Pathways to Patient Capital: Character-Based Lending

This guide is part of the Urban Manufacturing Alliance’s (UMA) Pathways to Patient Capital initiative. BIPOC (Black, Indigenous, and People of Color) manufacturers and makers face barriers to effectively financing their business’ growth.

These guides provide actionable steps that community-based lenders and individuals can take to provide non-extractive capital to makers and manufacturers of color.

The Urban Manufacturing Alliance is a national coalition of organizations and individuals that are building manufacturing economies fit for the 21st century. Our collective goal is to create pathways to middle-class jobs, spark homegrown innovation, and ensure that cities and towns continue to be the places where we make things.

UMA’s Pathways to Patient Capital initiative uplifts how policy and practice-based change with community-based lenders move quality capital into the hands of makers and manufacturers of color. This Action Guide is specifically for Community Development Financial Institutions (CDFIs) and other community-lending practitioners with a dual commitment to racial equity and exploring the power of making and manufacturing in their cities and towns. 

Dismantling racial and sectoral barriers to quality capital is essential to unlock the promise of entrepreneurship and manufacturing as a catalyst for community wealth-building, racial equity, and inclusive innovation. While the vision of making access to quality capital more equitable is a multifaceted issue, in this Action Guide we focus on the loan underwriting process for small business lending with a special focus on lending to meet the needs of makers and manufacturers of color.

The first step in loan underwriting for most lenders is evaluating the creditworthiness of the borrower. Five characteristics of the borrower and their business plan are considered: character, capital, collateral, capacity, and conditions. While there are Five C’s, they do not hold equal weight in most lender’s evaluations. This guide hones in on the Character C‘s and the too-heavily-weighted credit history or credit score. We believe that more community lenders could and should re-evaluate their underwriting process to include a true character-based lending framework that values the person and their relationship over their credit score.

What is it?

Character-based lending is an equitable, holistic, and relational lending process. CDFIs and other lenders practicing character-based lending extend loans based on the strengths of a business model rather than a borrower’s credit score.

Credit history, capital, and collateral are factors of a borrower’s access to wealth and privilege, not a reflection of the entrepreneur’s skills or the viability of their business model. The living legacy of systemic racism in finance – from small business to home mortgage lending – has perpetuated the racial wealth divide over generations. According to the Urban Institute, about 41% of Black communities, 29% of Hispanic communities, and 44% of Native American communities have subprime credit scores, compared to only 16% of white communities.

Unlike the instantaneous application results borrowers receive from automated credit scoring, character-based lending is a longer-term process where applicants engage with CDFI practitioners to develop a shared understanding of the business plan and the entrepreneur’s strengths. Historically, small-business lending was a deeply relational process but racially segregated. Over centuries and in its current manifestations, relational lending was racially exclusionary as commercial banks lent to white communities in their social networks. According to the Federal Reserve’s 2021 Small Business Credit Survey, Black- and Hispanic-owned small businesses were twice as likely to be “unbanked” (not use a financial service provider) than white-owned small businesses. Black-, Asian-, and Hispanic- owned small businesses were also substantially less likely than white-owned firms to borrow from small banks – a main source of capital in the entrepreneurial finance landscape.

The total over-reliance on credit scores for small-business lending means that entrepreneurs with strong skill sets and strategic business plans are shut out of opportunities to start up or grow their business. Having a poor credit score, or no credit history, is a barrier to small business financing because most banks require credit scores to qualify for small business loans, even loans guaranteed by the federal government, such as the SBA 7(a) program.

Why is this important?

Character-based lending is a way for CDFIs and other community-based lenders to re-calibrate underwriting and to deliver on their mission. Many CDFIs have already incorporated character-based lending practices into their own operating models and their loan products. Here are three traits we see these practitioners sharing:

Equitable: Equitable underwriting methods must account for how the racial wealth gap has shut out many entrepreneurs of color from qualifying for non-predatory business loans. Credit history, capital, and collateral are factors of a borrower’s access to wealth and privilege, not a reflection of the entrepreneur’s skills or the viability of their business model. Character-based lending acknowledges this historical fact and adjusts the evaluation accordingly.

