It’s hard to overstate the importance of small businesses to our economy. They account for nearly half the private sector jobs and almost as much of GDP. Keeping small businesses healthy is in the best interest of all of us, and yet many have a very difficult time accessing the capital they need to operate and grow.
For these small businesses–with anywhere from a few employees to a few hundred–working capital isn’t just a challenge; it’s also a necessity. They’re often at the mercy of seasonality and typically don’t have the kind of cash cushion that larger companies do.
For the smallest of these companies, a dip in cash flow or the loss of just one or two team members can endanger their ability to operate and keep the doors open. The need for access to working capital is very real, but so is the struggle to get it. The one source that has historically worked for small businesses is starting to disappear.
The challenges facing local banks
Traditionally, these small enterprises relied heavily on their relationships with local banks, credit unions, or Community Development Financial Institutions (CDFIs). These institutions provided a lifeline, especially when the size, structure, or maturity of the business made it challenging to secure funding from larger lenders. Unfortunately, over the past decade and a half, these smaller community banks have experienced significant headwinds, leaving small businesses struggling to find the financial support they need.
In the aftermath of the 2008 financial crisis, small banks faced numerous challenges, while larger counterparts benefited from government interventions. The crisis disproportionately impacted small banks, and subsequent government interventions like TARP and the Dodd-Frank Act inadvertently disadvantaged them further. It’s an eerie parallel to the trouble smaller businesses have in dealing with some of the burdens bigger companies can more easily handle.
Compliance costs surged, limiting the resources available to small banks for crucial functions like lending. This regulatory response left small businesses that once relied on local banks at the mercy of large conglomerates, which often implemented one-size-fits-all lending policies that didn’t cater to the unique needs of small enterprises.
With fewer of these small banks lending money, there are fewer options for businesses in need of funds. Fortunately, there is someone who still understands what it’s like to run a small business, and they’re quickly increasing what they have to offer financially.
The rise of vertical software
Trips to the bank are becoming less and less frequent as businesses accept more card payments and manage more of their business life online. In fact, software platforms are becoming the watering hole that local banks once were. It’s here that small business owners run their businesses from end to end and get the support they need.
If we look back just a few years ago, most software was horizontal. Payment platforms were for payments, scheduling tools were for scheduling, and payroll software was only for running payroll. Today, software is verticalized, allowing business owners to do everything in one place. For example, restaurant owners can use Toast (or, even more specifically, pizzeria owners can use Slice) to accept orders, process payments, run marketing, and more.
Until recently, the missing piece has been capital. But fintech is changing that. Vertical software platforms hold the deep industry knowledge and transaction data they need to become the new community banks on a much more niche level. Let’s talk about what that looks like.
Embedded capital and beyond
Traditional lending falls short for small businesses when it’s designed to fit much larger ones. For example, many traditional bank loans are based on credit scores, two or more years of financial statements, and some type of collateral assets. For younger and smaller businesses, any one of these elements can be a barrier to accessing financing, whether they deserve it or not.
Modern fintech makes it possible for financing to be underwritten directly from transaction data, reflecting a small business’s true ability to pay back the funds. I’ve seen this work very well with as little as six months of data, making it a much better fit for young businesses. With live revenue data as the basis for the decision, collateral is no longer needed to reduce risk, which is also a welcome change for small business owners.
This kind of transaction data is exactly what vertical software companies have in spades. As the operating platforms helping SMBs run every day, they have the first-party data needed to successfully underwrite small business loans with very reasonable risk levels. All they’re missing is the expertise in capital and the right models for risk management. This is where a fintech partner comes in.
Enabling capital access through fintech
By definition, embedded finance connects businesses or consumers to financial services through non-financial platforms. In this case, vertical software platforms are the perfect connection point, allowing business owners to access capital in the same place where they run their operations and accept payments every single day.
With secure APIs, fintech lenders can ingest all the underwriting data they need, eliminating most of the cumbersome manual application steps and cutting out the middlemen from the customer’s perspective. They can access the capital they need on the platforms they’re already using. Not only that, but capital also becomes seamlessly connected to the tasks that require it, like accessing capital for inventory inside of your inventory management system or the capital to cover payroll inside of your payroll software.
This is what it looks like when increasingly niche software platforms become the new community banks for their unique industries. With the help of embedded financing, likely built by fintech partners, they can offer financing solutions that are tailored not only to small businesses, but even to the specific industries they serve. As more vertical software adopts embedded finance, the need for small businesses to go to traditional financial institutions decreases. And as these platforms expand to offer broader services within their industries, they gain additional data points, allowing for even more tailored and bespoke financial solutions, all accessible in one place.
Luke Voiles is a passionate fintech leader and business builder, who brings over two decades of experience with innovative industry leaders into his role as Pipe’s CEO. Before joining Pipe, he was the GM of Square Banking at Block, where he led the global team responsible for managing, launching, and scaling small business banking and lending products. Previously, he led the team building out Intuit’s small business lending unit, QuickBooks Capital, from scratch, scaling it to $2 billion in loans originated. Luke made the switch from private equity to fintech after more than a decade as a distressed asset and credit special situations investor at top-tier funds, including TPG Capital and Lone Star Funds.