Launching a lending startup when you need a ridiculous amount of debt capital
Lessons learned from launching a mortgage fintech which raised hundreds of millions of dollars of debt capital
So you have a lending startup idea. You’ve talked to potential customers and you’ve validated it to the best of your ability prior to actually launching it. You are ready to pull the trigger and start working on it, but there’s just one small problem:
You need tens or even hundreds of millions of dollars to get started.
This was the situation that my co-founders and I found ourselves in when launching Fraction. Mortgages are, almost by definition, extremely large transactions. For most people they will be the largest transaction in their lives. A single customer might require over a million dollars. How do you even begin to get funding for something like that?
At Fraction, we raised over $200M in debt capital before we even closed our seed round. Before I continue, I’m not going to bury the lede and say two things about this: 1) We raised this capital in 2020 when interest rates were quite low—not at their lowest, but low. It would definitely be harder to do this in a higher-rate environment. 2) It wasn’t only low interest rates that made this happen. It was extremely challenging to raise the capital—we probably talked to 150-200 potential capital providers until we found our first partner. It was the right combination of product, team, market timing, and dumb luck.
First of all, know that you likely can’t raise equity capital to fund your loans. It’s just not an efficient use of VC dollars, who are looking for 100x returns on their investment. You can’t put that money to work at an interest rate that’s even slightly palatable to customers.
If you have very short-term loans, like a credit card startup, you can probably get away with using equity capital at the beginning because you can recycle those funds quickly. If you are doing longer-duration products like mortgages, that money will be tied up for years.
Maybe you can use equity capital at the beginning for the first few customers as a proof of concept, but chances are you won’t even be able to raise a seed round without having the debt capital already lined up—at least, that was our experience at Fraction. If you are a second-time founder or have some amazing pedigree, or have a really close relationship with a particular VC, you may have a different experience.
In most cases, you need to raise debt. If you don’t have any revenue yet, the only way that you are going to raise debt is if you pitch the product (which in lending terms will be called the “asset”) you are selling to lenders.
If you are selling a unique mortgage product for example, you have to pitch the mortgage product to the groups you want to borrow money from. They need to believe that the asset you are pitching fits within their mandate and also that you won’t lose their money.
Decide on the type of debt
a16z wrote a very thorough blog post on the different types of debt that are available to startups. I won’t really cover the differences here because they did a great job of going over it.
You may need to start small with a hedge fund or similar who will give you a small amount of money (low tens of millions in most cases) to prove out your model and you will pay a significant premium for doing so.
The only thing that I will add is that if you have balance sheet risk (i.e. you aren’t selling your loans immediately via a forward flow agreement or similar) that will generally be looked at quite negatively by most venture investors. You might have to take this balance sheet risk at the beginning to prove yourself out, but you should have a plan to change your model to an off-balance sheet model as quickly as possible.
Convincing the lender
Convincing the lender to give you access to debt has a few dimensions to it:
They need to want the asset
Do they already buy assets like this? Focus on groups like that, or groups that you’ve heard want exposure to this asset type. For example, there’s no point in pitching mortgages to a group that focuses on corporate debt because they are looking for a completely different risk and return profile.
Part of the challenge of this is that, as a startup with little to no money, you are inherently deemed risky. Banks and other large lenders prefer to deal with extremely well-capitalized businesses. Even if you are well-capitalized, the company won’t have much operating history. You will be considered a risky bet no matter how safe your product is, and you should expect to pay a premium for that.
Don’t try to be different
This is really hard for startup people to understand, and it was a lesson that took a very long time for us to internalize at Fraction. Startup people love change. They love creativity. Finance people hate creativity. Creative accounting is literally a bad word.
Okay I’m being a bit hyperbolic. Individual people in the finance world might like creativity. They might think your product actually makes a ton of sense, is economical, has a good risk profile, etc. But financial organizations like banks don’t operate on being creative. They thrive on stability and predictability. If your asset doesn’t look “vanilla” to them, you are going to have an extremely hard time selling it to lenders.
Fraction, for example, provided mortgages that were unique in two major ways: they had a variable rate where the interest rate was partially based on the home’s appreciation, and there were no required monthly payments. To consumers, this is a revolutionary product. It ties their ability to afford the interest rate to the underlying asset, and it frees up cashflow for them to invest in other parts of their financial life.
We could not pitch our product that way to lenders. If there’s not an existing bucket at the lender for your type of assets, you are almost certainly not going to be able to convince them to create a new asset class at their company for your little startup. You need to learn the language that lenders use and describe your product within that framework.
You need to fit into an existing bucket. Describe how your product is as much like a vanilla product as much as is possible. If you can’t believably make it look vanilla, you might need to change your product. You may need to do some financial engineering on the backend to make it look more like a traditional product. Just do it, it will make your life so much easier.
They need to believe consumers will want your product
Otherwise, why would they bother going through all the effort to due diligence you and paper up agreements if you are dead on arrival? Try to set up a waitlist that you can show the capital providers. At Fraction, we set up a waitlist of over 100 million dollars in demand (without doing underwriting on the applications, mind you), which we were able to then use as some amount of validation that people wanted our product. This later helped with raising our seed round too.
