Traditional Credit Assessment in Raising Money
Raising money is a daunting task to small business borrowers. Most lenders depend on traditional credit information sources and analytics such as obtaining an entrepreneur’s credit score. Providers of credit such as banks, credit card companies, depend on credit scores to assess the prospective risk posed by the potential borrowers.
For the small business borrower raising money, many entrepreneurs feel that they are at a disadvantage. In an empirical study by Allen N. Berger, Adrian M. Cowan, and W. Scott Frame (2011) found the use of consumer credit scores rather than business credit scores by community banks in small business lending when the banks underwrote small business credits. Community banks often used the scoring for only very small loans typically under $50,000. The study suggests that community banks depended more relationship lending than the using of technology when utilized credit scores for automatic approval/rejection of loan applicants.
In the U.S. the most widely used statistical credit score model is the FICO score initially developed in 1956 by Bill Fair and Earl Isaac and sold by the FICO Company. The FICO Score model is designed to measure the risk of default by taking into account numerous factors in a person’s financial history such as payment record, the utilization of credit, length of credit history, the type of credit used, and other proprietary metrics.
Currently there is an emergence of companies chasing small-business loans by using alternative data sourcing then consumer credit scores to extend credit. These companies include Capital Assess Network, Kabbage, and Amazon
Kabbage leverages social media data as part of lending decisions. The company grants working capital to online merchants as its credit risk model encompasses social media and loyalty assessments in an effort to attract, interact with, and retain small business clientele.
The Atlanta base company founded in September 2011, Kabbage connects with clients Facebook fan pages and twitter feeds. According to the Credit Union Times (Samaad, 2012), Facebook and Twitter feeds are immediately analyzed and translated into capital. With merchants increasing the number of followers, the enhanced activities and chatter on Facebook and Twitter increases the amount of capital access. Known a Social Klimbing, the merchant cash advance is called a “Kabbage Advance.”
The advance is not a loan. No interest charge is assessed. A fee is charged base on how long the advance is outstanding. No prepayment is assessed for early payments. Advances range from one to six months. The company founded a correlation between the activity on social media and default rates. Merchant cans obtain advances as low as $500 up to $100,000.
Last year in May, Bank Technology News awarded Kabbage’s CEO Rob Frohwein for conceptualizing its breakthrough technology and data platform that provides working capital to small business in less than seven minutes. In winning the Top 10 Innovator award, Frohwein was recognized for its significant impact on small business (PR Newswire, 2012).
Kabbage received venture funding by Mohr Davidow Ventures and BlueRun Ventures. Additional investors include David Bonderman, founder of TPG Capital, Warren Stephens, CEO of Stephens Inc., the UPS Strategic Enterprise Fund, and TriplePoint Ventures.
Capital Access Network, Inc.
Capital Access Network, Inc. (CAN) is becoming a significant player in providing small business credit scoring and capital. The company developed a technology platform that automatically analyzes a multitude of business performance variables that integrate data sources from banking, credit card processing data and other sources with its proprietary risk models assessing over 100,000 transactions over multiple business cycles reviewing over 650 SIC codes. Its model is considered an alternative to the FICO score. Over $2.5 billion in working capital financing were granted to small businesses since 1998 through NewLogic Business Loans, Inc. and AdvanceMe, Inc., both CAN subsidiaries.
Determining the strength of a business based on business performance rather than personal credit scores and the ability to provide access to capital has given CAN a leg up on other small business lenders. WebBank, a Utah-chartered FDIC industrial bank underwrites the loans for NewLogic Business Loans Inc. and AdvanceMe, Inc.
Headquartered New York headquarters, Capital Assess Network has presence in Boston, Atlanta and San Jose, including Costa Rica. The company employs approximately 400 people with the majority focused on data services technology and analytics.
Other Alternative Lenders in Raising Money
The companies using alternate means to assess credit risk to provide financing for small businesses include ZestCash, BillFloat and LendingClub.
Berger, A. N., Cowan, A. M., & Frame, w. S. (2011, August 1). The Surprising Use of Credit Scoring in Small Business Lending by Community Banks and the Attendant Effects on Credit Availability, Risk, and Profitability. Journal of Financial Services Research , 1-17.
PR Newswire. (2012). Kabbage CEO Selected as a Top Innovator by Bank Technology News . Atlanta: PR Newwire.
Samaad, M. A. (2012, June 27). Kabbage Links Social Media With Cash Advances. Credit Union Times, p. 15.
Bootstrapping is important for new and small businesses. Among other things, on average, many companies develop and flourished through the use of bootstrapping without access to long-term external financing, over a five-year period (Winborg, 2009). Bootstrapping is a form of raising capital (money) for the business. Many studies demonstrated the important role played by bootstrapping (Brush, N.M., Gatewood, Greene, & Hart, 2006). A large percentage of the businesses examined used bootstrapping to secure resources. These companies had reduced dependency on external financiers for capital. The positive influence of bootstrapping was demonstrated by profitability from the use of some kinds of bootstrapping methods (Patel & Sohl, 2007).
Access to capital continues to be tight. In a third quarter survey of lenders (Phoenix Management Services, 2012), the majority of lenders identified uncertainty as their chief concern regarding future economic growth. Less optimism was shown for opportunities of their borrowers, indicating a slight pullback in their own customer growth expectations and a reduction in new capital investments and hiring expectations. Respondents were asked whether they plan to tighten or maintain their loan structures i.e., collateral requirements, guarantees, advance rates, and loan covenants. Accordingly, in each of the four loan structures, 82 percent of lenders anticipate maintaining their loan structures in their in the near-term, which showed a slight shift towards tightening loan standards. For the entrepreneur, use of bootstrapping techniques will continue to play an important role in funding operations.
