Small business finance is a window of opportunity big enough to drive a truck through. Yet despite years of effort by many smart ventures, there has not yet been a breakthrough to mass scale. Many digital loan processing ventures, such as Ondeck and Kabbage have reached significant scale. Yet we are also seeing high Customer Acquisition Costs for these companies and no fundamental barrier to entry against the banks (who can acquire/build/license digital loan processing technology quite easily) and there are issues with some borrowers using the systems to borrow from one lender to pay back another lender. In another area of the market, Merchant Cash Advance ventures figured out a scalable way to loan against future credit card receipts. This works in B2C (i.e for Mom & Pop retailers) but has such high interest rates that many retailers who get hooked on this will not survive. Over in B2B, the niche that we call Invoice Finance (but which is also known as Approved Payables Finance, Receivables Finance, Supply Chain Finance and occasionally Reverse Factoring) has proven the proposition to both Lender (short dated, self liquidating assets) and Borrower (low APR %) and yet despite about 15 years, none of these have reached mass scale yet. Today’s research note looks at the thesis that Blockchain technology could be the breakthrough that makes Approved Payables Finance go mainstream.
Why Invoice Finance works for both Lenders and Borrowers
Marketplace Lending ventures have the tricky job of keeping two parties – Lenders and Borrowers – equally happy. The recent turmoil at Lending Club and Prosper shows how hard this is to do. Approved Payables Finance has the even trickier job of keeping three parties happy – buyer & seller & lender. That is why we call this niche Invoice Finance rather than Supply Chain Finance because the latter name looks at it too much from the perspective of the big company buyer (as opposed to the small company seller) but both buyers and sellers agree on the concept of an invoice.
Invoice Finance is a generic term that describes it from the point of view of the buyer, seller or lender. Generically it is cash flow secured lending as opposed to collateral secured lending and it works in B2B which uses invoices (vs B2C which uses cash or cards). Receivables Finance works on the credit assessment of the Seller (which is hard), whereas Approved Payables Finance works on the credit assessment of the Buyer (which is easy if the Buyer is big enough to have an existing credit rating). So both buyer and seller are happy with the term Approved Payables Finance which works like this:
- Seller sends invoice with agreed payment terms to Buyer and requests early payment.
- Once the invoice has been approved for payment (typically because the goods have arrived), Seller requests payment quicker than the agreed terms.
- Once the goods or service are delivered as per the agreed terms, Buyer approves the Invoice (which is now an Approved Payable).
- A Lender agrees to finance the difference between the payment terms (say 60 days) and the requested terms (say 30 days). If the buyer is a big company with a credit rating, the credit risk calculation is simple. For example, the risk of a AAA rated buyer reneging on a contractual commitment to pay on an already approved invoice is minimal.
The Seller/Borrower gets a low APR % because the Lender users the credit rating of the Buyer not the Seller (which is why this is sometimes called Reverse Factoring).
Lenders get what is highly prized in an age of ZIRP and NIRP, which is high credit quality, short dated, self liquidating assets. Lenders look at the arbitrage with Short Term Treasury Bonds and Corporate Bonds and back up the truck for as much as they can possibly get. That is the problem. Lender demand massively exceeds asset supply. Anybody operating in this market confirms that if they offer $10m of these assets, the Lender asks for $100m and if they offer $100m of these assets, the Lender asks for $1 billion.
What is holding Approved Payables Finance back from mass scale?
In other words, if Lenders are backing up the truck, why cannot Approved Payables Finance ventures deliver the scale they want? We see three structural impediments:
- # 1 The long slow death of paper. The delays in paper invoice processing make Invoice Financing too difficult.E-invoicing is an obvious benefit for both buyer and seller, but paper invoices (and paper payments aka checks) refuse to die. When e-invoicing gets to something like 90%, the buyer simply tells the other sellers to switch to digital invoices. Then the Buyer gets massive savings in their Accounts Payable (AP) department. The trend lines on this are clear, but inertia is a powerful force. This is an “inevitable but not imminent” change.
