Why recessions are so much harder for SMBs

Recessions are challenging to any business, but recent recessions demonstrate SMBs face them much more acutely, predominantly concerning cash flow, access to credit, and operational hurdles. In 2008, the recession hit SMB employees significantly harder due to a credit crunch that left small businesses with little access to capital:

Capital has always been a struggle for SMBs in the U.S. due to the construct of our credit system, a business owner’s lack of credit history or collateral, and the struggle for many small businesses to put together the proper financial documents.

SMBs are predominantly interested in lines of credit $250K or less, amounts that are generally unprofitable or unappealing for large banks for a number of reasons, including high costs of underwriting the loans due to heterogeneity of small businesses and a lack of a secondary market (community banks traditionally focused on building “trust” through personal relationships):

This has led to an ecosystem where less than half of small businesses get the requested credit amount, and a significant portion are locked out of the credit markets altogether.

Another factor that is limiting access to capital is the decline in community banks in the U.S. due to high M&A in the industry, reducing the number of lending sources[1]:

SMBs historically leaned on small, local banks to provide credit, especially in communities where personal relationships and familiarity with a business model helped lenders feel comfortable making a loan. As large banks acquire community banks, they have also reduced the percentage of small loans available.

A reduction in available credit combined with a smaller average cash position among small businesses makes them particularly susceptible to recessions where revenue may be reduced or stop altogether. A JPMorgan report shows small businesses already operate with cash on hand for less than a month, and the margins of daily cash inflow and outflow are incredibly thin.

Operating on thin margins means fluctuations in revenue, even temporarily, can be devastating to small businesses, which are also less likely to have e-commerce platforms and don’t have the consistency of digital transactions that large enterprises can rely on. In addition, many feel significant pain due to supply chain disruptions, a common recession symptom for businesses of all sizes. But many SMBs have little upstream clarity into their supply chain, leaving them few options in times of tight supply or supplier closures.

The confluence of these factors, the closing of physical storefronts, tightening of credit markets, and inconsistencies in supply chains, has made COVID-19 the perfect storm.

[1] Federal Deposit Insurance Corporation, Community Banking Study data

Startups can offer technologies that make an immediate and lasting impact for SMBs

We’ve seen the emergence of startups attempting to address credit and cash flow pain points since the last economic crisis, primarily in the form of alternative lending platforms such as peer-to-peer or collateral-based factoring.

While these platforms can increase access to smaller amounts of credit in bull markets, an economic downturn will impact alternative lending sources even more quickly than traditional bank lenders.

There is still ample space to innovate in the areas of cash flow access and management that could help SMBs create more stability and cushion to operate in both bear and bull markets. Some of the opportunities B Capital Group is tracking include:

· Cash flow management tools: Credit cards are the most accessible form of credit to SMBs and can provide up to 60 days of float, an extension that can be critical to an SMB. We believe increased data access to cash flows in the SMB space can create opportunities to provide factoring and small short-term loans based on inflows and outflows. We invested in Plastiq, a cash flow management tool for SMBs that allows them to utilize credit cards for all purchases.

Continued automation of bookkeeping, cash flow management, and other back-end processes that help small businesses monitor their current cash position will be increasingly important. Analytics to help predict cash squeezes and proactively offer solutions will be particularly valuable as SMB owners safeguard their businesses.

· Automation of the lending ecosystem: The technology driving loan applications is inconsistent and inadequate in banks of all sizes. Many small banks have implemented minimal technology and larger financial institutions suffer from significant technical debt due years of acquisitions and one-off system integrations. Loan application processes are still primarily manual, making small sized loans undesirable for larger banks because the underwriting costs are similar to larger loan offerings.

Advancements in business process automation, natural language processing (NLP), and robotic process automation (RPA) have the potential to truly automate the loan application, approval and fulfillment process. Optical character recognition (OCR) engines can convert written loan applications to become computer-readable and OCR tools can segment large quantities of information to the appropriate workflow and automate most lending decisions. OCR tools and RPA can also remove the need for human-keyed data entry and even some human oversight that have traditionally made the underwriting process long and expensive.

Creating cheaper underwriting would make this huge market much more attractive to large financial institutions and open access to credit to millions of SMBs.

· Next-Generation Credit Approvals: Much of the small business community faces credit approval challenges. A lack of business or personal credit history or collateral can end any chance at obtaining credit (this is especially acute for minority owned businesses). As a global firm, we see FinTechs in SE Asia solving this problem using AI/ML algorithms in conjunction with cash flow data to build their own credit scoring systems. Many of those countries have leapfrogged the U.S. when it comes to implementing alternative scoring and new underwriting processes due to a lack of existing standardized credit rating systems and adoption of new banking infrastructure, but we believe alternative credit modeling is a real opportunity in the U.S. in the future.

Increased visibility and flexibility around supply chain:

Upstream supply chain issues can have out-sized effects on small businesses. Many SMBs use spreadsheets to track supply chain, creating situations where they do not realize there is a disruption until it is too late to adjust purchase orders or inventory planning. Furthermore, most small businesses (and large ones for that matter) have little visibility into where the disruption is occurring, limiting the ability to react.

We believe this is a major addressable opportunity. There has been significant innovation in last mile delivery and warehousing logistics, but most companies still use spreadsheets and unsophisticated ERP products to track manufacturer to warehouse supply chain. Software that provides increased transparency and sourcing capabilities would lead to better planning and improved supply flexibility.

Small and medium sized businesses are an important component of the U.S. economy and the well-being of our overall population, and they are facing a more challenging road ahead than likely any other sector. Innovative companies can help SMBs become more financially secure, handle supply chain, and/or increase digital transformation (more to come on this!). Companies solving these issues can build a great business with reverberating effects. B Capital Group continues to be on the lookout for entrepreneurs who have immediately realized the needs of this category and are taking up the challenge, and we look forward to tracking rapid development of new solutions in the coming months and years.