An introduction to embedded lending and financing

What is fintech lending?

Embedded lending and financing options can be attractive to your customers while generating robust revenue. Learn what’s involved and how to get started.

In our guides Revenue in Financial Features and The Ultimate Guide to Interchange Revenue, we explore the five potential revenue streams you should consider when making financial features available to your customers. In this guide, we’ll take a deep dive into lending and financing and explain how to think about these opportunities for your company.

In the broadest sense, lending and financing involve giving your customers access to funds they don’t already have. They can be valuable because they help businesses to manage the timing of capital outflows (costs) and inflows (revenues). Common forms include cash advances, invoice factoring, credit + charge cards, term loans, and lines of credit. 

If you’re seeking to become more valuable to your business customers while generating robust new revenue streams, this guide is for you. In it, we’ll discuss:

• Why embedded lending and financing represent a compelling opportunity for software companies
• Five common kinds of business lending and financing—and when to make them available to your customers
• What’s involved in launching lending and/or financing products—and how to build them into your current product suite

Although we refer to “businesses” in this guide, these products may be available to sole proprietorships and independent contractors as well. (article continues below)

Embedded lending and financing represent a powerful, largely untapped opportunity

In the past, we’ve highlighted that interchange revenue is a powerful monetization strategy for companies that make financial features available to their customers. 

As a complement to interchange, we firmly believe that embedded lending and financing will emerge as another primary source of revenue in coming years. Here’s why:

• They’re attractive to nearly all customers. According to our recent survey with the Harris Poll (see above), access to swift, affordable financing is the number-one thing small businesses want from their financial providers—and the leading reason why they’d be willing to try a new provider. When done right, fintech lending and/or financing can drive new-customer acquisition at an affordable cost. That said, it also brings additional compliance obligations, underwriting risk, and capital requirements, so it’s important to take a thoughtful approach.

• Many customers are underserved by traditional financial institutions. For example, take ecommerce merchants and gig-economy workers. Because their businesses tend to be younger, with unpredictable income and less operating history, they are often misunderstood and underserved by traditional banks. Companies like Shopify and Toast have shown that small businesses aren’t just willing, they’re downright eager to get lending and financing from software tools they already use.

• You are in the best position to make lending and financing options available to your customers. Because you already know your customers and your industry, you are much better-placed than an external lender or traditional bank to know things like a) how much money your customers need, b) how safe/risky they are, and c) how to price the offering. It’s also easier for you to promote these products to your existing customers, whereas traditional banks and external lenders have to spend money to acquire them.
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• Lending and financing offer uniquely strong revenues. The income that companies stand to make by providing lending and/or financing to their customers complements other potential revenue streams from financial features (interchange, interest, payments, and software). For example, Toast started offering financing to their restaurant customers in 2019. Today, their lending business generates $14M per year.

Shopify is another case in point. Today, more than 60% of their revenue comes from merchant services, the vast majority of which represent embedded financial products.

The simplest reason for making lending and financing options available to your business customers is that you’ve already built the flywheel: distribution, software, data, trust. Through software, you’ve become increasingly valuable to your customers; you’ve gotten to know them and earned their trust. Now the infrastructure is finally here that allows you to efficiently meet their lending and financing needs, which spins the flywheel even further and faster.

5 kinds of embedded financing and lending and when to make them available to your customers

There are many kinds of business lending and financing; which you choose will depend on your goals, your customers, and their needs.

Say you’re the CEO of Invoicify, a company that helps 100,000 small businesses manage their finances (invoices, payroll, taxes, etc.). Your typical customer has annual revenues of $150K–$1.5M. 

You’re excited about white label lending and financing because of how well you know your customers. You can see with clarity their unmet needs, the peaks and valleys of their seasonal cash flow, and their ability to repay. Not to mention, you can offer financing in your customers’ exact moments of need—i.e., on your platform.

Let’s say that one of your customers is a general contractor. In the following section, we’ll discuss the circumstances in which it might make sense to offer them each of the following five types of lending and/or financing: cash advance, invoice factoring, credit + charge cards, term loans, and revolving lines of credit. In practice, you might choose to offer your customers just one, all five, or any number in between. (article continues below)

Cash advance

With cash advances, you purchase a portion of the future revenues of your business customer, typically at a discount, giving them early access to funds they expect to receive in the near future.

