Pipe’s Big Small Business Pivot: Embedded Finance For SMBs

Last week, Pipe announced its new Capital-as-a-Service offering to serve a wider swath of businesses beyond recurring revenue models to include predictable, charge-based revenue across various vertical markets, stages, and sizes— more specifically, small and medium-sized businesses (SMBs).

Pipe’s move could be among the first of many efforts to serve an often overlooked, yet critical market. While the SMB market offers financial institutions and fintech companies a tremendous opportunity in terms of addressable market, they have struggled to address small business owners’ needs, leading to dissatisfaction with their current financing options. Like the consumer banking and fintech, however, the confluence of technology and data are leading to viable new financing models with ease and efficiency.

SMBs: Unprecedented Growth in the United States

SMBs are a vibrant part of the American story. SMB owners are risk-takers that have taken a shot at building their futures in a free enterprise market system that allows them to do so.

SMBs have become a significant contributor to the growth of the American economy. According to the United States Small Business Administration (SBA), there are over 33 million small businesses that employ over 61 million Americans, roughly 46% of private sector employees.

In January 2024, Administrator Isabel Casillas Guzman announced that 5.5 million small business applications were filed in 2023, representing a 56.7% jump in the number of new businesses started as compared to 2019, pre-pandemic.

While there are a number of factors that contribute to this rise, it speaks to an American ingenuity that responded to an evolving job market. The job losses suffered early in the pandemic sparked a record 546,000 small business applications in July 2020. It’s postulated that increased government funding vis-a-vis stimulus checks, unemployment insurance and small business loans gave would-be entrepreneurs the confidence to start their endeavors.

Small Business Funding

Ask any entrepreneur about their journey from starting a business to profitability, however, and the picture is a lot less idyllic than the dream of small business ownership we envision. From day-to-day operations and managing resources, including their finances, small business owners juggle the same challenges faced by large corporations.

When it comes to banking and finance, there is a large discrepancy in the efficiency and accessibility of credit for small business owners. According to the US Chamber of Commerce, access to credit is the second biggest challenge facing small business owners today. Based on a survey conducted under Goldman Sachs
GS
’ 10,000 Small Business Voices initiative, 77% of small business owners expressed concern about their access to capital.

While these concerns may partially be tied to rising interest rates, the stress on the banking system caused by the failures of Silvergate Bank, Silicon Valley Bank, and Signature Bank
SBNY
last year placed scrutiny on the whole banking system, tightening small business credit even further.

Notwithstanding current conditions, small business owners often have limited options. For many small business owners, in order to secure financing, financial institutions either tap their personal credit history or rely on collateral, often the owner’s personal assets, or personal guarantee. For many business owners, it’s a risk that gives many pause for thought.

Butch Elmgren, owner of Thos. O’Reilly’ Public House in Sandy Springs, GA, talked about the process of opening his small business, a full-service restaurant and bar. Elmgren started thinking through his business plan and assembling financials in late 2018 to line up financing for his new business. “It was nearly impossible for me, as a first-time business owner to access bank financing without pledging my house and cars as collateral.”

The SBA is often cited as one of the first stop for small business lending, but the application process can be fraught with inefficiency. While the Administration says it can turn applications around between 2-10 days, it can take SBA lenders anywhere from 30-60 days to approve a loan. While SBA originations topped $41 billion in FY 2023, approval rates are cited by alternative lenders at less than 50%.

When asked about the SBA loan process, Elmgren shared, “The SBA loan process was much harder and more complicated than I expected. Going through that experience is what encouraged me to investigate other financing options.”

Elmgren eventually went the alternative finance route and secured a group of angel investors that was able to close and fund his needs in two months allowing the restaurant to opening in January 2020. Four years removed from that experience, Elmgren happily reports he has been able to pay back his original investors and that his business is thriving.

According to the US Census Bureau, immigrant (~18%) and minority (~21%) small business ownership points to high rates of entrepreneurism among these historically underbanked populations. For this segment of small business owners, access to small business finance can be equally, if not more, challenging.

Revenue Based Financing

Revenue based financing is another form of alternative finance available to small businesses. While a loan is secured with a form of collateral, this collateral is tied directly to the business’ assets and operations, and not the owner’s.

Revenue based financing models include merchant cash advance (MCA) and invoice factoring. While these products can be secured more quickly than traditional bank products, they have been scorned by borrowers and lenders alike for a number of reasons.

