What is Alternative Underwriting?
The “status quo” capital product in small business finance is the term loan. Entrepreneurs are generally familiar with the basic features of a term loan — probably the most common and widely understood form of capital, thanks to the ubiquity of auto and home loans in the United States. The essential elements of the business term loan are straightforward: a single distribution of capital upon loan closing is followed by immediate recurring repayments of principal loan amount plus interest, based on a fixed interest rate and a pre-established amortization table. There aren’t many surprises to be found in the fundamental economics of small business term loans today, especially from the perspective of the borrower.
There are, however, some significant innovations taking root across the country related to which businesses receive term loans, and how lenders assess an entrepreneur’s creditworthiness.
Chief among these innovations is a growing trend away from traditional underwriting methods — which tend to rely on historically discriminatory features such as asset-collateralization and individual borrower credit metrics (eg. FICO score) — and toward alternative underwriting measures. While the fundamental capital product remains the same as a typical term loan, an Alternatively Underwritten Loan (sometimes called “Character-Based Loan”) features a distinct and more in-depth underwriting process. This process often foregoes the elements of collateral and credit score entirely, in exchange for an intense focus on individual borrowers’ competencies, business plans, cash flow, and potential trajectory.
Unlike many modern trends in small business finance, innovations in the Alternative Underwriting space aren’t coming from the likes of Silicon Valley Fintech firms, but rather from local and regional CDFIs, nonprofits, and grassroots entrepreneur support organizations in pockets across the country.
Case Study — B:Side Capital & B:Side Fund Direct Lending Program
Rocky Mountain MicroFinance Institute Case Study
Two Types of Alternatively Underwritten Loans: Standalone & Programmatic
When a lending institution decides to offer debt capital to small business borrowers using an alternative assessment of creditworthiness, they have essentially two options:
- Standalone Loan Product: The lender establishes a systematic application process, underwriting policies, and fund structure to offer a streamlined alternatively underwritten loan product. Business owners apply for capital from the lender just as they would from a bank, and are directed by the lender to submit information in accordance with the underwriting policies. The lender makes loan offer decisions internally based on the underwriting criteria they have decided upon, and the entrepreneur repays the loan exactly the same as any term loan.
- Programmatic Alternatively Underwritten Lending: An organization with the capacity and structure to provide longer-term direct technical assistance to small businesses may decide to incorporate alternatively underwritten debt capital into their offerings for the entrepreneurs they serve. Over the course of a support program or small business development curriculum, debt capital is offered to entrepreneurs based on predetermined program milestones or measures of business success. Entrepreneur creditworthiness is assessed interpersonally, over the course of the program, and is often informal in nature.
Why Alternative Underwriting?
Benefits for entrepreneurs
- These loans are sometimes the only formal capital a business owner can access. Nonprofit lenders who offer alternatively underwritten loans are referred to as the “lenders of last resort,” and outside of this option an entrepreneur may be forced to consider astronomically expensive credit card debt or other predatory sources of capital.
- In many cases, these loans and the programs within which they exist are designed to provide technical assistance and support in addition to the lending capital.
- Upon successful repayment, such lenders often have processes to “graduate” borrowers to a more traditionally underwritten loan, or to make warm introductions on behalf of the borrower to larger, more traditional lending institutions for additional capital needs.
Benefits for lenders:
- Incorporating alternative underwriting practices allows lenders to serve another segment of the market that traditionally processed loans might overlook or disqualify — allowing the organization to increase the total addressable market.
- Alternative underwriting practices allow funders to reach some of the most credit-challenged businesses, which is often core to the mission of nonprofit lending institutions.
- Addressing non-traditionally-creditworthy borrowers improves CDFIs abilities to reach target demographics and geographies, increasing likelihood of re-certification and grant awards.
Costs for entrepreneurs:
- Alternatively underwritten loans frequently have a complicated and lengthy application process. Often very little decision-making is automated or based on algorithmic decisions; most commonly lending decisions are made by a team of lenders and underwriters based on a set of nuanced facts and calculations.
