Alternative Credit is scaling fast today, with ventures headed to IPO. OnDeck will be the first out of the gate. It is likely that Lending Club, Kabbage and Prosper will follow. This will give OnDeck a tremendous branding opportunity. It will also put OnDeck under intense scrutiny.
The weakness in the Alternative Credit model is a very old-fashioned metric – Customer Acquisition Cost. If they have to pay a lot of money to brokers or to advertise, their CAC maybe too high.
A high CAC is fine if you get a lot of repeat business. That translates to a high Life Time Value (LTV). The metric to track is CAC/LTV. That works in a SAAS business. You spend a lot of money to acquire the customer because the churn rate is low, your CAC/LTV ratio is still OK. If you spend a lot of money to acquire the customer and the churn rate is high, your CAC/LTV ratio will be bad and that translates into a profitability problem.
This is where Alternative Credit businesses that offer short term “stop gap” funding have a fundamental CAC/LTV issue. When pressed about the high APR rates (which you get to by multiplying the interest on a 30 day loan by 12 or a one day loan by 365), the response from Alternative Credit businesses is that the APR rate does apply in their case because the borrower only needs that “stop gap” financing occasionally.
If that is true, they have a churn problem aka a CAC/LTV issue. If it is not true, because borrowers become reliant on “stop gap” funding, then those APR rates are true and that puts the borrower into financial difficulties. That is where you can end up on the front page in a bad way, like Wonga. Reputation risk and regulatory risk are closely related in the social media age.
OnDeck is not the highest APR for SMB. That dubious distinction goes to Merchant Cash Advance which is the SMB equivalent of PayDay Lending. OnDeck is close to Factoring APR costs at around 70%. You cannot run a competitive SMB with 70% APR. So this must be “stop gap” funding only. In which case, their CAC/LTV will look bad.
Businessweek has a good review of their IPO prospectus and has this to say:
OnDeck isn’t profitable. The company brought in $108 million in revenue during the first nine months of this year but reported a net loss of $14.4 million, according to the filing.
At those interest rates and with such a low cost of capital, the profitability problem cannot be at the net financing revenue level. I think OnDeck has a fundamental model problem. They can:
EITHER: Keep acquiring new customers = bad CAC/LTV metric
OR: keep the same customers coming back for more, in which case high APR rates for their customers will be unsustainable, which will lead to higher default rates.
That sounds similar to the problem that Wonga has. Those default rates then lead to reputation problems and that leads to regulatory risk.
The Alternative Credit companies that are coming later in the IPO pipeline may have this one figured out.