn t think they would be approved Didn t think about getting credit 1. SBs are categorized as needing credit if they ever applied for a loan or thought about it and didn t because they thought they would be denied or they exhibited cash flow needs such as using cash management strategies or having g difficulty meeting payment obligations Source: Oliver Wyman New Form Lending Survey of Small Businesses The main reason for this need for credit is volatility in the business s cash flows. Sixty percent of small businesses report cash flow volatility; half of them say it happens often. This volatility often leads to challenges in being able to meet payment obligations, such as paying large invoices to key suppliers and paying for unexpected items such as equipment repairs. Figure 3 shows that 40% of small businesses have had cash flow problems in the past year. In order to meet these cash flow needs, small businesses would like access to a line of credit which would be equal to between half and one month s revenues. For example, businesses with annual revenues of around $500,000 would seek credit lines of between $20,000 and $40,000. Copyright 2015 Vantiv, LLC. All rights reserved.

5 Figure 3 HAVE YOU EVER HAD ANY SHORT TERM DIFFICULTY BEING ABLE TO MEET PAYMENT OBLIGATIONS OVER THE LAST YEAR (ASIDE FROM PAYROLL)? WHAT KIND OF PAYMENTS ARE SOMETIMES DIFFICULT TO MEET? SELECT ALL THAT APPLY 8% of these SB owners reported difficulty in being able to meet payroll. A total of 40% of SBs have difficulty meeting some type of payment No, not really 68% Yes, it s often an issue 6% Yes, maybe a couple of times a year 26% Paying large invoices for key suppliers of raw materials or resale items Paying for unexpected items: Accumulated bills from vendors Paying for unexpected items: Repairs to important equipment or machinery Quarterly sales tax/returns/payments (if you are required to colect sales tax) Paying monthly mortgage or loan payments Paying for unexpected items: Replacement of critical equipment or machinery that breaks unexpectedly Property taxes Paying for unexpected items: Other unexpected items Other 9% 3% 17% 22% 28% 26% 24% 38% 46% 0% 20% 40% 60% Small business owners Source: Oliver Wyman New Form Lending Survey of Small Businesses (Q1 2013) Why the need is unmet It is important to understand why banks don t offer what should be considered a core product. For several years, banks have had the realization that small business loan portfolios typically show positive accounting profits but negative economic profits through the cycle. Further analysis revealed three root causes of the profitability problem (see Figure 4): High loss rates: This isn t surprising since the failure rate among small businesses is quite high, and lenders often do not have recourse to the owner s assets. Misaligned pricing: In consumer lending, risk-based pricing is very common borrowers that are at higher risk of default pay more in order to compensate for that. However, it s practically absent in small business lending. It is important to note that pricing in SB lending is customized and often at the relationship manager s discretion, and RMs tendency to discount to win the business is probably a root cause of this.

6 High unit costs: Underwriting is one of the largest drivers of unit costs, and banks typically use manual underwriters for all business loans (they have experimented with semi-automated consumer-like underwriting Figure 4 A HIGH LOSS BUSINESS Net charge-offs are high for small-dollar loans methods but have not been very successful). As the sidebar titled What is the smallest small business loan that a bank can make? shows, it is very hard to cover costs for loans less than a certain size. In addition, small businesses have MISALIGNED PRICING Portfolio net interest margin by average loan size lower approval and funding rates, implying that for every loan funded, a loan officer is reviewing multiple such applications, thus adding to the unit costs. HIGH UNIT COSTS Lower approval and funding rates result in higher per loan costs Net charge-offs (%) Net booking rate R² = 0.0035 Portfolio NM R² = 0.9203 R² = 0.7031 0 200 400 600 Average loan size ($ K) 0 200 400 600 Average loan size ($ K) 0 200 400 600 Average loan size ($ K) Source: Oliver Wyman CBA Small Business lending study 2014 What is the smallest small business loan that a bank can profitably make? Assume the following characteristics apply to the loan and the bank: Term = 4 years Reasonable spread over cost of funds = 3% Allowance of losses (EL) = 1% Capital = 6 8% Required return on capital = 20 25% pre-tax, or ~1.5% on assets Underwriter cost = $600/loan (assuming 4 hours of underwriter time @ $75/hour and a 50% funding rate) Annual operating cost = $150/loan Discount rate = 11% In order to realize the required return on capital (expressed as 4-year NPV), the minimum size loan the bank needs to make is $65,000 If the underwriting cost were to decline to $50, and the operating cost to $100/year both possible in the new cash-flow financing models, the minimum size loan drops to $22,000. This opens up a significantly larger market for banks Copyright 2015 Vantiv, LLC. All rights reserved.

