A Brief Guide to Starting and Building a Lending Business

Starting a lending business is a highly intricate process that involves more challenges than developing a convenient app. Unlike tech startups, lending companies have various functions such as compliance and debt capital, which must work together seamlessly. Additionally, scaling a lending company is more challenging due to the uneven speeds of executing these functions, making it crucial to prioritize them correctly.

For instance, focusing on customer acquisition without having enough debt capital can harm customer trust. On the other hand, obtaining debt capital requires an equity cushion and a long wait of 6-9 months. Neglecting compliance can lead to fines, but prioritizing compliance can slow down product innovation. Successful unique underwriting during the early stages can cause discrimination at scale, leading to a reset that could potentially harm the business model.

When Stilt started in 2016, we didn’t know much about building a lending business. However, over the years, we learned and built out all the functions required for a successful lending company, including compliance statutes, payment systems, and debt capital raising. As fintech interest has grown, many founders have reached out to them for advice on building a lending company.

In this blog, we’ll will share what it takes to build out a functioning credit startup and discuss the five most critical functions a lending company needs, how to build them, and when to prioritize them.

5 Key Functions of a Lending Startup

When establishing a lending company, it is essential to concentrate on five crucial aspects:

1. Product
2. Acquisition
3. Underwriting
4. Debt capital
5. Compliance

Balancing and managing the interactions and interdependencies between these functions is challenging, particularly during growth, and will vary for each lending business. Although there are other functions, such as “Servicing” and “Fraud,” that founders must focus on, this blog will concentrate on the five areas mentioned above for simplicity.

In the following sections, we will delve into each of these functions and how to prioritize them at different stages of your company’s lifecycle, including pre-product-market fit, post-product-market fit, initial scaling, growth, and stable/mature stages.

1. Product

Lending companies usually fall into two categories: those that provide access to capital and those that reduce costs. During the pre-market fit stage, the most crucial area of focus is the product.

If you have not yet defined a clear value proposition or tested it on the target market, you should not divert your attention to any other functions, such as compliance or debt capital, as they can be distractions and time-wasters.

Online lending has various subcategories, and finding the appropriate niche for your company is challenging but crucial work. It is effortless to provide cheap loans and assume that it is a product-market fit, but the goal is to develop a product that people want and generates a profit.

One way to determine if your lending product is genuinely unique and has high retention is to test it at a higher price point. Many products perform well at lower prices but fail to sell or retain customers at higher price points. If you raise the price and sales and customer demand remain consistent, you have discovered your product-market fit.

Once you have identified your product-market fit, you can begin allocating time to other functions, such as acquisition. In general, most fintech products do not change once they begin to work effectively.

2. Acquisition

In the consumer fintech industry, the primary business is lending money, which inherently attracts a lot of customers due to the high demand for credit. However, some founders mistakenly believe that this demand for credit implies a high demand for their product, which is not the case. Fintech debt investors are aware of this and will see through such misinterpretations or misrepresentations, as well as any unique acquisition advantages the company may claim to have.

Therefore, acquisition is the most crucial and challenging function for fintech companies. After achieving initial product-market fit, founders must develop strategies to acquire new customers consistently and affordably.

There are several common issues founders face when it comes to customer acquisition. For instance, channel marketing can become problematic quickly, as channels that work initially may not scale, and new channels may reach their growth ceilings fast. Additionally, customer acquisition costs can quickly become expensive, particularly for marginal channels such as Facebook or with expensive channels like Google CPC campaigns.

Moreover, startups often face stiff competition from established companies with bigger brands, deeper relationships, and higher Lifetime Values (LTVs), making it challenging to spend on marketing. Despite the challenges, startups must become adept at identifying and exploiting new channels quickly and frequently, such as B2B2C partnerships (e.g., Affirm), referrals (e.g., Robinhood), and developers (e.g., Stripe).

As the company scales, customer acquisition will remain a key focus area, requiring ongoing attention and adaptation to remain successful.

3. Underwriting

Although credit risk is essential for all fintech companies, founders should spend less time on it than they think. Instead, they should focus most of their time on finding new data sources for underwriting.

The amount of time spent on a new data source should correspond to how unique it is. For instance, when working with an underserved population, founders should prioritize unique alternative data. Conversely, when using credit bureau data for underwriting, less time is necessary.

Founders must ensure that the alternative data sources used in risk models are reliable, consistent, non-discriminatory, and have high coverage. Moreover, they should avoid over-optimizing risk models before reaching product-market fit, as they are iterative and improve rapidly as lending and repayment occur.

