Entrepreneurs the world over know how difficult it is to convince people of their potential and to get the support they need. But what if there was a computer-based questionnaire an entrepreneur could fill out in 45 minutes that assessed their potential to run a business? And what if credit-granting institutions took those results seriously enough to lend significant amounts to entrepreneurs based on the results?

Actually, it's already happening. Small and Medium Enterprises (SMEs) form the backbone and future of any well-functioning economy: they employ more people, drive more innovation, and post better margins than any other segment. Yet they often can't access finance. Why?

Banks will tell you that the two major challenges in lending to SMEs are transaction costs and information asymmetry. A significant cost of any lending transaction is the analysis of a business and its owners in order to assess whether they will be able to repay. With a small loan size, it is necessary to have an efficient method for addressing the information asymmetry: the relatively little a lender knows about the risk of the entrepreneur and the business.

This problem of keeping costs low and addressing information asymmetry is a major factor behind the $2 trillion global shortfall of lending to SMEs (yes, a two followed by twelve zeros). So what information can a lender access that will give reliable results when they often don't have consistent or trustworthy financials, forecasts, or personal documentation?

The traditional answers include group lending on the micro side or relying on collateral. But microfinance does not match the business model of many traditional lenders, and collateral can be very hard to produce, verify, and collect in case of default, especially in countries with a weaker rule of law.

An alternative to the traditional methods is to take a closer look at the entrepreneurs themselves and to develop methods for assessing their ability and willingness to repay. Recently, for example, lenders have begun to use mobile phone records or web presence and attempted to correlate past behavior to repayment patterns.

The Entrepreneurial Finance Lab (EFL) has developed a different solution that is simple and easy to administer. Psychometric testing has been in use since the 1950’s and is currently used by 1/3rd of Fortune 500 companies: it is a proven method for assessing the personal characteristics of potential employees to help determine if an applicant is a good fit for a certain job.

EFL has developed a credit test that includes psychometric testing to help fill the gap of information asymmetry. The test links repayment behaviour to responses to questions on ethics and honesty, business skills, intelligence, and entrepreneurial psychology. The test is highly predictive of an entrepreneur’s willingness and ability to repay a loan. The best part: these models work precisely in situations where the applicant is trying to portray themselves in the best light, like job interviews or loan applications.

How it Works

The Loan Officer at a bank identifies a likely client who meets certain characteristics (number of years in business, a certain level of account turnover, etc.) but who does not have the necessary paperwork to apply for a traditional loan. The loan officer will then have the client fill out a questionnaire of around 200 questions on a computer or tablet - this usually takes about 45 minutes. The questions are constantly rotated through and new ones added so that cheating the questionnaire is impossible. The Loan Officer will then send the results to EFL, and the paper application to their credit department.

Within an hour, EFL returns a 3-digit score to the credit department that gives a relative ranking and a predicted risk of default for the applicant. A credit officer is then able to use this score to set limits and pricing for the client, rather than turning down such applications due to lack of information.

The real question however is of course whether it actually works: if the EFL test doesn't return valuable and actionable risk-mitigating information to the bank, they aren't likely to use it. I think our experience in Africa has been instructive. After a successful pilot, our African partners introduced a product based on the EFL score and, thrilled with its performance, scaled it across 11 African countries.

And the demand across the continent has been phenomenal: although we might think that a 45 minute questionnaire is onerous, in this last year alone 30,000 African entrepreneurs applied for loans through the EFL questionnaire. After all, what is 45 minutes of questions compared to the stress and strain of applying for a traditional intuitive loan and all the paperwork that goes with it?

Better yet, 20,000 of these entrepreneurs have received loans totaling $150M and are on the way to growing their businesses, hiring staff, and building their economies and communities.

Photo credit: http://www.flickr.com/photos/worldbank/7556691542/

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