Can Data Driven Lending Displace VC Funding For Some Firms?

Running a small business is not for the faint of heart — or the deeply optimistic.

The numbers, as offered by the U.S. Bureau of Labor Statistics, are not encouraging. About 20 percent of small to medium-sized businesses (SMBs) have failed by the end of their first year. That figure has grown to almost one-third by the end of the second year, and is a 50-50 coin flip by the end of the fifth.

And while startups fail for a variety of esoteric reasons, the common thread that ties them all together is cash flow. According to a U.S. Bank study, nearly one-third of SMBs fail due to cash flow problems directly (i.e., they run out of money). But even more notably, 84 percent fail due to poor cash flow management that kicks off the series of events leading to their doors closing.

Managing cash flow can be tricky work when one is new to the market or looking to expand because cash is in short supply. CircleUp entered the market in 2012 as a data driven variation on venture capital (VC) funding to solve for part of that problem in retail and consumer packaged goods (CPG) firms.

Initially, CircleUp was founded as a marketplace to identity fast-growing consumer brands and match them with private investors, but the firm went on to raise a $125 million investment fund focused on using data to scan for certain difficult-to-find metrics for early stage private firms and strategically invest in early scale building rounds.

Using quantitative analysis tactics, often colloquially referred to as “moneyballing,” is, as of late 2019, a fairly common practice for investors in publicly traded firms, but their applicability to private firms has long been questioned. The conventional wisdom is there is just not enough reliable data from those firms to use.

CircleUp was looking to buck that conventional wisdom with its proprietary software, Helio, a scanning algorithm used to find interesting companies by scanning and compiling data from sources to look for things like new partnerships, store shelf penetration and the like.

But CircleUp continuously realized that while a better and more data driven path to VC funding was going to be helpful for many startups in the retail and CPG sector — particularly those looking to expand, hire staff, open new locations or up their production levels overall — there was a whole other category of financial needs that were quite different and were entirely centered on normalizing cash flow because of the eccentricities of the long payment cycle.

Inventory is often a floating coast for retailers, and large buyers often will look for payments terms where inventory is not paid in full for 90 days after the sale is made. At best, these cycles will lead to cash crunches that slow growth and expansion. At worst, said Asher Hochberg, managing director of CircleUp’s credit unit, companies will go out of business while waiting to be paid for their goods.

CircleUp’s lending platform was founded in 2017 to fill that hole and has underwritten about $300 million in loans since then. Volume will likely be up notably in 2020 as CircleUp’s lending division recently announced a $200 million funding round to expand its underwriting business.

“Small manufacturers face a lot of pressure from retailers, so the credit works as a buffer,” Hochberg said. “They face questions like, ‘How do I keep the lights on for the next year?’”

CircleUp loans are pitched to companies that bring in between $500,000 and $5 million in revenue and haven’t brought in outside funding. Bank loan options for these firms are generally few and far between, particularly for younger firms.

CircleUp is not, however, the only FinTech player eyeing the larger SMB market. Square Capital, PayPal, Clearbanc and Kabbage are a very short list of firms also looking to expand the playing field for accessible SMB loans at reasonable interest rates.

But Hochberg said even though CircleUp contends with large and better-known competitors in the arena, it brings a few advantages to the field.

The first is focus. CircleUp is retail- and CPG-focused. It isn’t necessarily looking to capture the same general SMB market its competitors are.

Second, the lending department draws from the same proprietary Helio software to inform their underwriting choices, which means they at least believe they are better at identifying a wider range of better-positioned candidates.

And finally, although the equity and credit teams work separately and keep some walls between their operations in terms of data on customers, unlike its competitors in the lending space, CircleUp does provide a pipeline to equity funding for partner businesses looking to start building scale and pushing for greater expansion. At least some of CircleUp’s clients work with both the lending and equity sides of the house.

Will it be enough to solve the cash flow problem that kills so many businesses? Probably not, given that the problem ranges far and wide from the specific vertical CircleUp serves. But given that only half of SMBs are surviving to their fifth year — and 84 percent are brought down by cash flow — there probably won’t be one solution to stopping the fatal cash flow crunch but rather a lot of different solutions taking small bites out of the problem simultaneously.