Action Guide

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.

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Why We're Here

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.

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Jeremiah Robinson

Entrepreneur in Residence and Manager of the Multicultural Catalyst Fund at Mountain BizWorks

“The Multicultural Catalyst fund allows us to support our entrepreneurs in a holistic way, making sure they have access not only to financial capital but human capital (as it relates to education), and social capital so they have the right connections as they build their businesses”

Key terms

  • Community Development Financial Institution

    Community Development Financial Institutions (CDFIs) are lenders that provide mission-based loans to people and businesses typically overlooked by traditional banks. To find a CDFI in your area, search the Opportunity Finance Network.

  • Loan Underwriting

    Loan underwriting is the institutional decision-making process through which financial institutions evaluate whether to approve a loan, and if so, under what terms. It’s important to note that underwriting is not a science. It’s an evaluation method that enables institutions to process information and adopt a lens from which to draw judgments about the likelihood of loan repayment versus default (often called the “riskiness” of the loan).

  • The Five C's

    The Five C’s of credit are a proxy for evaluating whether the borrower, based on their business plan, can pay back the loan amount being applied for.

    • Character is typically the applicant’s credit history, which is the measurement of the ability to repay debts and the track record of repaying them. This is captured on a credit report which culminates this information in a credit score. Ideally this C should also include a more qualitative view of the borrower – such as who they are as a person, do they pay their other bills on time, how they operate in relationships, and their contribution to their local community.
    • Collateral is an asset that can back or act as security for the loan. This is typically physical items, business or personal, that a bank could seize if the borrower defaults. This could include real estate and machinery.
    • Capacity is the applicant’s debt-to-income ratio. Essentially this is a calculation of whether the revenue of the business can pay for operating expenses and the loan payment. Some use a cash flow analysis to understand capacity.
    • Capital is the amount of money an applicant has. For example, is there a savings account associated with the business, etc.
    • Conditions are the purpose of the loan, the amount being applied for, the interest rates, and an evaluation of the current state of the economy.

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Learning

  • 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

  • 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.

  • Common Future 

     

    Community Credit Lab

     

    b:side capital (formerly Colorado Lending Source)

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Case Study

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.

Mountain BizWorks’ Multicultural Catalyst Loan Fund illustrates how character-based lending is put into practice. Here are the core underwriting criteria and loan terms for the Multicultural Catalyst Loan Fund, a capital source for entrepreneurs of color seeking to start-up their business.

 

No credit score or credit history, instead the cohort focuses on credit building.

  • Cohort members create personalized strategies to strengthen credit score with support of a credit analyst.
  • Cohort members have the option to request a 0% interest credit repair loan if they need to consolidate or refinance existing debt.

No personal collateral required. 

  • Loans are secured by business assets or the Buncombe County rotating loan loss reserve fund in cases where entrepreneurs do not have business collateral.

Option to use an individual taxpayer identification number (ITIN) number rather than a social security number (SSN).

  • This removes barriers for undocumented entrepreneurs to access the fund.

No prepayment penalties.

  • This gives recipients the flexibility to pay back their loan early without incurring extra fees.

Other loan conditions:

  • Loan amount: up to $100,000 over up to 10 years.
  • Interest: 5% fixed interest rate.
  • Flexible repayment schedule: No payments for the first three months, three months of interest-only payments, regular principal and interest payments begin month seven.

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.
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Action Steps

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

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    Ground institutional lending practices in values (racial equity and manufacturing)

    How can character-based lending be part of cultivating an institutional culture that is accountable to racial and economic equity?

    Character-based lending offers an avenue for CDFIs to translate their mission and values into institutional practice. CDFIs can start this process by doing some basic self-evaluation and discovery. Your first action step is to assess how existing underwriting practices do or do not reflect a lender’s values. This action can be taken as part of a periodic strategic review process or an unplanned call-to-action from a CDFI’s community or executive team. Some prompting questions include: 

    • Portfolio Review: 
      • Does your current portfolio of loans reflect the racial, gender, and sectoral makeup of the geography you serve? 
      • How did the portion and quality of loans deployed to BIPOC loan applicants compare to white borrowers? 
      • How did the portion and quality of loans deployed to manufacturers of color compare to other sectors? 
    • Underwriting Review:
      • Does your CDFI place a higher weight on credit and collateral than the other C’s? If so, what can be done to re-calibrate your underwriting? 
      • Is your loan review committee racially and gender diverse? 
      • What assistance do you offer applicants who have been denied a loan, particularly if the denial was due to poor credit or lack of collateral?