They need to believe that you, the co-founders of the startup, are credible
Are you and your co-founders the right ones to execute on your plan? What’s your history in the world of finance and capital markets? Have you operated a business like this before?
This is very different than pitching VCs. You aren’t looking to sell a grand vision of how you will change the world and fundamentally alter the course of human history and make everyone extremely rich in the process. They don’t really care—they aren’t investing in your business, they are looking to buy assets or lend money to a business that will be able to pay them back with interest sometime in the future.
Instead, you want to be able to point to your experience and say “I’ve pretty much done this before”. If you haven’t—you are going to have a really, really hard time. In this case, I’d recommend you find a co-founder who has that experience and has credibility with capital markets. Find that person and give them whatever you need to bring them on board and they should be your CFO or COO.
Don’t think you can short-circuit this by bringing on great advisors—frankly, nobody gives you credit for having advisors or board members; they want to know who is operating the business day-to-day.
Things to look out for
Do you have a term loan rather than a forward flow arrangement? Do you offer fixed-rate (as opposed to variable rate) products? You are probably exposed to interest rate risk—if interest rates rise, you could be on the hook for the difference compared to what you lent out at. If you can, you should set up a hedging program to hedge interest rate changes. It’ll cost you money to do this of course, but having interest rate exposure could end up being a systemic risk to your business if your loan book gets large enough.
What advance rate are you being provided? If the lender isn’t buying the assets directly (which they would be doing in a forward flow arrangement) but rather lending you money that you then use to lend out, they may only give you a portion of the amount received by the consumer. For example, if you have an 80% advance rate, that means the lender will give you 80% of the asset value and you have to provide the other 20%. Your piece is subordinate to the rest i.e. will take the first loss if there’s a loss of principal.
You may need to tie up some equity capital to cover that 20%, or you can explore mezzanine debt (which will be at a higher interest rate to account for the risk) to provide all or a portion of that 20%.
Does the lender want you to agree to exclusivity so that you can’t shop around to other lenders? Push back hard on this. Make other concessions if you need to, but if at all possible (and it isn’t always possible—they definitely have the upper hand in these negotiations), don’t agree to exclusivity. Capital can dry up quickly, a very eager lending partner can get spooked by the market completely outside of your control and can shut off the taps and kill your revenue overnight.
Papering the agreement
You and a lender have agreed in principle to an arrangement. Great! You can start operating now.
After the legal work. Which will take months. Also, the lender will probably require you to pay for their legal fees too. Expect to spend hundreds of thousands of dollars on this.
Before you get to that stage, you will need to get a term sheet from the lender that you can use to start on the next part:
Raising venture dollars
VC firms are generally very reticent to invest in lending companies that have a lot of exposure to capital markets. These types of businesses are quite a bit more complex than the straight-up SaaS company that most VCs focus on. Additionally, there is always the risk to your business that your lending partner(s) will pull your debt financing that prospective investors have to get comfortable with. You should focus on sophisticated fintech-focused investors who have partners that have experience in banking/capital markets.
Use the term sheet that you have from the lender combined with the waitlist to show that you have supply (your debt) and demand (your customers) for your product. Other than that, it’s pretty much a normal venture process. Just make sure to allocate much more towards legal fees than you might expect to in a normal tech startup.
There’s sometimes a chicken-and-egg problem where the lender wants to see you well-capitalized before they do the deal with you and the VC wants to see you have an available debt facility before investing in you. From my experience, VCs are more likely to be flexible here; you just need to find one that believes in you, the product, and is comfortable with the lender and the lender’s reputation.
Going into the future
Once you accomplish all of the above, you’ve got your first lender onboarded and you’ve raised venture dollars. You will now likely need to get licensed to operate (as you need to do in mortgage lending). That can take a few months at least and can take over a year in some states.
Once all that’s done, it’s time to start operating!
Make sure you are familiar with redlining laws, which will likely affect your marketing efforts and might create an upward pressure on your CAC.
In addition to your company itself being licensed, you also may need your sales people to be licensed, so you should either find people that are already licensed (which shrinks your hiring pool significantly) or you should front-run that licensing process so that you can start operating as soon as possible.
From a technology perspective, make sure to have your customer’s personally identifiable information (PII) safely stored—or better yet, don’t store it yourself at all and use a technology provider to store it on your behalf (examples of providers include VeryGoodSecurity, Vanta, TokenEx).
Once you’ve locked in your first capital provider, you need to get back out there and find the next one. Fundamentally, you have a two-sided marketplace problem, where your supply is debt capital and the demand is consumers. You want as many participants on both sides as possible, so build out your capital markets team early and continually be pitching your product to new providers. The challenge is trying to balance those two sides despite their massively different sales cycles (days or weeks for customers, months for debt capital).
Once you’ve got all that up and running, you can actually get out there and start lending. This is the most exciting and rewarding part. Money is a big part of life and your startup can actually have a big impact on people’s finances—so treat that with the respect it deserves and get out there!