The goal at this stage is to ensure profitable operations. While risk models help manage risk, interest rates charged should cover the cost of debt, absorb anticipated defaults, and generate profits for running the business, including customer acquisition.

Most significant lending companies started with simple risk models that were primarily non-quantitative, such as SoFi’s use of university, income, cash flows, and FICO or Lending Club’s use of simple regression models on credit reports.

Risks With Underwriting at the Growth Stage

During the growth stage, underwriting carries two primary risks:

• Rapid changes in the overall risk quality of applicants – Initially, founders have a good understanding of their customers and credit risk. However, as the company grows, the quality of consumer or business applicants for credit can change dramatically, and eventually, the law of large numbers takes over.

• Untested models and a large population – In the early stages, models are not tested on a large user base. As risks change, the models must be continually retested and calibrated; otherwise, defaults will increase significantly.

Note: Servicing is the other side of underwriting that comes into play after loan disbursement, and it is also operationally intensive. Building a good servicing function takes time and can account for up to 50% of the total team. It is also important to debt investors.

To build a successful underwriting function, founders must establish an iterative setup and ensure that their models comply with debt capital requirements and compliance regulations. Once market-product fit is achieved and alternative data sources that meet these criteria are identified, it is advisable to hire a Head of Credit Risk and let them manage the function.

4. Debt Capital

The primary product of a lending company is money, which is funded through debt capital. After achieving product-market fit, raising debt becomes a founder’s primary, full-time responsibility until the growth stage. While equity can fund loans initially, it is not a sustainable approach for scaling, and equity should not be tied up in loans.

Raising debt is a lengthy and expensive process, often taking between 6 to 18 months and costing over $150k in legal fees alone. However, the first fundraising round is always the most challenging, and subsequent fundraising efforts become easier.

Founders must lead debt fundraising at two stages: acquiring the first small line of debt capital and securing the first significant line of debt capital. In both cases, debt investors evaluate the company’s data and bet proportionally.

During the early stages, it is essential for founders to focus on growing the business rather than worrying about the cost of debt capital. It is easier to raise expensive debt capital initially, as expensive debt providers require less performance data and can close deals faster with lower legal costs.

As the company progresses, the cost of debt capital reduces, and founders can expect to secure larger, lower-cost debt lines during Series B and Series C. After accumulating enough performance data and building an equity capital cushion, founders can hire a Head of Capital Markets to scale this function.

5. Compliance

The amount of time founders should spend worrying about compliance is a debated topic, with varying opinions depending on who you ask. In the fintech space, most founders lack knowledge in compliance and may prematurely build their compliance function by working with the best lawyers and acquiring licenses to make it seem like their companies are growing.

Generally, founders should avoid focusing on compliance too early, except for companies selling to banks or other regulated clients. B2C companies should be able to lend with limited or no compliance requirements, and the focus should be on launching the product without licenses. On the other hand, B2B companies will need to adhere to a stricter set of compliances, such as Banking as a Service (BaaS) companies or Cloud Lending Technology providers.

It is challenging to comply with all regulations in the early stages, and it can slow down product innovation and iteration. Therefore, before finding product-market fit and solidifying the final product version, founders should not worry too much about compliance. Compliance is necessary for long-term sustainable businesses, and after Series A/B, founders can set up a compliance team to drive the function.

Putting It All Together

Building a fintech company is a non-linear process, and founders will iterate throughout the journey to find product-market fit, test acquisition channels, scale, and grow into a multi-billion dollar company. The areas of focus will change as the company grows, and it’s crucial to know what to prioritize at each stage to avoid wasting time and energy on functions that don’t matter.

While this information is not a comprehensive guide on how to move a lending company through each stage, it serves as a primer for prioritizing functions at each stage of the company’s lifecycle.

Building the necessary infrastructure for running a lending business is complex. However, focusing on product-market fit early on, consistently identifying multiple acquisition channels, building risk models on high-quality alternative data, committing to raising debt, and deprioritizing compliance until it becomes essential will keep the company focused and on track for success.

Frank Gogol

A seasoned SEO expert, Frank has a long history of working with and for startups. Starting in mid-2018, Frank served as the SEO Strategist for Stilt, a fintech startup that provided fair loans for immigrants in the US and other underserved markets. While with the company, he scaled site traffic from zero to more than 1.5 million unique visits per month, driving the bulk of the company’s lead generation until it was acquired by J.G. Wentworth in December 2022. As employee #5 at Stilt, Frank was witness to, and part of, the successful building and sale of a fintech company, uniquely positioning him to create content for founders about all things startups.

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