Credit Data

Peter Thiel knows a thing or two about disruptive financial innovations. As one of the co-founders of PayPal, the Silicon Valley titan ushered in an era of online payments that forever changed the way commerce was conducted on the Internet. Through Clarium Capital, Founders Fund, and his own angel portfolio, Thiel has also backed credit card processing startup Stripe, as well as Palantir, BillGuard, BitPay, and numerous other companies redefining the way we transact in the digital age. (Disclosure: Founders Fund is also an investor in PandoDaily.)

It should come as little surprise then to learn that Thiel will personally lead the $20 million Series C financing of Los Angeles-based, big data-powered credit underwriting startup ZestFinance (fka, ZestCash), with participation from existing investors. The round brings the company’s total capitalization to $112 million including previous backers, Series B lead Matrix Partners, Series A co-leads Lightspeed Venture Partners and Upfront Ventures, and participating investors, Victory Park Capital, Flybridge Capital Partners, and Lighthouse Capital Partners.

Founded by former Google Chief Information Officer Douglas Merrill and former Capital One Head of Subprime Credit Cards Shawn Budde, the four-year-old company has been able to parse massive amounts of data to more than double the number of Americans that qualify for subprime credit, while reducing default rates by 60 percent compared to industry averages.

“When FICO launched in the 50’s, it completely transformed lending, moving it from a local business based on existing relationships, to a national one,” Merrill says. “But as part of that shift, we lost a lot of nuance. Credit today is based on past behavior – good credit begets more good credit, and bad credit begets more bad credit. We think that we have found a better way to get a complete picture on credit applicants. In 10 to 15 years, we expect this to be the only way credit is issued.”

ZestFinance, at its core, is a math company – a high powered one at that. Merrill has assembled a 65 person team, consisting largely of data scientists, who have built 10 machine learning-based analytical models which run in parallel to interpret more than 10,000 data points per credit applicant to arrive at more than 70,000 signals – all in under five seconds. Compare this to the 10 to 15 pieces of data that traditional lenders use and it’s unsurprising that the company is better able to assess consumer credit risk.

These data signals come from a variety of sources, not all of which the company is willing to disclose. Perhaps surprisingly, ZestFinance is less interested in social graph data than many other companies in its space. Not all signals are obvious, Merrill explains, noting for example that the way a consumer types their name in the credit application – using all lowercase, all uppercase, or correct case – can be a predictor of credit risk. Other seemingly trivial data points include whether an applicant has read a letter on the company’s website and whether the applicant has a pre-paid or post-paid cell phone.

“We feel that it’s an indicator of meticulous character,” Budde says. “Alone it has a minimal impact, but combined with thousands of other signals it begins to paint an incredibly accurate picture.”

When it first launched under the ZestCash brand, ZestFinance was a direct lender. The company has since evolved its model to that of an underwriting service provider to third-party subprime lenders, exiting the lending business to avoid the appearance of competition with its new partners. The lone such partnership announced publicly is with SpotLoan, which offers an online alternative to traditional payday lending. But, according to Merrill, the company has entered numerous other similar partnerships that it cannot discuss publicly.

Although ZestFinance declined to describe its monetization structure in detail, Merrill characterized it as “less of a licensing model and more of a transaction-based model.” This would lead one to believe that the company participates in the interest revenue that its partners generate on loans originated through the system, but this is purely speculative.

There was a time when online payments were considered unfeasible. Then Thiel and his partners created PayPal. Similarly, credit card processing has been regarded as a “solved problem,” Merrill says. Then Stripe, Braintree and others came along and began disrupting this long-held notion. Recently, Palantir has brought data-driven disruption to the remittance industry.

ZestFinance has shown similar disregard for the credit underwriting status quo. The company has achieved impressive results to date, significantly bettering the default rates achieved through traditional, FICO-based underwriting. Merrill and Budde believe that there is still more room for improvement and plan to use this new round of capital to deepen ZestFinance’s technical bench and further tighten its machine-learning algorithms.

“Getting credit into the hands of more people is one of the financial service industry’s biggest hurdles,” Merril says, adding that the company’s goal is to make billions of dollars of new capital available to the nation’s underbanked. “We’ve found that big data done right – machine learning, combined with human inference – can solve this problem.”

ZestFinance has a massive head start in its use of big data to solve credit underwriting problems. Merrill and Budde bring a rare set of experience to bear on this problem, and have now added additional cash and industry clout from Thiel. But like each of these previous financial sector incumbents, ZestFinance’s technical lead today puts a target on its back. With the amount of money to be made in this space, expect increased competition in the future, both from other startups and from traditional financial institutions.

The company also faces regulatory risk as congress and consumer protection agencies regularly look to tighten the reins on the often-onerous subprime lending market. ZestFinance is fighting to lower the interest rates and increase capital availability to this class of borrower, but that doesn’t make it immune from a future regulatory dragnet.

As I noted previously, ZestFinance is among a new breed of hardcore technology companies being built in LA. When Merrill left Google and his next project began to take shape, he headed for the sunshine and cultural diversity of Hollywood Boulevard – the company’s spacious offices are located in a nondescript second floor space on top of a local head shop alongside the Hollywood Walk of Fame. From here, the company is looking to disrupt decades-old financial institutions, many of which are located halfway across the country, and nearly all of which could stand to take a second look at the power of big data.

We caught up with the ink-covered entrepreneur recently at a tattoo parlor as we set him up to meet one of the most famous tattoo artists in San Francisco. We wanted to find out about the artistic man behind the data-driven company, why he left Google (He says it was a mistake to leave on April Fool’s Day), and how he hires (in case you are in the job market). Watch the video: