The Crowdfunding Threat to Traditional Business Lenders
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UPDATED: Jun 3, 2013
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Crowdfunding platforms are growing in number and expanding constantly. Everything from technology to movies to business ventures can be funded by these channels.
But if more and more businesses turn to alternative lenders for funding, what will happen to standard business loans provided by banks?
Loans.org found out how these two lending options vary, and whether or not there is room for each in the expanding economy.
Business is Booming
According to a report by crowdsourcing.org, on April 2012, there were 452 individual crowdfunding platforms (CFPs). Massolution, an industry analyst, reported that crowdfunding grew 81 percent worldwide in 2012. The next year is expected to bring even more growth.
Rewards-based crowdfunding, one of the four types of crowdfunding platform models, grew by more than 200 percent, according to Elizabeth Kulik, co-founder and CEO of crowdfunding platform ProHatch.com.
The other three categories of platforms are equity-based, lending-based, and donation-based crowdfunding.
The crowdsourcing report found that nearly $1.5 billion was raised by CFPs across the world in 2011. The United States was the largest market for this method of fundraising with 191 reported CFPs in 2012.
Kulik said that a recent $125 million investment by Google into Lending Club should reveal that there is a major market for alternative lending models.
The Growing Need for Capital
Alternative funding outlets, such as CFPs, are more and more relevant in our current economic climate.
Nancy Field, head of communications at Sterlingfunder.com, said that the recession and the subsequently restricted lending market have impacted the availability of business loans.
“Access to capital has become a real issue for entrepreneurs and small business owners,” she said.
CFPs provide funding for non-conventional issuers who have been refused by traditional lenders, said Chris Camillo, crowdfunding analyst and author of “Laughing at Wall Street.”
Beyond filling a much needed gap, the idea of these platforms is logical, Field said.
“Not only does it make capital more accessible for business owners, it also helps shift the balance of investment power from Wall Street to Main Street,” she said. “This opens doors for many people who might not otherwise have the capital to invest or start a business.”
One such group that is typically denied standard business loans are startups. For startups, funding by a traditional lender is difficult and rarely approved unless backed by wealthy investors or co-signers.
Jared Iverson, CEO of equity crowdsourcing portal healthfundr.com, said that crowdfunding will enable startups to begin easier, thus the business economy will see an increase in the number of startups.
“Crowdfunding platforms make the whole economic pie bigger,” Iverson said. “They may compete, on a small degree, with other existing capital sources, but for the most part they’ll dramatically increase the potential for funding.”
Many entrepreneurs who have been denied business loans are denied for reasons unrelated to the quality of their business. One rejected borrower is John Tordsen.
Tordsen, founder of Gigastrand International, said that despite owning businesses for the last 15 years, he has never been approved for a traditional business loan.
“Despite being guaranteed by the SBA, despite having good credit, despite having a track record of growth, I have never been able to get a loan,” he said.
He has owned three businesses in his career, and sought business funding for each one. His current business, Gigastrand International, has been funded entirely from sales and profits. But when he needs additional funding, he turns to CFPs.
“As long as I have a good idea and plan, I can get the small amounts of funding I need free of interest or the need to pay [it] back,” he said. “I call that a win-win.”
How CFPs and Traditional Lenders Differ
Consumers now have more options for attaining funding for their businesses or personal ventures, but CFPs and traditional business loans vary significantly.
Although they are both options for businesses, Tordsen said the two are “completely different platforms for generating capital.”
“Crowdfunding is more like running for political office than applying for a loan,” he said. “You put your name out with a video, some pictures and a description of what you want to accomplish. It’s more about how likable and relatable you are as opposed to what you can secure the loan with.”
Tordsen said that in rewards-based crowdfunding, if crowdfunders support the campaign, businesses only have to deliver on the rewards, but not repay the money they receive. After the reward is distributed to the supporters, the business or person is allowed to keep the funds to be used on the program.