Ten tested and widely used bootstrapping techniques (Sherman, 2005) include:
Entrepreneurs have an explicit motive for using bootstrapping techniques. The deliberate choice of using bootstrapping strategies can be seen in proactive ways from reduce risks, restricting expenses, and funding business activities. Such techniques allow for business opportunities without the need to own a sizable resource base and without the need to source external financing. These methods minimize the need for cash by obtaining resources at little or no cost. Additionally, the use of resources can be acquired without the need for bank financing. Overall, entrepreneurs can utilize their social contacts to obtain free access to specific resources.
Brush, C., N.M., C., Gatewood, E., Greene, P., & Hart, M. (2006). The use of bootstrapping by women entrepreneurs in positioning for growth. Venture Capital , 8, pp. 15-18.
Patel, P. F., & Sohl, J. (2007). Bootstrapping to buffer a venture’s core commercialization processes. Academy of Management Conference. Philadelphia.
Phoenix Management Services. (2012). Lending Climate in America 3rd Quarter 2012. Chadds Ford: Phoenix Management Services.
Sherman, A. J. (2005). Raising Capital (Vol. 2). New York: American Management Association.
Winborg, J. (2009, January). Use of financial bootstrapping in new businesses: a question of last resort? Venture Capital , 11 (1), pp. 71–83.
Bootstrapping…bootstrapping…bootstrapping, it can be said that the purest form of entrepreneurship is bootstrapping. During the prelaunch phase of a company and at times when access to business capital is difficult, bootstrapping is the way to go. To compete with existing businesses entrepreneurial firms face two major disadvantages: the burden of smallness and the disadvantage of newness. The reality means that the majority of start-up businesses and small businesses lack available resources to effectively compete (Winborg, 2009). Access to capital is a major issue for entrepreneurs. Inexperience of many entrepreneurs has made it extremely difficult to obtain debt and equity when lack of a track record, reputation, or collateral for loans exists. Starting with personal savings, followed by funding through family and friends, have been the main sources of finance for the vast majority of entrepreneurs. Engaging in “bootstrapping activities” is the way to go in operating the business.
Do not be discouraged with the thought of bootstrapping. There exist many great American bootstrapping success stories. A snippet include (Sherman, 2005):
Apple Computer. In 1976, Steve Jobs and Steve Wozniak sold a Hewlett-Packard programmable calculator and a Volkswagen van to raise $1,350. Through bootstrapping, the partners built the first Apple I personal computer in Job’s garage.
Hewlett-Packard Co. Starting with $538 in 1938, Hewlett-Packards first client was fellow bootstrapper Walt Disney, who required sound equipment for the production of Fantasia in 1940.
Microsoft Company. With is high school sidekick (Paul Allan) and dropping out of Harvard University, Bill Gates moved into an Albuquerque hotel room in 1975 to start the company and write the programming language for the first commercially available microcomputer.
Nike Inc. William Bowerman and Philip Knight in the early 1960s sold imported Japanese sneakers from the trunk of a station wagon with startup costs of $1,000.
Lillian Vernon Corp. With her brainstorming idea of selling monogrammed purses and belts through the mail, Lillian Vernon established a mail-order company in 1951. As a recent bride and four months pregnant, Lillian needed to earn extra money to support her new family. Society in the 1950s dictated that she stay at home for the duration of the pregnancy. A home-based business was her answer. Lillian took $2,000 that her husband and she received as wedding gifts and designed a bag and belt set targeted at high school girls. She manufactured the set through her father’s leather goods company. Than placing a $495, one-six-of-a-page ad in the September 1951 issue of magazine Seventeen the company generated $32,000 in orders by the end of the year.
The use of bootstrapping requires imaginative and parsimonious strategies for marshaling and controlling necessary resources. Think of bootstrapping from two perspectives:
1. Raising money without the use of banks or investors.
2. Gaining access to resources without the need for money.
First, entrepreneurs can raise money through the use of personal credit cards, cross-subsidizing from other businesses owned or through employment, reducing the time for invoicing seeking advanced payments and loans from friends and family. Entrepreneurs can hire temporary employees, share premises and/or employees with other entities, share or borrow the use of equipment, and obtain emotional support, skills, and knowledge from friends and family.
A key question that should be asked, “Do I need it or want it?” In the event the entrepreneur needs a resource, try to use a bootstrapping technique to get it. If the entrepreneur wants a resource, defer the purchase. Preservation of cash is important. This means controlling cost too.
Based on the writing of Oswald Jones and Dilani Jayawarna (2010) some bootstrapping techniques include:
• Customer related
• Delay payment
• Owner related
• Joint use
Simply put, bootstrapping is “entrepreneurship in its purest form” (Salimath & Jone, 2011). Overcoming resource constraints enables business operations to continue with the aid of external financial resources. Bootstrapping transforms human capital into financial capital also known as sweat equity that converts into bankable equity. It is about creating value that includes the idea of “meeting the need for resources without depending on long-term financing (debt or equity). Bootstrapping is the strategy of necessity for entrepreneurs and not of choice.
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Jones, O., & Jayanwarna, D. (2010). Resourcing new businesses: social networks, bootstrapping and firm performance. Venture Capital , 12 (2), 127-157.
Salimath, M. S., & Jone, R. J. (2011). Scientific entrepreneurial management: bricolage, bootstrapping, and the quest for efficiencies (Vol. 17). Orange, CA: Journal of Business & Management.
Sherman, A. J. (2005). Raising Capital (Vol. 2). New York, NY: AMCOM, 2. 30-33.
Winborg, J. (2009). Use of financial bootstrapping in new businesses: A question of last resort? Venture Capital, 11 (1), 71-83.