The financial crash of 2008 hit small businesses especially hard, reports a new study from the Small Business Administration. Almost a decade after the crisis, lending to small businesses is at 40 percent of pre-crisis levels. As small banks have disappeared and big banks spend more and more of their time and energy on well-established customers, small businesses have been left out in the cold when it comes to essential financing for start-up costs or equipment purchases.
Increasingly, though, small businesses have turned to alternative funding models, such as peer-to-peer lending. Is peer-to-peer lending right for your business? It certainly provides many advantages over banking alternatives, but it’s no magic bullet. Let’s take a look at this burgeoning finance field.
Most people are aware of crowdfunding by now, a type of fundraising conducted over platforms such as Kickstarter or GoFundMe. Individuals donate money to a project, often in fairly small amounts, and when it comes to fruition, they receive a gift in return for their donation whose value depends on the amount they gave.
The key word here is “donate”–crowdfund contributors don’t receive any ownership in the company and aren’t guaranteed any repayment or profit. The gifts they may receive for their contributions are more analogous to a tote bag you might get in return for donating to PBS. While this is a great model for many charitable causes and has helped some promising new products get off the ground, it’s not an ideal model for day-to-day small business funding.
The Oculus Rift VR headset was launched on Kickstarter, and when it was sold to Facebook for $2 billion dollars, many dismayed donors abruptly realized they had missed out on a 145x return on their contribution by donating rather than investing. The incentives of the crowdfunding world, in short, are fundamentally misaligned with many business purposes.
Peer-to-peer lending is a platform that replicates some mechanics of the crowdfunding world but uses true loans rather than donations. An issue brief from the Small Business Administration explains that if a small bakery needs $15,000 for a new oven, it could turn to peer-to-peer lending to get a $1,000 loan from fifteen people spread across the country.
Because the money being exchanged is a loan rather than a gift, lenders are incentivized to invest larger amounts in less glamorous projects because they know they’ll receive repayment with interest. Though true peer-to-company loaning is illegal in the US–you have to meet certification requirements with the SEC in order to invest directly in businesses–many peer-to-peer loans are given to individuals who use them for business purposes.
While most peer-to-peer platforms have minimum income requirements for joining as an investor, the bar to entry is still much lower than for true business investing. Forbesreports that the typical maximum loan size for P2P lenders in only $25. Borrowers gain access to multiple small loans rather than clearing the onerous application requirements of getting one large loan from a bank that is more interested in well-established business customers, and lenders enjoy the safety of a highly diversified loan portfolio.
According to the Small Business Administration, loans developed through P2P are often more appropriately designed for small business needs than loans straight from banks. Small businesses often require smaller loans over shorter periods of time. And though, as one would expect, potential borrowers do have to provide credit scores and other business information to make a case for the validity of their request, the SBA reports that P2P applications are generally far less onerous for borrowers than bank applications.
And it’s much quicker–while the process of searching for a traditional small business loan can take an average of 26 hours, many P2P loan decisions go through in a matter of hours. Because P2P is done through an online marketplace rather than through a series of bank encounters, the process is much lower friction and allows for an easier matchup between borrower and lender needs.
Sounds amazing, right? But there are some things to consider. For one, P2P loans tend to have much higher interest rates than bank loans, and there’s ongoing debate on the long-term health of the market. A late 2016 analysis of the German P2P market found that interest rates are higher in P2P platforms than bank loans, and the Wall Street Journalrecently reported on high default rates in P2P marketplaces.
Because most P2P loans are unsecured, when a borrower defaults, investors are usually left with no recourse. TechCrunch reports that many lending experts believe as interest rates rise, loan defaults will also rise, and “this will cause the bubble in the lending space to pop.” Peer to peer lending probably isn’t going anywhere soon, but it’s a flawed financial tool like any other, and it might change significantly over the next decade.
Currency’s model is a kind of marketplace lending, a term that applies to both peer to peer lending and online lending by large banks. But Currency doesn’t exactly follow the P2P model. Its lenders are verified institutional investors, rather than individuals, and third-party checks assess borrowers’ credit histories.
These factors contribute to Currency’s default rate being under 1 percent. The speed and flexibility of the online Currency platform allow small businesses and investors to find each other quickly, much like standard P2P networks. In fact, Currency’s search algorithm does much of the finding and matchmaking itself. Because the friction of matching lenders to borrowers is still so much lower than going through a bank loan, the benefits of P2P loans are still in play: businesses can find smaller, shorter loans, and they can find them quickly.
If you’re interested in learning more about lending options, please contact the Currency team today. We’re always available for a call at 877-358-4595, and would love to answer your questions and guide you toward the best financing option for your business.