Building A Lending Business From Scratch I — Capital from Partnerships.

A lending business is the perfect example of a flywheel. There are two parts that you must balance and must optimize for with every other part; Capital and Repayments. These two parts feed into each other. When one is not working well, it throttles the other. This further throttles the first part and the cycle repeats, heading you for a crisis at a really fast pace.

Capital

I’ve written about capital sources before; Use your money, use your company’s money, start a savings product, form partnerships, or be a bank. There’s only one good and somewhat sustainable method; be a well-structured and properly managed bank.

I went the partnership route because it seemed like the second best option as I didn’t have the ability to be a well-structured and properly managed bank.

The partnership route is simple. Find financial houses that lend and partner with them to lend through you. However, they will set their rates and terms, but you will do the work of origination, KYC, underwriting, management, and recovery.

Since August 2021, we’ve processed about 3 billion naira, with the highest single amount being 45 million naira. Here is what that looks like in practice.

We partnered with different types of financial institutions; family offices, microfinance banks, private credit firms, loan houses, other fintech companies, and development/impact institutions. When we started the partnerships, we were enthusiastic because, from a venture-backed perspective, I wanted to grow as reasonably fast as I could and negotiate for better terms as we went along. Did my plan work? No!

Transaction terms are the beginning of the things beyond your control

As MPR increased, rates only followed suit. Yet, we couldn’t increase ours as fast as they did. (You can read here for my perspective on high rates as a lender). We started out with a 2% to 4% per month rate in 2021 and are currently at 4% to 5% per month in 2024.

From our partners, the lowest rate we started off with was 2.35%. This means that for everyone we lent money at 2% pm, it came from our own dedicated funds. We tried to keep 15% of our loan balance from in-house financing. The partners that gave those rates have since increased to 3.5%.

We had a partner that had a rate of 7%. No, you didn’t read that wrong — 7%. We negotiated a reducing balance with that partner as a way to balance out the cost versus the lending price. For every transaction that partner financed, we made $0 in net revenue, yet we delivered over 50% of the total principal amount in interest income to that partner over the 18 months of partnership.

The first thing our former head of finance did when she joined in 2021 was introduce a management fee. I didn’t want to introduce more cost, but she ran the numbers, put her foot down, and I had to concede. We charge 1.5% as a processing fee, out of which a third goes to credit-life insurance. Some of our partners charge 1.5%, which basically extracts the entire fee. The highest charged 2% and asked us to increase the fee to our customers as a way to balance out. One partner tried to charge 4%, but I outrightly rejected it. The ‘reasonable’ partners charged 0.8%. Whatever you do, don’t forget that rates will not go lower.

They could also put a cap on the amount, timeline for disbursements, repayment structure, industry, and operational structure that they are willing to be exposed to per customer.

Coordinating these multiple demands from all partners to provide coherent terms for all customers can be tricky but not impossible. Categorization, matching, and choices make it easier.

KYC and shared risks

KYC and underwriting are distributed. While we do KYC and underwriting of our own, some partners will insist on doing theirs. This seems like a good thing — shared risk, eh? No, it’s not. It’s a waste of time. They will not share in the risk and sometimes they will cause you trouble.

For example, a partner’s rep might fight with a customer during address verification or announce to the customer’s estate security that they are there to give Mrs. Y a loan. Those are the kinds of issues you’d have to deal with. When a loan goes bad, they will not share the risk of default with you either, so essentially, they are underwriting for underwriting’s sake. You remain the sole risk bearer.

Disbursement and customer relations

That you can have an agreed disbursement period doesn’t mean it will always be upheld. We had a disbursement delayed for 9 weeks, although we received reassurance of disbursement daily. I’ve had a partner tell me at 2 a.m. WAT that they were in the process of disbursement and were only waiting for authorization, only to ghost completely the next day.

Meanwhile, you have communicated a timeline with your customer as to when to expect fund release, and they’d be expecting it. When we paid vendors directly, we had a 72-hour disbursement timeline compared to the 48 hours with our partners. This was somewhat easier to manage. We could renegotiate timelines, but that meant weakening their enthusiasm to work with us. The customers were shielded from this and whatever urgent need they had would have been met. One way to manage this is to have a float on your balance sheet. This meant that you could immediately process to customers while waiting for partners to reimburse. We had this but quickly outgrew what we had. This is something you’d have to consider figuring out funds for.

Customers will quickly blame and mistrust you for KYC/B inconsistency, but also for delays in disbursement. Your customer support or success team will understand this better than anyone.

A single point of failure and efficiency

The worst mistake you’ll make is over-reliance on one partner. However, partners want you to rely on them solely. To them, the risk of your operations is higher when you have multiple partners; splitting loans among multiple partners, processing the same transaction multiple times across partners, or another partner fulfilling a transaction after they have deployed resources on KYC. Financing partners often want to control you because you are their obligor. You shouldn’t give in. Trust me, I’ve experienced it so you don’t have to.

Security Requirements For The Capital

For security, different partners will request different or multiple things. They will request things from you, things you must collect from the customer, and things they will collect from the customer. The terms were much more lenient in 2021 than they are in 2024. Many of them currently want a 100%+ backing of transactions in one shape or form. There are those that will request 20% to 40% without any significant yield. It is, however, not impossible to stake your reputation and make a gentleman’s agreement based on mutual trust.

The price of success

What happens if you are too successful with a partner? The thing you expect the least — panic. Yes, a partner will panic when a significant portion of their monthly transactions is now linked to you, and as part of their risk management processes, they might take a pause, start rejecting your transactions unfoundedly, or do something else that sabotages your operations. The way we thought to manage this was to negotiate and force a monthly and lifetime cap from partners. But as you grow, you will negotiate upwards until panic ensues.

What you can do

Better contracts? I’ve seen so much disrespect and disregard for written contracts that I do not think it’s binding enough even when terms are negotiated fairly.

Lend from your equity raise? I’ve shared in my previous essay on credit pricing why this doesn’t work — because it doesn’t scale

The only thing you can do is become a bank.

This is already getting too long, so I will dedicate other essays to capital from a savings product, navigating venture debt, repayments, the balancing act and finally, if a VC-backed company should be a purely lending product. I guess we are in for a series!

Notes

*I’m very happy to make introductions to partners, or help structure capital sources for as many that reach out. Shoot me a message on LinkedIn and although I’m not the fastest to reply, I always reply.

*A significant chunk of this essay was edited by o1-preview.