Lessons in raising debt capital for lending company founders

In the past few years, there has been a proliferation of companies using technology to profit from arbitrage on various asset classes — for both consumer and business debt.

We started Stilt about 2.5 years ago while working full-time jobs on H-1B visas. After we were accepted to Y Combinator’s W16 class, we completely focused on Stilt. As an online lending company, we raised debt capital from multiple investors and continue to do so as we scale the company. I get multiple requests for guidance from new companies that are just starting a lending business. Here are some learnings from our journey.

A quick background of the lending industry

The original wave of lending companies were divided into 3 classes:

• Consumer Lending — Lending Club, Prosper, Oportun (formerly Progresso Financiero), etc.
• Small Business Lending — Ondeck Capital, Funding Circle, etc.
• Real Estate Lending — Realty Shares, LendingHome, PeerStreet, FundthatFlip, etc.

Consumer Lending:

The consumer lending companies are largely divided into 2 categories — unsecured personal loans and student loan refinancing.

Prosper and Lending Club were the pioneers of the P2P lending model. The years after the financial crisis were the golden years for this. Most of the banks had pulled back on lending (Citibank sold its subprime lending business to Springleaf a few years ago) and middle-class Americans were left with a lot of credit card debt and no other options.

These companies created a platform to help consumers refinance credit card debt with an unsecured personal loan for a term of 3 years to 5 years. The idea was novel and worked well. Lending Club went public in 2014 with a $10B valuation. It is valued at ~$1.7B at the time of this writing.

SoFi was the first startup to establish the student loan refinancing market. They were the first ones to do it at scale and have been the biggest non-bank player in this asset class. For the first few years, SoFi funded the loans using their balance sheet. They were originating, funding, and servicing the loans on their own. Since then multiple other startups have come up and some banks such as Citizens Bank and DRB (Laurel Road) have since jumped on the bandwagon.

Small Business Lending:

The small business lending market has flourished in the past 10 years. As banks pulled away from financing small businesses, non-bank lenders such as Ondeck made it simple and faster (than banks) to get a business loan. Many small businesses did not even have other options. But these new generation lenders came in with a completely online model and attracted small businesses with higher approval rates and better service. Now business owners don’t have to visit a bank branch multiple times to convince a creditor to get a loan. Other players such as Funding Circle (started in the U.K.) have also been around for almost a decade helping businesses get access to funds faster than a bank.

The other big area of lending has been invoice factoring. Almost every business that delivers a product to other businesses gets paid in 30-, 60-, or 90-day cycles. This creates cash flow issues as the payment for a delivered product is stuck while the business has to pay the bills every month. The invoice factoring companies such as Fundbox and Bluevine advance the funds to the business (while taking a 2–3% cut) and get paid later over 90 days. This is a multi-hundred billion dollar market without much innovation for the past few decades. The new set of companies have developed systems to provide almost instant invoice factoring solutions to thousands of small businesses.

Real Estate Lending

In the recent years, a new asset class has emerged that promises high single digit returns (7%-9%) on a collateralized asset — houses. By using technology, online real estate lenders are able to better price residential properties and improve the speed of funding. The most common use of these loans is to fix and flip houses.

A few venture funded companies like Realty Shares and Lending Home started in 2013 to offer this asset class through their marketplace. The loans are relatively shorter term — most are less than 12 months — and have a 75% LTV (Loan to Value Ratio). This asset class has quickly become popular amongst funds looking for a slightly lower risk profile and faster liquidity. Most marketplaces only allow HNWIs and investment funds to participate (no retail investors). A few companies are now funding billions of dollars of these loans every year.

For a detailed history on consumer and business lending, I recommend Frank Rotman’s (QED Investors) detailed white papers (he is one of the most experienced fintech/credit investors).

1. Consumer Lending — The Hourglass Effect
2. Small Business Lending — The Brave 100

Another one is a white paper by Charles Moldow of Foundation Capital:

1. Consumer Lending — A Trillion Dollar Marketplace

Debt Capital

The common thread across all lending companies is that they had to raise debt capital. This capital is separate from equity and solely used to fund the loans originated by the platforms. Raising quality debt capital from diverse sources is one of the most important aspects of a lending business that founders need to learn.

At the end of the day, every platform is operating a marketplace between investors and their consumers. The success of a lending business is dependent on securing debt capital (supply) to match consumer/business loan originations (demand). The original P2P model set up a marketplace between retail investors (people who invest their savings) and borrowers. An investor could invest small amounts in multiple loans to diversify their risk. As the platforms matured and demonstrated high returns compared to other asset classes, it attracted bigger funds to invest billions in these loans. The model evolved to become a marketplace with large investors on the supply side.

Managing debt becomes a competitive advantage for lending businesses and helps them scale to billions of dollars in annual originations (as few have done). All the big players are taking advantage of their scale and expertise in managing debt. However, large scale is not reached in one day, and a startup has to go through various stages before they can expect to deploy nine figures of capital every year.

Below is a high level classification of debt capital investors in the market. This is by no means the most exhaustive list, only the most common. A founder will have to work with various types of investors based on their scale and growth. I will also discuss types of debt deal structures later in the post. Let’s get to it.

Types of Debt Investors:

Pre-Seed — Pre-Series A

• High Net Worth Individuals (HNWIs) — They are the first source of capital for most lending startups. These are individuals (sometimes angel investors) with a large net worth and your best bet for a first check. They generally invest based on personal relationships with the founders and should believe in you and your idea. They may be your friends, work colleagues, friends of your investors, or family. A personal relationship underpins their investment and expectation that you will make sure their capital is returned. They are easy to sign up and terms are straightforward. They really help you get off the ground but are limited in terms of how much you can scale.

