At Locavesting, we’ve always thought the best use of Regulation Crowdfunding was helping individuals invest in local businesses. Rather than buying stock (or SAFEs) in speculative tech startups, we believed that lending money to established small businesses would become a mainstream option. Lately, that’s looking more likely, as new funding platforms emerge that cater to local businesses and use some form of debt financing. The latest: SMBX. The Bay Area funding portal offers “small business bonds” in $10 increments. It’s tagline is “Be the bank.”
SMBX was founded by Benjamin Lozano, a PhD and former finance professor and CEO of SBMX (pictured above, second from left); Gabrielle Katsnelson, an accountant and financial manager and SMBX COO (at center); Bhavish Balhotra a banking technologist and SMBX CTO (second from right); and Jackie Chan, a former investment banker and SMBX CRO (far left). All were “fintech” enthusiasts who saw the potential of the JOBS Act to usher in “a new model of finance where people can earn a steady rate of return, fund the businesses they choose, and be the bank they want to see,” as the SMBX web site explains. We spoke with SMBX as they prepared to launch (the SMBX app will be available on the Apple app store).
What led you to start SMBX?
Ben: I was imprinted by two events in my life: first, growing up watching my dad’s boutique accounting firm in Santa Ana walk small businesses struggling through the SBA loan process, and second, teaching disaffected millennials finance for 10 years. We know that the money used to fund these SBA loans comes from our bank deposits. And the millennials I taught who were previously broke college kids now increasingly had investable wealth, but cared more about where their money was being invested than generations before them. I realized that a small business capital marketplace was the best mechanism to connect these high quality SBA small business owners and the millennials who would rather invest in them than fund their banks.
In 2012, the JOBS Act was passed. I waited and watched for a few years to see how the rules would be written for Title III (Regulation Crowdfunding). When it was finally published in 2015, we had the green light to start building this capital marketplace. We thought, “What the hell – it’s not every day you get the opportunity to build a small business capital marketplace from scratch. Let’s do it.” Fortunately for us, we were naïve enough to not realize how hard this can be.
What differentiates your platform?
Gabrielle: We are a FINRA licensed Reg CF platform focused on small business debt, specifically the SBA loan market. Most platforms focus on equity of startups. Some are introducing revenue sharing of Main Street businesses, and more recently a few are starting to market term loans. However, we are unique in that we standardized small business debt by engineering a new asset class: The Small Business Bond. The Small Business Bond is a fixed debt instrument issued at a $10 par value yielding principal + interest monthly.
Ben: In addition to engineering a new asset class, we introduced dynamic pricing into our offerings by way of a kind of auction method called a Modified Dutch Auction (MDA). It’s the way Treasuries get auctioned, and the way Google did its IPO. What this looks like is, we underwrite businesses based on objective criteria to assign them a risk profile that’s defined by a range of interest rates, a 200 basis point spread, say between 6% to 8%. Investors can reserve bids at the lowest yield, or if they are yield sensitive they can choose to bid at the higher end. It allows for gamification by way of market price discovery.
What are the benefits of that approach?
Ben: Auctions have proven to be the best method of discovering how much demand there is relative to supply. In the case of the Small Business Bond™, that means that investors in these bonds should get the correct yield on their bonds relative to the true risk in the investment, and that the small business owner who’s issuing the Bonds should pay the correct interest payments relative to their true risk profile. In other words, the MDA is the best known method for achieving fairness for both parties to the transaction—it’s a win-win for both.
Gabrielle: Businesses that we host on our platform have to have operating history and be profitable so as to service their debt. We want to mitigate the downside for our investors.
Ben: We want to be where the best businesses go. Our intention is for the best businesses to no longer ask to take out bank loans, but rather to offer to issue bonds on the SMBX.
Why focus on the SBA loan market?
Ben: Because it’s flawed and starved for competition. The SBA process is arduous and burdensome. If you are going the SBA route as a business owner, you are mentally and emotionally prepared to endure the paperwork and wait months for your cash. The issue is the additional regulatory fees that get smuggled in and that, because interest rates vary with Prime, businesses can’t manage their cash flow effectively. Everyone has known there’s a problem here, but until now there’s nothing we could do about it. Online lenders can’t compete because they have to follow private lending laws. They’re also partnered with institutions for liquidity that want a higher return than the SBA loan rate of return, which causes adverse selection on the small business side. When Title III was implemented, it made it possible to service this market by keeping operational costs low, and we could pass along that cost savings to businesses and investors alike.
