As distrust and dissatisfaction with commercial banks grew during the recent financial crisis, there was large growth in nonstandard types of borrowing arrangements. One such arrangement that has seen substantial growth in the past five years is crowdfunding —peer-to-peer (P2P) lending, in particular. Crowdfunding arrangements involve groups of individuals, not institutions, providing funding. As the name suggests, P2P loans are generally personal loans. However, small business owners often intermingle their personal and business finances so as overall P2P lending grew, so too did P2P borrowing for small business purposes.
Crowdfunding
The term crowdfunding has come to represent a spectrum of activities. The underlying idea is that funding that one would typically have to borrow through a bank or other financial institution is gathered from a group of individuals, or “the crowd.” This is not a new concept; rotating savings and credit associations (ROSCAs)[1] operate under a similar premise and have been long used in developing countries and within minority communities in the US. [2] However, the growth of the internet has given the concept a boost, allowing for a much larger and diverse “crowd.”
There is no longer a need for the individuals in the group to live in close proximity to one another or to actually know each other; crowdfunding sites are proliferating.
Early adopters of the internet for crowdfunding essentially used their websites as fundraisers. In some instances the crowd receives nothing in return, donating the money out of a sense of altruism. This is the model of websites like Kiva and Crowdrise.[3] In other cases, the crowd is essentially pre-buying the good or service being produced. This is the model of websites such as Kickstarter where funders are often given a copy of the book or CD that is being produced.[4] In both models, borrowers do not pay interest to the crowd or specifically repay the funds.
A second form of crowdfunding is equity crowdfunding as laid out in the JOBS Act of 2012.[5] In such cases, rather than receiving interest and principal for their investment, investors receive equity in the business. Prior to the JOBS Act, it was illegal for private companies to publicly solicit investments. It is only recently that the SEC has finalized its ruling making equity crowdfunding legal for accredited borrowers.[6] In an even more recent occurrence, the SEC has proposed rules to allow entrepreneurs to raise capital online with fewer restrictions on who can invest.[7]
The final piece of the crowdfunding pie is debt-based, so-called peer-to-peer (P2P) lending. In P2P lending, the individuals fund small portions of loans and receive their principal plus interest when the borrower repays the loan. The two largest P2P sites are Prosper and Lending Club. Prosper started in 2006 and Lending Club started about a year later.[8] Both websites use a credit score-based model for evaluating investment options. Applicants allow the evaluation of their credit to be translated into a letter grade and investors can then choose how much risk they wish to take on when funding a loan. As in traditional credit markets, higher risk translates into higher interest rates. P2P lending provides funding that might not be available elsewhere and rates are lower than for alternatives, such as payday loans.
The steady increase in peer-to-peer lending suggests the potential for much more growth. Currently, Lending Club loans are available to borrowers in all but six states while Prosper is available in all but three states. Investors face greater restrictions. Investors in only 29 states plus the District of Columbia are given access to Prosper. Investors in a slightly different set of 28 states have access to Lending Club.[9] If P2P lending were to become available throughout the rest of the U.S., investment dollars and P2P borrowing could grow substantially.
- A ROSCA is a group of individuals who meet at regular intervals; at each meeting, each member contributes a given sum of money which is then given to a single member at the end of the meeting. Meetings continue until all members have received the lump sum. See Ardener (1964) and Geertz (1962) for a historical perspective on ROSCAs. ↑
- https://faculty.arts.ubc.ca/asiwan/documents/siwan-qje.pdf ↑
- For more information, see the individual websites of these companies, http://www.kiva.org/ and http://www.crowdrise.com/ ↑
- See http://www.kickstarter.com/ ↑
- See http://www.whitehouse.gov/the-press-office/2012/04/05/president-obama-sign-jumpstart-our-business-startups-jobs-act ↑
- See http://www.bizjournals.com/portland/blog/perspectives/2013/09/secs-solicitation-ends-but.html ↑
- http://www.washingtonpost.com/business/on-small-business/sec-introduces-unanimously-approves-crowdfunding-proposals/2013/10/23/f5709630-3bee-11e3-b6a9-da62c264f40e_story.html ↑
- See https://www.prosper.com/ and https://www.lendingclub.com/ for more information on the individual companies. ↑
- See http://www.prosper.com/help/investing/http://www.prosper.com/help/borrowing/
http://blog.lendingclub.com/2011/06/10/is-lending-club-available-in-my-state/ ↑