For borrowers, rates are onerous (in some cases, exorbitant) and often struck at severe discounts (or haircuts) to the collateral provided. For lenders, rates of delinquency and default are high due to structural market issues caused by a mix of issues including fraud, a lack of data, or a lack of understanding around the borrower’s business.

Data and Technology in Revenue Based Finance

In 2021, Pipe, an ambitious Miami-based startup raised $50 million from an all-star investor cast including Alexis Ohanian, Marc Benioff, Chamath Palihapitiya, and Michael Dell. Pipe’s premise was based on the tenets of revenue based finance. The early business model focused on providing financing to SaaS companies based on the value of their contracts with recurring annual revenue streams. Invoice finance (or a slightly sexier cousin) was suddenly en vogue.

In February 2023, Pipe appointed seasoned fintech veteran, Luke Voiles, as CEO. Prior to taking on the role, Voiles led loan origination teams at Square Banking and was President and CEO of Intuit’s
INTU
QuickBooks Capital, where he built a lending business that scaled to $2 billion in loans. Past stints with TPG Capital and Lone Star Funds also form the foundation of Voiles’ deep understanding of credit and the ways in which technology and data can be leveraged for more efficient underwriting.

Embedded Finance

Last week, Pipe announced new technology and capital partnerships to enable an embedded finance offering, Capital-as-a-Service, that has the potential to reach millions of small businesses. Initial partners in Pipe’s embedded finance program include Priority, a leading provider of unified commerce solutions to businesses that accelerate cash flow and optimize working capital, Infinicept a leading provider of embedded payments, and Boulevard, provider of the client experience platform purpose-built for appointment-based, self-care businesses.

During this year’s Fintech Meetup, I had the opportunity to learn more about the changes at Pipe. Over the past year, Voiles has revamped Pipe’s offering to broaden its appeal to more than just the software industry. He related his every day experience to the eventual focus on small business.

“Over the course of the week, I swipe my card at any number of small businesses– a coffee shop, a deli, a barber, a dry cleaner– all of which use a POS terminal to accept a payment. These small businesses also rely on a number of different software packages [vertical software] to help them run their businesses. Whether it’s managing appointments, taking online orders, or accepting payments, there’s a tremendous amount of data that can define the health of their business.”

While invoice factoring and merchant cash advance (MCA) use discrete transactions as the basis for their origination. Pipe seems to be adding more context to the borrower’s inquiry, which should enhance the understanding of the business and the inherent risk of lending to that business. This idea is a key tenet for embedded finance. With payments data and permissioned data derived from other software, a holistic picture of the business can be created more quickly than conventional underwriting means. According to Elmgren’s experience, small business bankers are more likely to take on small business clients with one to two years of operations under their belt.

According to Voiles, “With as little as 6 months of historical data, we can project what the next 12 months looks like… We can assess the health of these businesses and give them access to capital in a much simpler and more user-friendly way.”

While the initial roll-out will seemingly focus on self-care businesses like nail salons and spas, Pipe’s partnership structure has the potential to extend capital access to tens of millions of small businesses. In the same way that Boulevard focuses on the self-care space, there are a number of vertical software like Toast and Slice that cater to specific businesses (ie restaurants and pizzerias). According to Voiles, any business that has regular daily transactions or high transaction volumes could be a good prospect for financing.

The Future of Embedded Finance in SMB Lending

In a recent interview on the What’s Going On in Banking podcast, Nigel Morris, co-founder and managing partner of QED
QED
Investors, touched on the opportunity in embedded SMB finance. Morris says, “It’s a space where banks could easily have been involved. They have access to the checking account, work with them [data] and they have low cost deposits, but it’s a space that traditional banking has just not engaged in.”

While Elmgren uses vertical software in the operating Thos. O’Reilly’s, he has not taken advantage of revenue based financing. However, he has heard from other small business owners about the ease in accessing funding. “For owners, like me, that need to access some liquidity, it’s pretty straight forward. They click a button and can get funds in as little as 2-3 days.”

Pipe also announced they have secured up to $1.2 billion in capital to extend to the small businesses they serve. While the company has not disclosed the investors in this new go-to-market strategy, it is clear that investors see the opportunity promised by embedded finance. By leveraging technology to aggregate and analyze payment and operational data, new business models in the space stand to benefit while serving this historically underbanked, yet critical, sector of the US economy.