You can expect to pay an interest rate of 10–15%, and generally these loans are for 2 years. HNWIs can help you get up to $5M in originations.

Seed — Series A — Series B

• Venture Debt — After your company has had some traction and proven some level of success with your credit risk model with capital from HNWIs, and you have raised a seed round, you can start knocking on doors of some banks for venture debt. If you have a brand name investor in the U.S. , you can expect to get some debt from a bank as a loan. This is a senior loan secured by your company’s assets and comes with covenants. However, There is risk involved with this option. If you aren’t able to pay off the loan, they can sell your company’s assets to get paid. The venture debt providers are banks (like Silicon Valley Bank) and capital providers like Western Technology Investment. The amount of debt raised from these sources will be proportional to the equity and brand value of the investors.

Venture debt can range from $500k — $5M with interest rates currently between 8%-15. These loans are for a couple of years and come with a set of covenants.

• Family Offices — These are private or combined offices that manage the wealth of rich families. They have a mandate of preserving principal. So, most family offices are risk averse and don’t do risky deals. They still work with startups at smaller scale if you can make them comfortable with the risk. They are certainly more risk-taking than HNWIs. Family offices can be varied depending on the wealth of the individual. Anyone with $1B+ in wealth may have an office that manages his/her wealth. Other family offices manage money for multiple families ($50M+) in net worth. The best way to reach family offices is through your network. You can generally get to them through your investors. The deals will be smaller but they can be done faster. Family offices also value warrants in many cases. They are unlikely to be the first check, so you will need some data to prove your underwriting. Some family offices also have a social mission and if that fits with your company’s goal, you may have a better chance.

Family offices can help you scale originations up to $10M+ and beyond. Depending on the size of the family office and their appetite for risk, you can get to $50M in originations with them. They seek anywhere from 10–15% interest rate based on the quality of your originations.

Series A and beyond

• Hedge Funds and Investment Management Firms — These funds are one of the largest sources of capital in the market, but can be expensive and they need scale. There are a lot of hedge funds who participate in the online lending industry. Hedge funds are looking for mid-teen returns but they also use leverage (on their books) to juice up their returns. The lending platforms have to offer scale to make it worthwhile for hedge funds — as they want to deploy $30M+ per deal and can go up to hundreds of millions of dollars. The time it takes to close these deals can easily be 6 months or more — even if someone’s working full-time on this.

As you get to $25M+ in annual origination volume with an equity cushion, you can start reaching out to hedge funds to scale to $50M+ in capital. The interest rates will start at 8%, but the line is scalable.

• Alternative Lending Funds — A new class of funds are cropping up to specifically fund alternative lenders. These funds are mostly forward-looking in terms of unique and different risk classes. As online lending platforms have unlocked new types of assets, alternative lending funds have been increasingly providing initial capital boosts to fledgeling startups. These funds are easy to work with and deals can be quickly signed, but they will expect to be compensated well for taking the initial bet. The advance rates are generally lower than what is offered by banks, family offices, and other capital providers. These funds are also the most experimental in setting up unique deal structures. As they are dealing with startups mostly, they understand the value of equity and are willing to accept warrants as a part of the deal. These funds have gotten bigger in size over time (some are $1B+), and they invest across both consumer and business loan asset classes.

If you want to close deals fast and not worry about giving away some equity in terms of warrants, alternative lending funds can be your best bet. You can get started anywhere from $2M+ to $100M+ with a path to more.

• Banks — As the name suggests, they are the largest sources of capital and a pain to deal with. If you are going to source capital from banks, give yourself 9 months to close the deal. They will move slowly and will be the most concerned about compliance. Banks have really low cost of capital but are also risk averse. Banks also don’t like to deal with startups as much. The lines of credit are offered to companies with a strong equity position and a proven track record of performance. If your underwriting models are too fancy, banks will need more time to understand them, and in some cases, they will not fund the loans due to compliance risk — irrespective of how good the risk/return reward is.

Banks are a cheaper and larger source of capital with rates starting at 6%, but they would want to make sure you are compliant and your underwriting models are thoroughly proven with a strong equity position.

• Insurance companies, pension funds, sovereign wealth funds, and other asset managers — As you scale to hundreds of millions of dollars in originations, you will need diversified sources and bigger pockets to fund loans. Insurance companies, pension funds, and large asset managers have that kind of scale, but they are extremely risk averse. These firms are usually looking for assets with low risk and stable returns for the long term. Student loan refinancing is a common type of asset class where they invest. Also, most of these funds invest in rated bonds through the securitization market. This requires a lot of effort up front and only after Series B can realistically expect to access the securitization market.

If you have a low-risk asset class with a long-term stable return, insurance companies and asset managers can deploy billions of dollars. The securitization market starts at $50M and offers competitive options.

This is just a high level overview of the debt capital markets, and by no means exhaustive. If you are starting a lending business, it is worthwhile to think through the stages of growth and capital needs for your business.

You can secure debt capital from providers who offer capital to companies that are a stage ahead of you, but jumping multiple stages is difficult and unlikely. As you plan on scaling up your business, take into account the equity required to get access to larger capital sources.

I hope this helps as an overview of what you can expect before you start raising debt capital for your online lending business. I’d be happy to help with any further questions.

Thanks to Aaron Harris, Yee Lee and Louis Beryl for reviewing drafts of this.