7 What s at stake Banks can create a sizeable new profit pool from offering cash flow and receivables financing. We estimate that ~8 MM small businesses could have use for this product. Given that the average small business would use this 2 3 times a year, and have a revolving balance between half and one month s revenues, we estimate that the potential revolving balances could approach $80 120 B. Given current spreads, this translates into a $1.5 2.5 B profit pool, or a 15 25% increase in total bank profits from small businesses. There is also a significant first-mover advantage associated with offering this product. According to our research, 20% of small businesses would definitely or probably be willing to switch banks to access this product. The increased switching propensity is impressive given that small businesses rarely change banks and typically only do when pushed out (see Figure 5). Only 6% of small businesses switched their primary bank in the last 18 months, and more than a third of these switchers did so because they were dissatisfied with their existing bank. Acquiring new small business customers via this product then gives the bank access to very lucrative other revenue streams from deposits, credit cards and merchant services. As we described in an earlier Vantiv Oliver Wyman white paper titled High Value Small Business Targeting, these three products account for almost all the profits in small business banking. Figure 5 IF YOUR BUSINESS S PRIMARY BANK DID NOT OFFER THIS PRODUCT BUT ANOTHER NEARBY BANK DID, WOULD YOU SWITCH PRIMARY BANK IN ORDER TO ACCESS THIS PRODUCT? 2, 3 HAVE YOU RECENTLY SWITCHED YOUR BUSINESS S PRIMARY BANK? Definitely not 9% Definitely 1% Probably 19% Yes, in the last 18 months 6% Yes, over 18 months ago 7% Probably not 26% Unsure 45% No 87% 2. Excludes respondents who would definitely not use a preapproved line of credit 3. Of those identified as needing credit Source: Oliver Wyman New Form Leading Survey of Small Businesses

8 How new entrants are creating value Players such as Kabbage and OnDeck Capital which provide financing to small businesses have seized on the simple but powerful insight that the data describing a business s cash flows can be a strong real time indicator of that business s creditworthiness. One source of data can be its merchant services account (if it is a card-accepting merchant). Another source is the business s primary checking account (whether the business is, or is not, a merchant). Using these data sources helps reduce unit costs by increasing the automation of the underwriting process, and by improving risk discrimination (and pricing). The idea of examining a small business s near real-time cash flows to derive risk insights seems to have originated in the world of merchant receivables financing. Starting 10 15 years ago (see Figure 6 for a timeline of this industry), firms like Capital Access Network and AmeriMerchant emerged to advance funds to card-accepting merchants based on an analysis of the patterns in their monthly charge volumes. Extending that logic, firms now use a combination of merchant account and/or DDA cash flow patterns to assess a business s creditworthiness. The wider view is rapidly becoming the standard template and makes this approach work for both merchants and non merchants. This wider view takes a more complete cash flow picture than merchant receipts alone and more-than-doubles the total market by making financing available for both merchants and non merchants. Figure 6 NEW ENTRANTS INTO THE US MERCHANT CASH ADVANCE INDUSTRY Extensive product portfolio including term loans, MCAs and accounts receivable finance Since 2007, OnDeck has funded over US$1 B in loans Since 2011, IOU Central has funded over US$84 MM in loans Merchant Cash & Capital Merchant Capital Source OnDeck Kabbage IOU Central Newtek Business Financial Services Capital For Merchants GRP Funding LLC MCA Merchant Capital Access American Express PayPal 1999 2001 2003 2005 2007 2009 2011 2013 1998 2000 2002 2004 2006 2008 2010 2012 CAN Capital AmeriMerchant AFS American Finance Solutions Rapid Advance AmazonLending Swift Capital Strategic Funding Leading MCA provider with over US$2.5 B funded amount US$1 B in funded amount since 2002, offering MCAs, loans and inventory purchasing program Works cooperatively with other MCA providers to co-fund larger MCA opportunities 2012: OnDeck secured US$80 MM in syndicated loan and US$17 MM in venture debt 2013: CAN Capital secured US$460 MM in syndicated loan from banks including Goldman Sachs and Wells Fargo Copyright 2015 Vantiv, LLC. All rights reserved.

