The Next Big Thing Is Actually, Small
Banking on small: what Empire Startups Contributor Ron J. Williams thinks could be the next frontier of financial innovation.
In the financial world, adages like “flight to quality” and "bigger is better" have been the hallmark of the banking industry's focus on large institutions.
This preference stems from various factors: lower risk profiles associated with large-scale operations, lower volatility, mature businesses, and the presumed predictability of future cash flows.
However, banking large institutions is not without its challenges.
Historical examples abound where focusing too heavily on big businesses has introduced significant risks into the financial system. For instance, the 2008 financial crisis highlighted the perils of over-leveraged large financial institutions. Similarly, the dot-com bubble burst and the subprime mortgage crisis revealed the vulnerabilities in banking systems heavily invested in specific, large-scale sectors.
In every cycle, we can find examples of FIs being severely impaired by “well-understood” asset classes that have been levered up, securitized, synthesized and traded to high heaven…But that’s a post for another time. For now, let’s simply ascribe those market-crashing black swan events to bad apples abusing otherwise well-functioning markets and systems.
What is clear for LFIs (e.g. big multinational banks with massive balance sheets) is that investing in small businesses has often been left largely to smaller banks… and increasingly to FinTechs seeing a bit of blue, underserved, sky.
But what if more smaller businesses were better at understanding and operating their businesses as well as transparently sharing out metrics (financial and operational)?
And what if investors of all kinds – from large institutions to individual retail investors – could better understand and confidently take risks capitalizing these smaller entities?
And what if there were better understanding and matching of capital-demand type for small business to capital supply type for investors?
What would that look like?
The landscape of banking is undergoing a change, again, with regulators wanting banks to be more conservative around risk.
In this case, new capital requirements call for bigger banks to maintain a higher ratio of liquid capital, which means they will need to choose which kinds of bets (i.e. which loans, which trades) they will liquidate and no longer make to satisfy new requirements.
This may be particularly beneficial for smaller financial institutions.
These requirements, aimed at ensuring greater stability in the financial system, could create a window of opportunity for smaller entities on both the supply and demand side of banking, particularly around lending.
With their inherently lower-risk profiles and more agile business models, smaller banks should be particularly well-positioned to capitalize. How? By ratcheting up innovation to help them better serve “Main Street” small businesses.
This could be a no-brainer for intrepid FinTech founders and bold bankers.
“Small Business has always been the backbone of the American economy.”
Small Business has always been the backbone of the American economy. As of the first quarter of 2022, there were 56 million workers employed by firms with fewer than 50 employees, constituting 45% of all private-sector jobs. The resilience of small businesses was particularly notable during the pandemic, with 2021 witnessing the largest growth in new jobs among businesses with fewer than 50 employees, exceeding 3 million new jobs. This period also saw the highest years of business applications on record; nearly 10.5 million.
Those are big numbers.
Which means that when the banking industry collectively began to pump the brakes after last year’s bank failures, the initial commercial segment hit hardest was “less credit-worthy” commercial borrowers, and small businesses. Hard.
It became much harder to get a loan and much more expensive to service that loan; even for solid businesses sitting on significant order volume, customers and cash in the bank. Why? Because it’s tough for bigger banks to get a high-resolution picture of health and risks associated with each individual business. For larger institutions with policies and risk assessment protocols geared toward big business, the unit economics of sorting out the long tail of small business hasn’t historically been worth it. And for the business owners, who don’t have dedicated treasury management or corporate dev teams, running an extended process to update business plans, models and do roadshows has proven to not be worth it.
Meaning less jobs, less income, and less community (i.e. consumer and small biz) spending.
To be clear, I’m not suggesting that banking smaller businesses is easy. Particularly in areas like lending and cash management, there are lots of challenges that are unique and pose real risk to capital providers.
20% of small businesses fail within the first year, with that number going up to 50% by the 5th year. They fail for lots of different reasons, from bad business plans, to insufficiently understood markets, poor execution and insufficient capital. Being able to accurately predict outcomes for a large diversity of small businesses is objectively more challenging.