Say your customer, the general contractor, needs to access $50K to buy new excavators. Through your platform, you can see that they consistently generate an ample amount of revenue each month and should have no trouble paying you back.

If your platform has unique or proprietary insights into the ability of your customers to generate future revenues, cash advance could be a good fit for you.

With cash advance, you could offer the general contractor the ability to tap a button, sell you a portion of their future revenues, and access the funds right away. Later, when the revenue lands in their account, the cash advance can automatically be repaid.

Cash advances may be a good fit for businesses that struggle to qualify for traditional bank loans. If your platform has unique or proprietary insights into the ability of your customers to generate future revenues, this may be a good option for you.

‍A real-world example: because DoorDash has unique insights into the revenue potential of the restaurants on their platform, they are uniquely well-positioned to offer financing to their customers by purchasing a portion of their future revenues.

Invoice factoring

With invoice factoring, your customer sells you the right to collect the money owed from invoices that are due to be paid by their end-customers. 

Say your customer, the general contractor, needs to pay their subcontractors, but they don’t have enough cash on hand. In many industries, including general contracting, large buyers often pay smaller suppliers 30–60 days after the work is performed and the invoice is received.

Invoice factoring transforms future revenue into funds your customer can use immediately.

Let’s say the general contractor is holding invoices worth $100K over the next three months. With invoice factoring, the general contractor could sell you the right to collect those revenues from the building owners in exchange for a lump sum of $97K. You keep the difference, in this case $3K—as well as the risk of missed or late payment. The general contractor would still be responsible for continuing to provide services to the building owners as usual. Only now, instead of paying the general contractor, the building owners would pay you (for the specific invoices you've purchased).

Invoice factoring can be appealing for customers like the general contractor because it’s a way to transform future revenue into funds they can use immediately—for example, to hire new team members or invest in better infrastructure.

Credit + charge cards (credit as a service)

There are two types of business credit cards: revolving cards and charge cards. A revolving card can carry a balance between statement periods, whereas a charge card must be paid off each statement period (typically monthly).

Say your customer, the general contractor, is looking to cover day-to-day expenses—things like gasoline and trips to the hardware store. After processing their application, you decide to offer them a charge card with a limit of $50K. 

Credit and charge cards generate robust interchange revenue—typically between 2–3% of the total transaction value for each purchase.

Or say you offered a revolving credit card and decided to offer one to the general contractor. As long as they don’t carry a balance (i.e., as long as they pay down their card in full every month), they won’t pay any interest. If they do carry a balance, they’ll typically pay 12%–23% interest on it.

Credit and charge cards can be a great addition to your product offering because they generate robust interchange fees (revenues you earn when your customers make card purchases). The amount of interchange you earn will vary based on your card network (e.g., Visa, Mastercard) and your partner bank. But it’s generally between 2–3% of the total transaction value for each purchase—often 50 basis percentage points more than a business debit card.

A real-world example: Ramp offers a suite of embedded financial products that gives them unique insights into the creditworthiness of their business customers. By providing their customers with business charge cards (both physical and virtual), Ramp turns these insights from its software product into incremental revenues in the form of interchange fees while also adding value to Ramp’s customers by helping their customers manage monthly cash flows. (article continues below)

Term loans

With term loans, the lender sends the borrower a lump sum which is repaid over a fixed schedule, usually with the addition of interest and/or fees.

Say your customer, the general contractor, plans to open an office in a nearby suburb. They need to purchase equipment and construction materials at a cost of $100K. After processing their application, you decide to offer them an unsecured loan of $100K with a five-year term (60 installments) and an annual interest rate of 10%.

Term loans can be appealing because they are easy to understand—and when it comes to how the funds are deployed, there are few strings attached.

Significantly, a term loan can be either secured or unsecured. “Secured” means that the loan is backed up by something the borrower owns—referred to as “collateral.” In the event of nonrepayment, the lender is legally entitled to seize it. “Unsecured” means that the borrower doesn’t collateralize the loan; that is, they don’t “secure” it with one of their assets. 

Because they’re less risky, secured loans typically feature lower interest rates and are less stringent in terms of the criteria for credit approval.  Returning to our example: the general contractor might collateralize the loan with a pair of concrete mixer trucks (value: $100K) and thereby qualify for a lower interest rate (perhaps 5%, rather than 10%).