Gabrielle: Businesses are agnostic to their banks and lending institutions. A side effect of automation is commoditization. Businesses are always looking for sources of capital. If you can ease the paperwork/diligence process and offer better rates, the businesses will show up. The SBA market makes sense because we have the most data on it and we know we can serve these businesses in a way that they will show up.
They’ve also been rigorously vetted by the SBA loan approval process, so are less risky, right?
Gabrielle: Precisely! We know they have gone through SBA loan due diligence which means they must have coherent financial statements, be compliant to ongoing financial reporting, have an actual plan for how they will deploy funds, etc.
Can you name some businesses that you are launching with?
Gabrielle: Our first offering, live this month, is Bernal Cutlery, a globally renowned cutlery shop based in the Bay Are. Offering details can be found here. We have a pipeline of 5 other Bay Area Main Street businesses—a brewery, boutique fitness studio, food truck, and a chocolatier. We can’t disclose by name yet as we are still working out details. We’re focused on Bay Area consumer-facing businesses to start because (1) we are based here, (2) there is retail capital with interest in supporting local businesses here, and (3) consumer-facing businesses draw in a crowd unto themselves.
We intend to expand into new geographies rapidly. And once we host 100 successful offerings, people are getting paid, and we as a platform have built credibility with the crowd we can expand to the B2B small business market.
What do you charge issuers?
3.5% of the capital raised at the close of a successful offering plus $100 annual service fee for the duration of the bonds lifetime.
What are you views on equity crowdfunding, where the payback for investors depends on an “exit”?
Ben: I think equity crowdfunding is great if you can invest through an index to get diversification, and have liquidity so you can exit the investment as you wish. Otherwise, you have no idea what your investment is worth and the odds are against you that that you’ll choose the one business out of the many who is going to hockey stick grow like Airbnb, Uber, etc. Unfortunately, I don’t think it’s a scalable business model without these features.
Gabrielle: Equity crowdfunding also has a lot of hype because it came out of this notion of democratizing angel investing. I love the concept in theory, but having been in the Bay Area the last couple of years my perception has evolved. The chances of the average retail investor seeing the capital gains pop from equity crowdfunding are less than favorable. It’s still early days and potential exists, though I’m wary.
How does the auction process work?
The auction is the method by which a small business bond offering is issued to investors. During an auction, investors can either buy now at the lowest yield or bid within a pre-set range of yields. Think of it like an eBay auction versus ‘Buy It Now’. If you want to be certain to get bonds, you buy now. If you want to game, you bid.
A successful auction arrives at a single offering yield, or interest rate. Investors who are willing to earn less yield will be the first to get the supply until the supply runs out. And the yield that the last available bond is sold at determines the rate that all investors will be paid.
Here’s an example: Suppose ACME Co. wants to raise $1,000 by issuing bonds of its company. It will auction 100 $10 bonds within a range of 6%-8%.
Investor A bids for 40 bonds at 6.0%
Investor B bids for 40 bonds at 6.5%
Investor C bids for 40 bonds at 7.0%
Investor D bids for 40 bonds at 7.5%
By logic of the auction: 40 bonds will be awarded to Investor A, 40 bonds will be awarded to Investor B; 20 bonds will be awarded to Investor C to close out the offering; Investor D is the highest losing bid yield; therefore the market clearing yield (offering yield) is set at 7.0%, and Investor A, B, and C’s bonds will yield at the uniform price of 7.0%.
What does the Fed interest rate cut mean for you?
Ben: Because we’re a two-sided marketplace, the rise and fall of interest rates will always increase and lessen demand on one or the other side of our marketplace, respectively. When rates rise, more small businesses will want to refinance their SBA loans on our platform, but investors will have other equally-attractive investment opportunities to find yield. Conversely when rates fall, as happened recently, more investors will be searching for yield, such as in Small Business Bonds, but the pain point for small businesses of paying too high of interest rates on their SBA loans will swing from unmanageably difficult to simply intense and annoying. Either way, if we execute our business model, we should be fine.
Gabrielle: The rate increases in 2018 made my job at business development way easier. We were seeing a 20% response rate on cold outreach because people who took out loans since 2015 were paying 200 basis points more than initially quoted. I think the rate cut will lower our response rate but not to a point of actual concern because those businesses are still paying 175 points too many.