Small retailers are the backbone of the economy and yet they are the last place getting value from Fintech innovation. This is a massive opportunity, but not an easy one to crack. It needs some disruptive innovation.

Working Capital Finance for small business is the massive market we have been focused on this week in two earlier research notes (here and here).

We see three distinct categories within the overall market for Working Capital Finance for small business. I hesitate to call them niche markets because they are so big:

1. Supplier to Global 2000. This is where Supply Chain Finance (SCF) rules. This works. You get credit based on the credit rating of the buyer, so the APR is low.

2. Supplier to SMB. This has historically been the province of Factoring (or a variant called Invoice Discounting). The APR cost is high and it can be a cumbersome process, because neither the buyer nor the seller has a credit rating. There have been many markets to trade these invoices, but the biggest conceptual breakthrough has been the move by Prime Revenue to to go beyond the Global 2000 (which already have a credit rating) into the mid market using statistical modeling based Insurance as a proxy for an individual credit rating by partnering with AIG.

3. Supplier to consumer aka Retailer. This is the world of Merchant Cash Advance. The merchant gets an advance on future credit card revenue. The APR is even higher than for Factoring/Invoice Discounting. It is like PayDay Loans; it is OK if used in an occasional emergency, a business killer if used regularly. This is scalable through automation so there have been a few venture-backed startups in this space.

Big Retailers obviously do not use this; one cannot imagine Walmart using merchant cash advances. That is why this research note is about Small Retailers, the backbone of the economy.

One thing that confuses people across all these types of working capital finance is that lenders often quote a rate for say 30 days. This could be the time when the invoice would normally be paid or when a merchant cash advance is collected from future credit card receipts. You might hear 2% quoted (for 30 days), but that translates to 24% APR (12 months * 2%). Some lenders and platforms fight against this normalization to APR, but only a desperate or financially illiterate borrower would fail to calculate APR.

The fitssmallbusiness site lays into merchant cash advances;

“Typically, merchant cash advances are extremely expensive with APRs ranging from 29 % to 132 %, so we don’t recommend them unless you’ve exhausted all other ways to get a business loan.”

So is there any alternative to merchant cash advances? One can see Square jumping into the fray with Square Capital and that will create competition, which is good. However that sort of sustaining innovation tends to produce something like a 10% improvement. When retailers are paying 29 % to 132 %, they need a lot more than 10% improvement. They need a disruptive proposition that cuts that APR by 90%. That would let retailers borrow at 2.9% to 13.2%. That seems ridiculous, but all disruptive innovation seems ridiculous when it first appears. Of course the lower amount of 2.9% is only for the best quality credit worthy retailers (which seems reasonable given our ZIRP base rate foundation). The problem is simply that there is no efficient scalable way to measure credit worthiness of retailers. If anybody has seen something like this, please tell us (in comments or on Twitter).

By Bernard Lunn