Why? For one, the lack of standardized operational and financial metrics in small businesses makes it historically more difficult to assess risk and viability quickly and accurately. Additionally, many small businesses lack the systems or support to drive detailed reporting other than for mandated reporting like tax filings. The net effect is a lack of transparency that makes it challenging for banks to get comfortable taking risk.
Second, small businesses need lots of support. They are not simply “little big businesses” as this classic HBR piece detailed 40 years ago. There is less resilience built into the operating system of most small businesses. Business owners will have questions, and want advice, and at times require flexibility the typical banking business model cannot profitably sustain. The challenge for many banks is that a people-driven, relationship-banking model breaks if every account manager is on the phone with every small business customer for every question. The administrative burden of banking smaller entities is higher…and the return on investment are insufficient in traditional models.
“You don’t have to get ready if you stay ready.”
So, how can we get to a place where the juice is worth the squeeze for bankers and capital providers to look at more small businesses, and for small businesses to invest the time and effort in seeking capital in more places?
By applying two frameworks together:
1. “Stay ready” operating systems
2. “Letting the data do the dating” for capital markets and business development.
Time is money.
So on a lengthy to-do list that is consumed with operating and growing the existing business, creating the space to reinvent a more compelling business narrative, creating a new forecast, identifying strategic growth opportunities, and pitching one hundred banks just doesn’t rank. Today, in order to successfully pitch those banks, business owners have to find time to get ready.
But what if they were always ready? What if they “stayed ready”? What if their business and market data (i.e. revenues, churn rates, contract sizes, broader market research, competitive landscapes, macro factors, growth rates, comp ratios) was always turning itself into versions of pitches, business plans, tax filings and pitch decks that were one click away? And what if a business owner could simply hit ‘Print’ to grab copies and jump on the phone with a compelling ask for capital without having to hire an HBR student?
Let the data do the dating
I’ve pitched hundreds of times over the years and one of the bigger challenges I’ve learned is the importance of “pitch-audience-fit”: Even a well-prepared, awesome pitch can fall on its face 99 times before finding the right investor.
This principle is as true in Silicon Valley as it is at a bank branch. Finding the right audience for your story is a part of the work and that often takes time. Lots of time. It occurred to me a few years ago in a conversation with a founder over breakfast that an alternative to building the pitch and then going on the road with anyone who will take the meeting might be to allow selective parts of your data and data story to be made available to a pre-vetted audience. You’re only talking if your preferences are complementary; like a dating app for small businesses banking.
What would it look like if, pseudonymously, I could share parts of my growth story, ratios, customer outcomes and more (i.e. my business name and other identifying factors not revealed but my identify and veracity of data verified)...and what if on the other side, investors with verified data around defined risk appetite and target deal parameters and committed funds, were in system. If we both swiped right, the meeting gets scheduled.
Now put 1 and 2 together.
From better standards around how owners report on business performance, to algorithmically vetted potential investors, and how we match folks with particular risk appetites to a basket of small businesses that meet those risk requirements… The potential might be limitless. You can imagine a future where businesses are anonymously and passively notified the right kind of capital from the right types of investors at the right time.
Into the “small” future
Figuring out how to better bank and capitalize small business is really good, really big business; and the downstream implications for the economy are huge.
If businesses are better equipped to tell their up-to-date story and report on their performance in standardized ways, they’re in better shape to do everything from file taxes to, seek capital and pursue business relationships.
If investors and capital providers of all kinds are willing to commit capital to specific deal types “blindly” across a spectrum of risk based on verified data, then the pool of capital of small business grows massively.
While the move towards making “small” a more investable asset class, and creating a richer pool of investment dollars represents an awesome potential future, it’s not without challenges. But the rewards – both for the financial sector and the economy at large – are too significant to ignore. With the right strategies and regulatory support, small businesses can become THE cornerstone of a more diversified and resilient system.
We just need some folks to take those first (innovative) small steps.
Ron J Williams
Partner at Co-Created, Empire Startups Contributor
Empire Startups Contributors are a community of experts providing unique perspectives and insights on the latest in FinTech. Our model is is merit-based and does not offer monetary compensation.
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