OnDeck is currently one of three ventures on my Fintech IPO Watchlist. Like Lending Club, OnDeck Capital is in the “alternative credit” space i.e. not via banks. OnDeck is clearly focused on small business lending. Lending Club is more generalized but HBR analysis shows that a big growth driver for Lending Club is small business lending.
Small business lending is one of the biggest and most broken markets. Two other lending markets work – imperfectly but they work:
- Consumer Lending works because of FICO scores. There is increasing acceptance that FICO alone is a broken model (subject for another post). However FICO does sort of work, a bit inefficiently, at least much of the time for many Lenders and Borrowers.
- Corporate (Global 2000) Lending works because of Credit Rating Agencies. Moodies, S&P & Fitch rate Investment Grade Companies. Again, there is plenty wrong with how this works today, but Corporate Lending to Investment Grade Companies does sort of work, a bit inefficiently, at least much of the time for most Corporates and Lenders.
In comparison, small business lending is fundamentally and completely broken. Lenders resort to treating small business borrowers either like Consumers or like Corporates:
- Like Consumer: “we will lend to you, secured against your house, and you can lend to your business. This is the tough reality that most entrepreneurs have learned to accept i.e. that business failure could lead to loss of your home.
- Like Corporate: “show me your 3 year P&L and we will consider a term loan”. This is an expensive, labor-intensive business for the Lender, so it is expensive for the Borrower and, as Banks exit this business, it is also increasingly rare.
There are two lending models that are native to small business lending, both of which take from contracted future revenue to give you cash today:
- Factoring (in B2B)
- Merchant Cash Advance (in B2C ie for Retailers)
These native small business lending models work and they have scaled for both Borrowers and Lenders, but most small business owners hate them for their high fees and interest rates.
There are two ways to go after big broken markets such as this:
- Add a layer on top of the existing ecosystem. This could be derided as “painting lipstick on a pig” but when markets are as big as this, there are big short-term opportunities with this strategy. The natural exit is via Trade Sale.
- Fundamental innovation that will create a new ecosystem. Any company aspiring to IPO must do this.
I have not yet dug into the OnDeck model to see which strategy they use. I assume there has to be fundamental innovation that will create a new ecosystem, because they are doing an IPO. So tomorrow’s post will be “Understanding OnDeck’s secret sauce”.