How Shopify aims to level the playing field with its machine learning-driven model of lending

Shopify is widely known for giving independent merchants a platform to start, run, market and manage their businesses.

But over the past 5 years, the company has been steadily growing another part of its own business: Shopify Capital. Through this arm, the Canadian commerce giant revealed today that it has provided $2 billion in funding to tens of thousands of entrepreneurs.

Besides being a cool milestone, how it works is interesting. Merchants don't necessarily have to apply for loans. Shopify's machine learning models identify eligible merchants based on their previous sales history and store performance, according to Solmaz Shahalizadeh, vice president of data science and engineering, commerce intelligence at Shopify. If a merchant accepts a pre-approved offer, they can generally receive funding in 2 to 5 business days.

While the milestone is significant, I was especially intrigued by the model by which Shopify lends money to its merchants.

It is intentional about using machine learning and AI to make sure offers are based on factors different from any other in the financial industry," Shahalizadeh said. We don't ask for a business plan. Our models see the business performance and it's potential and makes an offer based on that."

We use 70 million data points to understand larger trends across the platform for merchants, and can see they are growing before they even can so we can preemptively offer them," she added.

Kaz Nejatian, vice president of merchant services at Shopify, emphasizes that Shopify Capital does not lend in the manner of traditional banks by charging interest on loans.

Our funding is designed to work off sales. If you don't sell anything, we don't get paid back until you make sales," Nejatian said. It's a highly merchant aligned form of funding designed to fund the type of people banks and VCs won't fund."

The company's model also aims to eliminate any biases that exist in the current financial system, when it comes to educational background, ethnicity, race or gender, he added.

For Nejatian, it's also personal. His mother is a Shopify merchant who herself struggled with getting capital herself last year.

Our goal is to reduce barriers to entrepreneurship by offering access to funds," he said.

As part of that effort, Shopify Capital has increased the maximum amount of funding to $2 million. Previously, it granted funds ranging from $200 to $1 million.

Shopify offers two types of funding - merchant cash advances and loans. Shopify Capital charges a fixed fee (factor rate) on its financings.

On a merchant cash advance for example, it purchases $10,000 of a merchant's future receivables in exchange for a promise to remit $10,900 of their future sales. The $900 is the amount it charges for the financing, and is repaid by a merchant's daily remittances on days they make sales.

On its loans, it also applies a similar fixed fee to get a total repayment number, which is repaid via daily payments and milestone payments.

Simply put, the fixed fee that it charges is how Shopify earns money in exchange for funding our merchants. This fee, plus the amount advanced, are returned to the company over the life of a financing via daily remittance payments.

Says the company: By charging a fixed fee, a merchant is able to understand exactly how much they'll be expected to repay, before they take financing from Shopify Capital. These amounts don't change over the life of a financing."

Over time, Shopify plans to continually improve the machine learning algorithm behind Capital, making its predictive model even smarter," Shahalizadeh said.

Our model allows us to predict merchants' minimum sales with 90% accuracy while helping us make more proactive, pre-qualified offers as quickly as possible," she added.

Shopify merchant Steven Borrelli, Founder of CUTS, says that when he was looking for funding as a newer business, he ran into the challenge of most traditional banks and lenders wanting to see that he had been in business for several years.

CUTS started with getting $2,000 in funding from Shopify Capital. Over the last three years, it has grown into a business with sales in the tens of millions."

We found Shopify Capital to be so valuable that we've returned for 10 rounds of funding. Our most recent round of Shopify Capital was $1 million," he said. So far we've used the funding for expanding our product line and growing our inventory."