  • 2

    Embed manufacturing expertise in your lending and technical assistance team

    How can a CDFI develop internal capacity and external partnerships to support makers and manufacturers of color seeking business loans?

    Since an understanding of the viability of the business plan informs underwriting in character-based lending, it is crucial that underwriters are equipped with a robust understanding of the operating cycle of firms in the manufacturing sector. Identify lending staff who have the interest and capacity to become a lead on manufacturing loans and provide them training. 

    Evaluate your program and technical service offerings to see if you have training and business coaching targeting manufacturers. CDFIs that house creative business accelerators can provide targeted technical assistance and business development services to craft and creative businesses. Small- and mid-sized manufacturers have a business operating cycle that is particular to production-based businesses. Receiving specialized support from business coaches in the manufacturing sector is key to giving manufacturers the support they need. 

    If no current program exists, consider replicating one from another CDFI such as Bridgeway Capital’s Creative Business Accelerator and their Origins Program, which celebrates and supports Black makers with networking, consulting, and funding. 

    Another action is to reach out to existing external partners that support manufacturers including Made-In (e.g. Made in NYC or Seattle Made) or Local Branding Initiative (LBIs), Manufacturing Extension Partnership (MEP) centers, and manufacturing skills training programs, among others. Manufacturing practitioners can contribute their industry-specific expertise by advising underwriters on the nuances of the operating cycle for niche sub-sectors ranging from asset-intensive manufacturers to small-batch artisanal producers. 

  • 3

    Source supportive capital to enable and sustain character-based lending programs

    How can CDFIs and other community lenders tap into the right capital sources to enable character-based lending?

    What forms of support do CDFIs or other lenders need to incorporate character-based lending into their underwriting and technical assistance process? Access flexible capital sources, public sector partnerships, and aligned philanthropy to start and sustain a character-based lending program.

    Grants are key to shore up and sustain operating capacity for “high-touch” character-based lending. Quite understandably, character-based lending uses more institutional resources to extend a loan than automated credit scoring. The power of character-based lending stems from the relational and personalized approach to borrowing. Implementing this form of “high-touch” finance requires CDFIs to employ underwriters and technical assistance coaches. These CDFI practitioners work alongside the entrepreneur over the life of the loan to ensure the borrower is best positioned for success when they receive the loan. CDFIs can approach their philanthropic or institutional funders to provide a grant to support operating capacity for character-based lending.

    An inspiring recent investment was by Lever for Change through their Equality Can’t Wait Challenge, a $40 million fund supported by multiple large philanthropies. New Mexico Community Capital (a CDFI) and Native Women Lead were awarded funding to support indigenous women business owners. 

    Collateral support and loan loss reserve funds can offer crucial support to CDFIs implementing character-based lending. CDFIs practicing character-based lending step away from the collateral and capital that a borrower brings to the table. CDFIs can work with funding partners to develop collateral support programs and loan loss reserve funds in order to provide additional cushion to an institution’s reserves. This may be particularly useful for CDFIs implementing a character-based lending approach for the first time, or beginning to become more flexible on collateral requirements. State and local governments can be powerful partners in mobilizing collateral support programs, or a rotating loan loss reserve fund. 

    Since 2019, Mountain BizWorks and two other local CDFIs have partnered with the City of Asheville and Buncombe County to establish a shared loan loss reserve fund for the three participating lenders. The Mountain Community Capital Fund specifically aims to support entrepreneurs from Buncombe County who are not eligible for small business loans from the CDFIs because their application materials need additional collateral to qualify for the loan.

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What are you working on?

We know that a lot of great work is happening out there supporting BIPOC manufacturers and we want to hear about it! Our goal is to build a network of practitioners that can share information, resources, insights and help celebrate the achievements being made. Please fill out this form to let us know what you’re working on.