Term loans can be appealing to businesses because they are straightforward and easy to understand—and when it comes to how the funds are deployed, there are few strings attached. (article continues below)

Revolving Lines of Credit

With revolving lines of credit, a lender provides funds up to a specified limit that a borrower can withdraw, spend, and repay over time. 

Let’s return to the example of the general contractor. As a business, they’re likely to earn more revenue in summer—when days are longer and the weather is more conducive to construction—and experience a corresponding slump in winter. But regardless of how busy they are, they still need to pay their full-time employees.  

Unlike credit cards, funds accessed using revolving lines of credit can be used to pay by ACH, check, cash, or wire transfer.

After processing their application, you approve them for a line of credit with a revolving limit of $100K. That means they can withdraw $10K today, $50K tomorrow, $35K next week—as long as they stay within their $100K limit. Once they’ve repaid what they’ve borrowed, their credit limit may be replenished.

Another productive way that businesses use revolving lines of credit is to fund inventory purchases. Once the inventory is sold, they repay the amount they’ve withdrawn plus interest. Unlike credit cards, revolving lines of credit aren’t limited to card purchases; the funds can be accessed directly and used to pay by ACH, check, cash, or wire transfer.  

Revolving lines of credit are typically used by businesses to smooth out uneven cash flow and fund inventory purchases ahead of sales. Interest is typically paid only on the amount withdrawn, and only for as long as the borrower holds it. (article continues below)

What’s involved in launching a lending and/or financing program?

How you choose to set up your lending and/or financing program will significantly impact your time to market, setup costs, and hiring needs.

There are a number of ways to launch a fintech lending or financing program, including those in the table below, with a great deal of ongoing market innovation. Regardless of which approach you choose, there are a number of potential factors to consider:

• Bank partner. Most software companies don’t have the bandwidth to apply for and maintain licenses in every state where a license is required for a given lending or financing product. For this reason, they often prefer to partner with a bank—either with or without the help of an embedded finance platform. We’ve written elsewhere about the challenge of finding the right bank partner, but suffice it to say that it’s crucial to partner with an institution that is fluent in modern technology, open-minded about your use case, and reasonably fast-moving. It’s also worth noting that a bank partner will be necessary if you plan to offer credit or charge cards.

• Compliance. Lending and financing products are compliance-intensive. Myriad regulations apply; in fact, in addition to federal law, every US state has its own, unique set of definitions and rules. You’ll need to acquire compliance expertise that can become fluent with these laws. If you’re planning to partner with a bank without the help of an embedded finance platform, be aware that banks will typically expect to see a strong business commitment in this area. You may need to hire a Chief Compliance Officer.

• Technology. You’ll also need to build or otherwise acquire the technology that will power your lending and/or financing program. As with other financial features, your software will need to do things like keep track of account balances, generate statements, and integrate with multiple fraud-prevention tools. However, lending and financing programs require additional tech: you’ll need to do things like calculate interest, monitor the performance of your portfolio, and report to credit bureaus. Perfecting these processes can take years; they require specialized engineering, product, and business talent. By contrast, many embedded finance platforms make this technology part of their core offering; if you plan to partner with one, then there’s no need to build it.

• Underwriting. Your estimation of a customer’s likelihood to repay is the basis on which you’ll make decisions about whether to make lending and/or financing available to them, how much, and how to price the offering. (In general, customers you deem riskier are given shorter terms at a higher cost.) How do you assess risk? The answer is that effective underwriting (risk assessment) is based on the smart use of data—both data that is publicly available with your customer’s permission (e.g., credit score, bank transactions) and data that only you have access to (cash flow, tenure on your platform).

• Capital. As part of making lending and financing options available to your customers, you'll need to figure out where the money to fund the loans and/or financing will come from. For example, if you issue 100 loans of $10k each, the program will require $1m of capital. In general, it will come from one of three sources: 1) your own capital reserves and/or money you’ve raised from investors, 2) your bank partner, or 3) third-party capital. Regarding the third option, many specialized credit funds and large investment banks specialize in providing funds to embedded lending and financing programs.

In all five of these areas, working with a bank without the help of an embedded finance platform can take years and millions of dollars. Fortunately, over the last few years, platforms have emerged that make the process much easier. The result is that it’s finally possible to launch financial products in a matter of months, without hiring a large full-time team, and without sacrificing your other priorities.

If you’re interested in learning more about how launching a lending and/or financing program can make you more valuable to your customers while building your bottom line, contact us to book a demo or sign up for sandbox.