- Typically charge higher interest rates than traditional bank loans.
- May include additional obligations such as ongoing reporting and communication with lending institution, recurring check-ins, and participation in technical assistance programming.
Costs for lenders:
- Alternatively underwritten loans often lack collateral and personal guarantees, which can significantly diminish the enforceability of default obligations and recuperation of principal.
- Lending teams must be re-trained, and staff obligations are significantly higher for this more nuanced and subjective lending process. The underwriting process is not typically as formulaic as with traditional debt capital, and as such automation or technological support systems may be more difficult to engineer.
The single most obvious benefit of Alternative Underwriting in small business lending is that it enables lenders to offer capital to viable and important small business borrowers who otherwise would not qualify for a term loan under traditional underwriting guidelines.
Unlike in the mortgage industry, there is no national public database of small business lending by race and ethnicity, gender, or other key demographic variables. However, based on consumer surveys and private research endeavors, we know that female business owners account for less than 5% of all capital loaned to small companies. This comes despite the fact that women own 30% of small companies — six times as much as the share of funding they receive. Furthermore, small businesses owned by women only receive 16% of all traditional small business loans. Women’s applications for business loans are more likely to be rejected, or have more stringent terms, than those for men. Black business owners struggle with debt financing too: in 2018, only 31% of them received all the funding they applied for, compared with 49% of white-owned businesses, 39% of Asian-owned firms and 35% of Latino-owned businesses, according to a 2019 report from the Federal Reserve Bank of Atlanta. Beyond application success, Black business owners also pay higher average fees and interest, due in part to the lack of personal assets to collateralize loans, attributable to the significant racial wealth gap.
Capital Product Fit
When is an alternatively underwritten loan a good fit for businesses?
Entrepreneurs who tend to benefit most from alternatively underwritten loans typically:
- Have a non-speculative business with a clear pathway to growth and stability. Most often these businesses are generating revenues and are near break-even on their balance sheet.
- Lack significant formal assets necessary to collateralize a traditional term loan (business assets, home equity, personal assets such as vehicles, etc).
- Have a lower than average personal credit score, sometimes with historical blemishes including bankruptcies, collections, or late payments.
- Have young businesses without the 2+ years of track record many lenders require.
- Lack formal bookkeeping systems to efficiently track business transactions and verify financials.
- Are interested in working closely with a lender to build credit, improve business financials, and graduate to a traditional debt product upon repayment.
When is an alternatively underwritten loan not a fit for businesses?
- If a business is speculative in nature, including pre-revenue startup firms. These are typically not a fit because repayment of loan principal plus interest typically begins immediately.
- If a business does not want to participate in hands-on programming with the lending institution, or does not want to provide intimate and personal information as a part of the loan application process.
- If the entrepreneur(s) have strong personal credit and assets, which would likely mean they could access lower cost capital elsewhere.
- If the business’ revenues are highly seasonal, with significant peaks and troughs throughout the year. Fixed monthly payments can squeeze already slim cash flows during down-times if an entrepreneur cannot afford to budget for future debt obligations.
Small business balance sheets across the country have seen historically challenging circumstances made only more grave by the economic effects of COVID-19. In the wake of an economic crisis that hit small businesses especially hard, entrepreneurs have found themselves spending down assets, liquidating reserves, and defaulting on personal debt obligations — all of which pose significant challenges within the context of a traditional underwriting process for a small business term loan. However, these challenges — whether incurred due to COVID or otherwise — do not necessarily reflect poorly on a business entity’s ability to repay a loan. Adopting alternative underwriting practices allows lenders to look past these challenges to still identify and provide mutually beneficial capital products for small businesses.
Access Ventures Growth Loan Playbook: Guide to Launching a Character-based Lending Program
This playbook is an open-sourced culmination of the steps Access Ventures took and lessons they learned in building a community-first, character lending process.