In late 2013, the New York Fed did a survey on small-business owners about their financing and credit needs. They found that the search for credit is time-consuming--business owners spent 26 hours on average on their search, contacted three financial institutions, and submitted three credit applications. Despite all that work, around half of these businesses never secured financing, and another substantial group of businesses was discouraged from even applying for loans. Most of these businesses were looking for less than $100,000.
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With so many small businesses looking for financing, and so many institutions (banks, alternative lenders, nonprofits) looking to lend to them, why does the search process take so long and frequently end unsuccessfully? In 2010, three economists won the Nobel Prize for their work on this problem, but luckily for you and me, the basic ideas behind their work can be easily explained.
In many markets, buyers and sellers can't always reach one another easily, and even when they do, a transaction may not necessarily occur. For example, think about the labor market--companies post job openings while there are large numbers of people who are unemployed. The search and matching process requires time and resources--known as "search costs."
Why Business Loans Have High Search Costs
Why does securing a business loan from traditional lenders take weeks or months? The answer is that businesses are diverse--much more diverse than consumers from a lending perspective.
Every lending institution has different ways of handling this diversity, but they generally involve a people-based and paper-intensive process, and as a result there is little transparency about success rates before business owners apply. And so the search cost for small-business credit becomes 26 hours of work--even 3x that amount sometimes. For business owners whose most precious resource is their time, that's a significant investment. The process is inefficient and costly for banks, too--the number of sub-$250,000 loans in the past five years has steadily declined.
From Weeks and Months to Minutes and Hours
There is lots of attention these days given to the rise of technology-enabled online lenders to small businesses. These online lenders have built technology and credit-scoring models that handle the diversity of small-business information more efficiently than traditional lenders do, allowing them to render decisions more quickly and say yes more often without nearly as much prep work on the part of the small business.
Given the significant value of small-business owners' time, when a relatively small amount of capital is needed for a growth opportunity with an identifiable return, a large search cost simply doesn't make it worthwhile.
And although it's no secret the annualized rates for technology-enabled online lending can be more expensive than traditional sources, in the eyes of a business owner, the true cost of a loan is equal to his or her search costs plus his or her capital costs.
The New Business-Loan Search Process
This week at OnDeck, we announced the results of an economic impact study that looked at the $1 billion we had deployed nationwide. One of the most surprising things we observed was that although our customers researched multiple options for loans, the vast majority never applied elsewhere. Their No. 1 reason for not doing so? They thought it would take too much of their time. Further, a number of our customers who applied for and were eventually approved by traditional lenders ultimately decided not to take the loan because they thought funding would be too slow.
As technology-enabled lending to businesses continues to grow, search costs for business owners are coming down, and that is causing them to try online lenders first before going the traditional route. And the good news for business owners is that the lending space is becoming increasingly more competitive, with many more options for financing than ever before. For business owners, thinking about search costs is essential to understanding the relative benefits of loan options.