Happy Sunday, friends. I had a wide ranging conversation with Melissa Bradley at 1863 Ventures that really got me thinking this week. (Stay tuned for a Speaker Series podcast with Melissa to be released soon!)
Melissa spent part of her early career as a banking regulator, so she has a uniquely informed perspective on SVB and the recent banking crisis. She (like me) has seen several predatory lenders emerge in recent years, many of them recent fintech darlings, and she sees these lenders as a problem for the early-stage company ecosystem, particularly when entrepreneurs do not possess the financial literacy to understand the predicament they get themselves into when they take (or stack) poisonous loans. She also sees the negative effects these loans have on the entrepreneurs she serves. Melissa shared that she is frustrated when she sees an overleveraged company that needs help, but that can’t be helped because they’ve taken on so much debt that there’s no real way to refinance that debt out.
As we were talking, we touched on a couple ideas that I think are really important. First, the regulators are coming. That’s obvious – just look at the number of states that are taking up this question and that are now enacting legislation. Look, I am no fan of regulation, but I am changing my mind, as I see that we do need regulation in this market, and it needs to be focused on the right problems so that it can provide the right protections. To be clear, I’m not talking about high-minded ideas about the goodness or badness of certain loans and practices; I’m talking about real rules that prevent lenders from preying on companies. I’m talking about preventing payday loan-like harm to entrepreneurs. That said, I do think the key overarching principle we should use is simple: Do no harm. Pretty simple, right?
Second, since the regulators are coming, it is important that we have a voice and that we share what we’ve learned as new guidelines are crafted. For example, I think the regulators need to focus on more than just APR and disclosures, which is where they typically focus in my experience. Yes, APR is critical, but there’s more to predatory lending than just that. In fact, here are two ideas I think might be useful to insert into any regulatory framework:
Consider a cap on loan sizing. You can kill a company even with a low APR if the size and structure of the loan is punishing. They would never even have the chance to worry about whether a loan is usurious! I think rules on sizing could be a function of revenue relative to payback timeline. The typical rule of thumb in RBF has for a long time been 30% of a company’s revenue, generally paid back in 3 years. That’s not a hard and fast rule, but on average it seems to work. When lenders provide substantially more than that, things start to get risky. When they provide more AND they require payback in less time, the risk to the borrower really starts to increase. Maybe it’s a sliding scale, but I think structure is just as important as APR.
Consider the idea that there is a minimum level of financial sophistication required on the part of a borrower for a lender to truly be exempt from regulation. In many states, for example, a lender need not worry about APR or usury laws if the loan is a business loan, made to a corporation, partnership, or LLC. That sounds great, but it relies on the assumption that someone can make the leap from founder to CEO and gain sufficient financial sophistication to make decisions about complicated loan products. That is simply not feasible. I’m a reasonably smart guy, and I get twisted up in loan docs all the time. For a founder who doesn’t have the benefit of experience or a sophisticated advisor, it’s hard to make a decision on a loan that’s marketed well but might be predatory.
I have two favors to ask of you all. First, I’m continuing to refine my thinking on these topics, so I’d love your feedback on either, both, or ideas on other areas that coming regulations might want to consider. Please share, and as I hear from you I will share more thoughts and ideas. Second, who in this community is working on this with regulators today? Please let me know!