9 A second innovation in this product is the use of a daily remittance cycle to administer the loans. A key early feature of this type of financing was the idea that advances would be repaid directly from the merchant services account. This led to the deployment of daily remittance platforms that could connect directly to a merchant services account (or, later, to a DDA account), and process small loan principal and interest payments on a daily, as opposed to the more traditional monthly, basis. Our research shows that more than half of small businesses are either indifferent to or prefer daily repayments. In a daily remittance cycle, the borrower accepts a commitment to repay interest and a slice of principal in small increments each day over the term of the loan (or cash advance) rather than the standard monthly remittance cycle of almost all other bank lending (see Figure 7). The daily remittance cycle offers two benefits. First, by monitoring the advances and payments on a daily cycle, the lender is more on top of things and in a better position to respond to late payments as well as to adjust and potentially increase or decrease the loan or line size. This makes intuitive sense: if a lender is reviewing monthly, weekly and daily cash flows as a basis from which to infer creditworthiness, i.e. to underwrite a loan, then she would also administer the loan on a daily remittance cycle. The second benefit is that the use of a daily remittance model helps smoothen the cash flow impact of the new loan for the SB; after all, monthly remittance introduces yet another source of cash flow lumpiness and cash flow volatility was the issue the business owner needed the loan to address in the first place. Figure 7 THE RELATIONSHIP BETWEEN BANK, SMALL BUSINESS, MERCHANT ACQUIRER AND INDEPENDENT NEW ENTRANT (E.G. ONDECK CAPITAL) FROM LENDER 3a Daily loan repayments, fees and interest (for new-form bank loans) 1 NEW-FORM LENDER $$$ Loan advances Daily loan repayments, 3b fees and interest (for merchant advances) If this weren t already a frontal attack on banks core value proposition to small businesses, players such as PayPal and Square are taking it a step further by combining this with their core payments processing offering. They already have access to the transaction data through the acquiring relationship; why not leverage that to offer the lending product as well? Such an offering reduces the value of banks merchant services offerings Non-card sales receipts 2a (checks, wires, cash, etc.) SMALL BUSINESS SHOP 2b Credit, debit and charge card receipts PRIMARY BANK (with DDA) BANK 3c Deposit the rest of amount after repayment MERCHANT ACQUIRER/ MERCHANT SERVICE BANK PayPal or Square can match the bank on the merchant services offering, and add the flexibility associated with the availability of a line of credit to make the offer differentiated. The implications of this are even more severe banks could lose share in merchant acquiring, which is one of the largest profit pools in small business banking, and a critical source of capital-efficient income. OK

10 How banks should respond While new entrants have a significant head start, we believe that banks, with their extensive small business deposit bases, have a significant information and relationship advantage. They also have a few capability gaps, but those can be overcome via partnerships and licensing arrangements. The information advantage A bank that provides a business with its primary DDA has access to real time cash flow data for the business (if the bank has the merchant services relationship as well, then it s even better). Using this data, a bank can generate a more accurate assessment of creditworthiness than it could the old-fashioned way, and get to this point much quicker and more cheaply. Of course, the underwriting process will likely use additional inputs. But for smaller lines or loans, an adequate assessment of risk can be made at low cost, through a combination of cash flow data and selected use of traditional credit scores and tax returns. Our experience shows that cash flow data is significantly more predictive than credit bureau data. Figure 8 shows that using a DDA based cash flow score is twice as effective as using credit bureau data alone. Finally, using DDA data allows the bank to underwrite all types of businesses and not just card-accepting merchants, which is a significant advantage over the receivables financing players. Figure 8 EXAMPLE: DDA-BASED CASH FLOW SCORE DISCRIMINATORY LIFT OVER CREDIT BUREAU (SMALL BUSINESS) 120% 100% Cash flow score % of bads eliminated 80% 60% 40% 20% 2x more effective SB owner Consumer bureau Cash flow score 1:1 ratio 0% Personal credit score 0% 20% 40% 60% 80% 100% % of population Source: Oliver Wyman client experince Copyright 2015 Vantiv, LLC. All rights reserved.