Holistic: Mainstream underwriting practices tend to prioritize credit scores above all other criteria, creating a skewed picture of the viability of the small business loan application. In contrast, character-based lending is grounded in building a shared understanding of the business and the viability of the business plan in the current climate, thus placing proper emphasis on cash flow and conditions.

Relational: While credit scoring reduces loan approvals to an algorithm that generates an instant result, character-based lending is inherently a relational process between the lending team and the prospective borrower. CDFI practitioners describe how the underwriting process is interwoven with coaching and mentorship. Lending teams often work closely with prospective borrowers over an extended time period to craft their business proposals and a customized loan package. CDFIs also make sure if their loan committee and their loan offers reflect the race and gender of their borrowers, in an effort to address potential implicit bias. If a loan is denied, many of these CDFIs provide an opportunity for the business to understand why (instead of a blanket rejection) and an invitation to re-apply if certain goals are met or issues are addressed.

Who is doing this well?

Character-Based Lending at Mountain BizWorks: The Multicultural Catalyst Fund

Nestled in the Blue Ridge Mountains of western North Carolina, Mountain BizWorks is a CDFI loan fund committed to embedding equity in their lending practices and organizational culture. In 2019, Mountain BizWorks issued 2,816 loans to small businesses amounting to $74 million. While Mountain BizWorks serves a diverse portfolio across business sectors, they have a meaningful focus on manufacturing with nearly 20% of borrowers in the sector. Mountain BizWorks serves a multifaceted manufacturing base in western North Carolina that is home to clusters of makers in the textile, beer-making, and outdoor and recreational equipment industries.

The Multicultural Catalyst Fund provides financing and support for people of color and immigrants ready to launch their early-stage small business. Eligible Catalyst cohort members are entrepreneurs of color with start-up businesses that have between one to 10 employees.

For Mountain BizWorks, underwriting for the Multicultural Catalyst Fund is a holistic evaluation process somewhere “between an art and a science.” Mountain BizWorks’ lending team works closely with applicants over several weeks to several months. Underwriting is a deeply relational process where the lending team learns about the applicant’s business plan and strengths that they bring to the table. Ultimately, Mountain BizWorks and the prospective borrower work toward coming to a point where both parties feel confident that the loan can be put into action as a successful business plan.

A prospective borrower’s credit score is not the key that unlocks loan approval.

“We are not credit score driven,” explains Christopher Murrey, Mountain BizWorks’ Chief Credit Officer. “If you’ve had bankruptcies, we don’t get fixated on it, but it is part of the discovery process.”

Rather than penalize applicants with low or no credit score, Mountain BizWorks offers credit-building programming to support borrowers and position them for future financial success. Catalyst cohort members have the option to request a 0% interest credit repair loan if they need to consolidate or repair existing debt.

Flipping the Risk Paradigm: How Mountain BizWorks ReThink the C’s of Credit

• Character is a must. Entrepreneurs bring their unique mix of experience, skills, and talents to the table.
• Mountain BizWorks is creative when working with businesses in different stages of generating revenue and a predictable capital (cash flow). Capital flow is not a driving factor and Mountain BizWorks structures financial products with flexible repayment terms so that borrowers are supported in their early-growth stages as they are just starting to generate predictable revenue.
• Mountain BizWorks has flexibility on collateral requirements by drawing on a loan loss reserve fund to collateralize the loan with external assets. The Multicultural Catalyst Fund does not take personal assets to protect borrowers from potential losses.
• Market conditions remain an important factor in evaluating potential loans. Mountain BizWorks prioritizes investments in high-growth sectors that are well positioned for success in a post-COVID economic climate.

If you are inspired to deploy character-based lending for makers and manufacturers into your CDFI or lending institution, here are the steps to take: