Embedded Lending — Our Thesis on SMB Lending, Enabling Infrastructure and the Opportunity to Unlock Access to Capital
Sample lending tech stack for SMBs. Note: This visual does not capture companies that focus exclusively on personal, mortgage, auto, student debt lending. This visual also does not capture embedded lending companies that bundle lending operations into a single API.
At Thomvest, we have closely followed the evolution of lending across investments in LendingClub, Kabbage, SoFi, Tala, LoanSnap, and Figure. From personal to SMB to student loans and mortgage, we have seen how the first wave of online lending businesses created immense value at the time — we have also seen the distinct challenges of the lending 1.0 businesses, some of which were inhibited by their own full stack models. These businesses had to build, own, and manage every part of the lending workflow themselves, and this ultimately impacted their scalability, growth, and valuation in the public markets.
In the wake of lending 1.0, fintech has become one of the dominant sectors in the private capital markets. In 2Q21, 1 in 5 VC investments was a fintech investment. This boom in fintech has been driven by a paradigm shift in how financial services are distributed and consumed: a shift toward cloud-native, API infrastructure companies that are spearheading the connectivity between regulated bank entities and consumer-facing platforms and that are reshaping how financial products are created, configured, and distributed. Embedded finance is well underway and is enabling companies to embed financial services in their product offerings, driving retention, upsell opportunities and enhanced customer experiences.
Taking this into consideration, we’ve taken some time to reflect on what this means for the future of lending. Net interest income, which is largely driven by lending, represents nearly 60% of total revenues for US banks, yet it has not been fully unlocked in fintech.
- Challenger banks predominantly monetize on debit interchange today
- Banking-as-a-service companies have credit card products on the product roadmap, but lending has never been the primary focus — until now.
We are now seeing lending infrastructure companies come into play to handle specific jobs to be done in the lending workflow — we believe that this will expand the market opportunity for embedded lending altogether.
Embedded Lending: What’s New This Time Around?
Embedded Lending is not a new concept. Synchrony Financial, founded in 1932, is the largest provider of private label credit cards in the US and has long partnered with offline retailers to offer credit products and POS solutions. More recently, Square Capital, Stripe Capital, Toast Capital and others have pioneered capital programs for merchants on their platforms to offer working capital and growth capital financing.
While the concept of embedded lending is not new, we are seeing a shift in the market opportunity for embedded lending due to innovation in 1) distribution, 2) data sources, and 3) product.
- Innovation in distribution — perhaps the biggest shift from lending 1.0 to embedded lending today is the shift from horizontal → vertical distribution. Lending 1.0 businesses digitized the offline lending process and made it easier and faster to get a loan online. Lending 1.0 businesses offered lending across many verticals and relied on direct customer acquisition, which became increasingly expensive overtime. Embedded lending today is marked by a shift toward more verticalized distribution as fintechs, SaaS, and eCommerce companies embed lending into their platforms. Said differently, embedded lending is expanding who can produce a loan — this shifts the producer of a loan from only banks and alternative lenders → to an growing number of end platforms that sit at the center of valuable transaction data and that are closer to the end consumers of the loan product.
- Innovation in data sources — data sources have matured and expanded as more social and economic activity moves online. Access to this rich, normalized, digital data is supported by infrastructure APIs that provide connectivity to specific types of data that are relevant for underwriting (i.e. bank statement data, accounting data, KYC/KYB data) Data infrastructure companies are increasing access to consumer/business data and providing more customizable workflows, resulting in more sophisticated data sets and decisioning engines for underwriting. Identity platforms such as Alloy have evolved static KYC processes by incorporating digital data sources for underwriting and developing customizable identity-related workflows that are unique to each fintech platform. This innovation in the quality & quantity of accessible data sources is perhaps the most critical shift in financial infrastructure over the past few years, powering the shift towards more customized financial products.
- Innovation in product — credit products are increasingly structured based on a merchant’s ability to pay (cash flows) vs. willingness to pay. This shift towards “ability to pay” is leading to two fundamental shifts: 1) highly customized credit products with repayments structured as a percentage of sales 2) the unlocking of embedded capital more broadly across the debt → equity spectrum. The shift toward ability to pay has also spurred innovation in the ways that businesses access capital as companies such as ClearCo and Capchase offer revenue-based financing for eCommerce and SaaS companies.
Embedded Lending: Why We are In the Early Innings of Embedded Lending
We believe that embedded lending is just getting started — there are areas in the market, particularly the long tail of SMBs, that are still vastly underserved. This includes gig-workers, microbusinesses, and the growing number of small businesses that are sole propreitors and single member LLCs.
Innovation in distribution and innovation in data sources are making it easier to access and underwrite underserved SMB borrowers. Embedded lending companies, such as Lendflow and Parafin, are stepping in to aggregate, orchestrate, and bundle parts of the lending value chain, selling it as a service to vertical SaaS, marketplaces, and other distribution partners. SMB borrowers are increasingly gravitating towards these digital platforms and aggregating on marketplaces. As more economic activity moves online and distribution partners amass rich, proprietary transaction data on SMB borrowers, new data points and risk signals will emerge to help lenders examine the central question in underwriting small businesses: What is the quality of this manager? How good is this person as a manager?
Underwriting small businesses is a much more complicated endeavor than underwriting consumers for this reason. This is why enabling infrastructure that increases access to digital data and makes sense out of untraditional data signals are key to unlocking this next leg of growth.
However, increasing access to digital data may not be enough — this data has to be recognized and incorporated into financial products for underserved segments. If we believe in the power of data to unlock insights about people and human behavior, it is our responsibility to ensure that this data is recognized by our financial system.
Finally, if we envision a world in which digital data is recognized and incorporated into financial products, then we may be a step closer to unlocking access to capital for more (SMB) managers. As more managers access working capital to manage their businesses during upturns and downturns and growth capital to expand their businesses, the impact of this economic growth cannot be understated: unlocking access to capital for (SMB) managers has a compounding, intergenerational impact in our economy and should expand the market opportunity altogether.