11 The relationship advantage Having an existing relationship also makes it easier for the bank to distribute this product in a cost effective way. First, the marketing cost of attracting qualified loan applicants will be significantly reduced through the likely mechanism whereby many small business customers will be pre approved for a cash flow loan and later upgraded when they qualify for a more traditional line that does not need to be validated on a monthly basis. And from there, successful, growing businesses may further qualify for multi-year term loans. Second, branches give banks a low incremental-cost distribution channel. Unlike consumers, small businesses are not abandoning branches in droves; 70% of them visit a branch at least once a month. This gives small business bankers the opportunity to have an in-person discussion on whether this product meets the small business s needs. This has the potential to be a richer interaction than what the small business owner can have online, and is higher likelihood to result in a sale. Ownership of lending products also makes customers stickier to the bank, so there s the added benefit of higher relationship tenure and retention rates. These two advantages counter the three root causes for banks not being active participants in this space, as we identified earlier. Given better predictive power of the cash flow data, banks can cherry-pick the risks they want to carry on their balance sheet. Better assessment of risk also helps banks price for it appropriately. Using automated underwriting and pre-approvals reduces operational and marketing costs. Addressing the capability gaps The biggest challenge that banks face in offering this product is the absence of a robust infrastructure, such as a loan platform which allows for daily remittances. Most banks do not have the appetite or the investment dollars for building one from scratch. Several banks do not have the resources or the capabilities to do automated underwriting. We see three options for banks to address these gaps: License the technology: Several receivables financing players have built automated underwriting and daily remittance platforms. Banks can license the technology from these players and pay an annual fee. However, the receivables financing players may be more interested in acquiring customers, since they re lenders too. Partner with a receivables financing player: Banks can also enter into broader partnerships with receivables financing players whereby they refer their turn downs to the receivables financing players. So banks get to keep the credit risks they want and pass on the ones they re not interested in. They get access to the platform and in return, they provide new customers to the receivables financing player. Partner with a merchant acquirer: Most banks partner with a merchant acquirer to offer card acceptance services to their small business customers. Several of these acquirers have partnerships with receivables financing players (e.g. Vantiv has a partnership with Amerimerchant) so the bank can reduce friction and create a better experience for its small business customers by only having one firm act as the intermediary. What is critical in this arrangement is to ensure that the bank s small business customer doesn t get handed off too many times and then end up blaming that on the bank.

Conclusion As we highlighted in our earlier white paper titled High Value Small Business Targeting, the majority of Small Business Banking profit currently derives from high-balance checking accounts, merchant services accounts and credit cards. The growth of cash-flow financing will certainly add to that profit pool. The biggest positive impact of this for an individual bank, however, may not be the profit that it adds directly, but the role it can play in crafting a winning value proposition that is used to win over high-value prospects in the sales process and protect existing high value customer relationships against competitive inroads. It is a great opportunity for banks, and one where they have the right to win. About Oliver Wyman This Helping Small Businesses Manage Cash Flow and Receivables paper was prepared by the Financial Services practice of Oliver Wyman, a leading independent management consulting firm, and all opinions expressed are solely those of Oliver Wyman. Oliver Wyman serves Global 1,000 clients on a wide range of strategic issues, and counts 75 of the global top 100 financial institutions as its clients. The firm has guided some of the world s most sophisticated institutions on their retail banking and payment strategies. Oliver Wyman s staff of 3,000 operates from offices in more than 50 cities in 25 countries. For more information, please visit www.oliverwyman.com. About Vantiv As part of its ongoing commitment to industry thought leadership, Vantiv commissioned a series of reports of topical interest to financial institutions, including this report, but had no editorial influence over the facts and opinions provided herein. Vantiv is one of the leading integrated payment processors in the United States, differentiated by a single, proprietary technology platform. Previously known as Fifth Third Processing Solutions, the company, headquartered in Cincinnati, Ohio, changed its name to Vantiv in 2011, and became a public company in 2012. Vantiv is the third largest merchant acquirer and the largest PIN debit acquirer based on number of transactions in the US (Source: The Nilson Report). The company s growth strategy includes expanding further into high growth payment segments, such as integrated payments, payment facilitation (PayFacTM), mobile, prepaid and information solutions, and attractive industry verticals such as business-to-business, ecommerce, healthcare, gaming, government and education. For more information, visit www.vantiv.com. Copyright 2015 Vantiv. All rights reserved. Vantiv Corporate Headquarters 8500 Governors Hill Drive, Cincinnati, OH 45249 866-622-2880 www.vantiv.com