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Forever A Loan - A Look At Lending

As long as civilization has existed, people have had a basic problem: they want to buy or build things but don’t have the cash. And so, we invented the loan - I’ll give you the money if you promise to return it, along with a little extra for my trouble. Without this basic financial instrument, there are fewer entrepreneurs, fewer scrappy stories of building something from nothing. The only ones who can build are those who already have capital, or those that slowly bootstrap and save their way to growth. And it is no coincidence that today, the economies with access to cheap capital are the ones leading the pack in building innovative technology, quickly. Every time we get better at evaluating risk and offering credit in new ways, we’re able to unlock a higher multiplier of growth for our economy.


A Short History Of Lending


In the 17th and 18th century, maritime shipping of goods was an extremely lucrative business, but it could also be very risky. So shippers would seek insurance from wealthy people - the shipper would pay the insurer a premium, and in return, the insurer would make the shipper whole if the ship sank. Just like a bank today deciding whether to provide a loan, the insurer had a thorny problem - they could make a boatload of money, but only if they could reliably tell which ships to underwrite and which to reject. In other words, they needed data. A man named Edward Lloyd was going to give it to them.


Edward Lloyd operated a small coffee shop in 17th century London. Over time, it became a gathering place for merchants, underwriters, and other people involved in shipping goods. Lloyd realized that a lot of valuable information was passing through his shop, and began writing down the news of the day and circulating it among his patrons. This information was gold - it contained detailed information about the condition and seaworthiness of ships, which insurers could use to decide which shippers to insure. That piece of paper became Lloyd’s Register, a compendium of the ships and crews of the day. If Lloyd’s Register gave a ship a good rating, an insurer could offer a lower premium to that shipper because their risk was lower. As a result, high quality shippers were rewarded with more business and cheaper insurance.


This story illustrates an important theme - better data means cheaper capital, and with cheaper capital comes gains for both merchants and lenders. The next chapter in the story comes in the beginning of the 19th century. Let’s say you were a farmer living in 1820s Virginia, and you needed a loan so you could buy seeds for this year’s cotton crop for your humble farm. You wouldn’t go to your town bank - they only lend to the wealthy and politically connected. Instead, you’d approach your friend Fred at the local supply store. Since Fred’s known your family for years and your dad fixed his roof last year, Fred is happy to lend you the seeds with the promise that you’ll pay him back after the harvest in the late summer.


This is how credit worked for the working class in the early 19th century. Credit came not from banks but from merchants and store owners, who mitigated risk by extending credit only to friends and family. The limitations of this are obvious - would-be entrepreneurs with few connections were locked out of startup materials.


On the other side of the spectrum, banks would soon learn that lending to the wealthy was not as sure a bet as it would seem. Following years of relentless growth in land value and cotton, banks were forced to raise interest rates due to running low on monetary reserves. At the same time, the price of cotton began sharply declining due to lower transportation costs, and a speculative land investment bubble was collapsing. This came to a head in the Panic of 1837, when banks in New York famously ran out of gold and silver as people frantically tried to withdraw their money. This kicked off one of the largest depressions in US history.


Again, the problem was risky lending to speculative investors. Banks needed data - they needed to figure out who was likely to repay their loan, and who wasn’t. The solution was an authority that could determine the creditworthiness of borrowers. Following the Panic of 1837, the first commercial credit organizations formed, the predecessors to Equifax and Experian today. These organizations would keep a ledger of transactions and loans taken out by individuals, and banks and merchants could consult them to inform their lending decisions.


Credit reports helped banks make smarter loans. Thus, fewer borrowers defaulted on their loans, and banks were able to charge a lower interest rate and still make a profit. This was great news for both the banks (whose cash reserves were less volatile and thus were less likely to fail) and successful entrepreneurs (who could keep more of the profits from their ventures). But now even Fred, the local shop owner, is willing to lend his merchandise on credit to the new folks in town, provided one of the credit agencies gives a thumbs up.


A New Way To Lend


Now, jump forward to this century – the last ten years have seen a renaissance in fintech. Total investment in fintech increased 35X over that time period, from $6B in 2011 to just over $210B in 2021. Many of those companies are built on the idea that traditional lenders are unable to serve the needs of many deserving businesses. With new technology, these fintechs are leveraging data to finance underserved markets. As a result, businesses needing capital have more options than ever. Let’s talk about a few.


Kabbage was founded right here in Atlanta in 2011. Their value proposition was simple - fast cash. Traditional lenders can take up to a month to approve a loan, and the process is often long and tedious. Kabbage offered small businesses short-term loans that were approved within minutes. To underwrite these loans, Kabbage used data like transaction history, credit score, and even social media activity. They’re now one of the largest lenders in the country by volume - compare their 270,000 PPP loans with JP Morgan Chase’s 274,451 as of July 2020.


In September 2019, a fintech startup called Pipe was founded in Miami. Less than two years later, they raised $250M at a valuation of over $2 billion. Pipe is a company based on the key insight that VC firms had 20 years ago - Saas companies have extremely reliable recurring revenue. Traditional lenders had not caught on yet - they look at current assets or outstanding receivables when determining the creditworthiness of a business. Pipe, and others like them, began offering Saas businesses much better terms than those that traditional lenders could offer. Now, tens of millions of dollars flow through the platform every month.


Another genre of fintech that has flourished in the last decade is buy now, pay later companies. Affirm, Klarna, and Afterpay each offer similar services to retailers, and each one has a market cap of over $1 billion. The idea of buying goods and paying for them in installments is actually not so new. In fact, Americans have been buying large items like cars and televisions using installments since the early 20th century. Like Kabbage, what these BNPL companies actually offer is speed and convenience. Retailers know that consumers will spend more if they don’t have to pay for merchandise up front, but they don’t want the headache of underwriting and managing financing. So they outsource it to companies like Affirm, who perform a credit check on consumers and approve or deny them within seconds. They are valuable businesses because they have instant access to data on the creditworthiness of consumers and can offer them financing at the point of sale, and retailers are willing to pay for that.


If you’re looking for financing, but you don’t like the terms that banks or fintechs offer, then you have another option: crowdfunding. Over $73 billion was raised through crowdfunding in 2020, and that number is growing quickly. Crowdfunding is an interesting comparison to traditional lending. Backers of crowdfunding campaigns are generally not looking at assets, receivables, or P&Ls like banks are. Instead, people are voting with their wallets on projects that they like. It’s a way to validate a business in a way that traditional lenders can’t - if thousands of people like a business enough to contribute money to the project, it has a good chance of being successful.


The upshot of this is we are getting better and better at offering financing to entrepreneurs. Capital is the fuel that feeds our businesses. And every time we figure out another way to offer that capital, we are paving the way for more wealth for everyone.


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