- # 2 Closed networks. The ventures that have been at this the longest, such as Prime Revenue, Orbian and Taulia operate closed networks of buyers and sellers. There is no single standard for e-invoicing, so it is based on the clout of the buyer (if a big buyer tells a Seller to use their standard in order to reduces their AP cost, the Seller may agree despite the fact that using multiple standards increases their Accounts Receivable (AR) costs. Some big buyers tie in their suppliers by offering low cost Invoice Finance (ie they become the Lender) and this gives them a more robust supply chain, but this is clearly a closed network.
- # 3 No Secondary Market. Short dated assets such as Sovereign or Corporate Bonds that reached massive scale all have a secondary market.
# 3 will only happen when #1 and 2 happen. #1 is already happening and is inevitable. So the key is having an open network for Invoice Finance. This is where the integration of the physical and financial supply chain via a blockchain could be the game changer.
The vision of Digital Trade Finance
Banks make a lot of money on Trade Finance (as I recall from years of selling Trade Finance workflow software to big banks). They make money on three transactions – short term lending & payments & foreign exchange. Invoice Finance could be the unbundling of Trade Finance aka Digital Trade Finance.
In ye olden days of Analog Trade Finance, it felt like a throwback to Victorian days with terms like Bills Of Lading and Demurrage (for a full glossary go here). A lot of the workfkow and process complexity was because tracking the physical supply chain is so hard. This is where the arrival of Internet Of Things and Blockchain could be the game-changer.
Cracking the provenance issue and tracking shipments
Flexport is a Silicon Valley venture that raised $20m Series A in August 2015 that aims to bring freight forwarding into the Internet age (out of the Victorian age of analog Trade Finance). TechCrunch memorably described them as the unsexiest trillion dollar startup.
We recently described how an immutable shared database (aka Blockchain) could create a better supply chain by cracking the provenance issue. This matters to consumers who want to know what they are buying. It is also matters in the B2B world where invoice approval gets held up by real world issues where the buyer wants confirmation of exactly where the goods came from and how they travelled to the buyer.
The physical supply chain now has a digital overlay. Everything can be tracked and verified from a computer. This is where the physical supply chain can now intersects with the financial supply chain.
How Fluent is tokenising the invoice
Fluent is a Lexington, KY based venture that recently closed a $1.65m Seed round. They are tokenizing invoices so that they can be tracked and approved on a blockchain. This is a critical innovation because it prevents the invoice from being refinanced (aka “double-spent” in Blockchain lingo).
It is a small step from there to a smart contract on a DAO that ensures that the right people automatically get paid the right amount. Sellers can get paid. Lenders can get paid. Intermediaries (such as a DAO) can get paid.
The key is that both the physical and the financial supply chain can be tracked on the same networks. Buyers can approve invoices on the Fluent Network once they receive the physical goods.
This is a game-changer for global supply chains and small business financing.
A Blockchain on Top of Banking
The Fluent Network’s blockchain is largely based on Bitcoin’s architecture, but purpose-built for global supply chains with specific focus on invoicing and payments. It is perhaps best described as a blockchain layer on top of the existing banking infrastructure.
Despite using a blockchain, the Fluent Network typically uses U.S. dollars and funds remain in custody of banks at all times. So this is practical and aims to coopt banks rather than being a rant against banks.
Fluent is a permissioned network of financial institutions and global enterprises that have an extended supply chain. It uses a hybrid consensus model, with both a federated system as well as proof-of-work security. The proof-of-work security – SHA-256 – works similar to the way it does in Bitcoin, but with one great difference: mining is not an open process anyone can participate in, but a closed circuit where participants are permissioned by Fluent.
As one of the founders explains it “Think of giving permission to your neighbors to come to an open house but locking up the good china for extra security. Also, because we know who the miners are, we don’t need nearly as much hashing power as you would on a permissionless blockchain.”
This is an example of a permissioned network that makes sense. At some point, a permissionless network that includes consumers may evolve and interact with this network. However right now, this is a game-changer for global trade and small business financing.