Can Embedded Capital Democratize Credit Access with Unbiased Data?

The problem

Small and mid-sized businesses (SMBs) play a pivotal role in driving innovation and economic growth. However, despite their significance, a staggering 53% of these businesses find themselves in a challenging predicament – they have "no current access to credit," according to a revealing statistic from PYMNTS Intelligence. This glaring gap in credit access has broad implications, especially for businesses in the nascent stages of their lifecycle.

Traditionally, this lack of access to credit was directly linked to the nature of small business underwriting. Traditional business underwriting was heavily dependent on financial statements and bureau information that created a bias of more favorable outcomes for large & more established businesses. 

Young businesses often lack sophisticated accounting processes to create robust financial statements. Financial statements are a static information source that provides a point-of-time view of the business, which may not reflect the current financial situation. 

Early-tenure businesses tend to rely heavily on the owner's personal credit. The nature of small business credit needs drives higher & more volatile credit utilization leaving these small business owners with a knock on their personal credit as they build their business. This creates a deterrent in their access to credit and hence becomes a self-fulfilling prophecy.

The early fintech solution

Post the 2008 crisis, as banks pulled back from small business lending, a wave of fintechs tried to solve this problem with underwriting algorithms that combined these traditional sources of information with bank cash flow information that was now available via opt-in methods like Plaid/Yodlee. After some initial success, scaling this business model became an issue due to several limitations. 

These early fintech efforts used algorithms that still relied heavily on traditional bureau data and did not fully solve the access issue for businesses with a low traditional credit footprint. They were primarily reliant on direct channels for customer acquisition, which led to high cost of acquisition and high fraud losses due to an adversely selected pool of applicants. In direct channels, with most of the information required to underwrite being available only at the time of application, pre-approved offers could not be served, andthe conversion of applicants to actual funded loans was quite low.

 Today’s embedded lending

Embedded lending, where capital solutions are integrated within the digital ecosystem of the business, is proving to be a game changer. 

In this model, the card processor and vertical software provider become the channel partners for the distribution of capital. Technology integration with these partners means that capital solutions can be provided to borrowers within the ecosystem that they leverage on a day-to-day basis to run their business, thereby bringing capital to their digital doorstep. This also provides lenders continuous & real-time access to revenue data of the business enabling pre-approved loan & other credit offers based on this information. 

Revenue data tends to be much more portable across industries & geographies than bureau data. Even a short revenue history can enable offers of credit, whereas a bureau score takes years to gravitate to a prime score. By tapping into revenue data and being in the flow of payments for collection, businesses, especially those deemed "too risky" by traditional models, can be given access to capital more fairly. This shift not only reduces risk but also democratizes access to credit, providing a lifeline to the small and mid-sized businesses that are often left out of the traditional lending equation. 

Embedded lending also solves the “conversion” and “cost of acquisition” issues with direct channels. Since the offers are pre-approved, most of the applicants can be approved, unlike the direct channels that have a much lower approval rate. Given the limited information required to be collected from applicants, the customer experience is much more frictionless, driving higher borrower adoption.     

Over the next few years, I believe we’ll see an explosion of embedded lending and capital products, allowing a much broader range of companies to thrive and grow with access to credit.