The varied campaign process, which can be beneficial for business owners, increases the risk of failure for the lender or contributor.
Carl Wargo, C.O.O. of u-Wish LLC, said that crowdfunding models have more risk and exceed the threshold of risk that traditional banking lenders are allowed to surpass.
“If you have a solid business plan, potential investors lined up, and or some sort of collateral, you go to a bank,” he said. “If you have an idea, and a sketch of a watch, you go to crowdfunding.”
Wargo referenced the Pebble, a wristwatch that interacts with an iPhone, which was an extremely successful bid on Kickstarter.
Although the Pebble project surpassed $10.2 million in pledges, such success is a rare occurrence. In reality, similar startups or projects rarely gain approval for traditional business loans because there is no way to reasonably predict their success.
“There is no algorithm for the development of catchy ideas,” Wargo said.
Tordsen said that business owners approach the two options differently.
He said that when business owners need money and turn to crowdfunding, they will ask themselves “What is the minimum amount I can ask for to get this accomplished?” In contrast, borrowers of traditional bank business loans will ask “What is the maximum amount I can get away with borrowing to do this right?”
Not only do borrowers view the funding process differently, but the lenders themselves can vary drastically. Although a traditional business lender can offer hundreds of thousands of dollars in business loans for successful corporations, the amount requested never increases. With crowdfunding, the funding can vary significantly and can be a “more than you ever expected” type of funding.
“With a bank, you request $100,000 and hope to get all of it,” Wargo said. “With crowdfunding, you request $100,000 and potentially get $10,000,000.”
The Pebble exemplified this case.
But the opposite can occur as well. An owner can request $10,000 on CFPs and, due to uninterested or underfunded investors, only reach $1,000, and therefore not raise the necessary capital for the project.
A Place for Each Business
Despite appealing to different borrowers, there is a point when the market could become too saturated with funding options.
Most of the experts loans.org spoke with believe this will not be seen in the near future.
Wargo said that crowdfunding unambiguously increases the potential for funding in the business realm. This is because riskier investments are allowed to take place, which can be both good and bad.
“High-interest loans have their place, and high-risk crowdfunded venture capital will have its place also,” he said.
Camillo said that the two types of funding ventures are completely different and do not cross financial paths.
“There is virtually zero crossover between crowdfunding and traditional banking due to the early stage nature or inherently high risk of many crowdfunded companies,” he said.
Iverson believes that traditional banking will not only break even, but actually prosper, due to CFPs. He said that crowdfunding will likely increase business for traditional banking lenders. On the short term, some companies will turn towards crowdsourced capital instead of traditional business loans, but on the long term, crowdfunding will increase the number of practical and revenue-generating companies.
“Many of those companies, that may not have survived if not for the crowdsourced capital, will go on to pursue loans from traditional lending institutions,” he said.
Although statistics highlight crowdfunding platforms’ success and popularity, it is too soon for the platforms to be viewed as equals or any real threat.
Wargo said that traditional lenders have been “necessary middlemen” throughout history. These middlemen are now able to be bypassed.
In the future, Wargo said that traditional lenders will not vie for the attention of start-ups, but rather for established firms that use crowdfunding to bypass the fees from traditional lenders. Traditional lenders will likely have to re-adjust their policy on certain fee scales in order to attract borrowers.
And even though crowdfunding platforms could take funds away from the traditional business economy, Wargo does not believe they are the biggest threat to major banks. Instead, he believes overregulation will hurt large lenders the most.
New Medium, Old Concept
Although CFPs are still in their infancy stages, the concept around them is nothing new, according to Vernon Martin, a certified fraud examiner and a commercial real estate appraiser.
Real estate syndication started during the 20th century as a way for investors to pool their resources into a larger venture. Although the concept of real estate syndication could have prospered, it changed into a “more malevolent form” Martin said.
For example, a successful real estate developer would receive 100 percent loan-to-value financing from a bank for anything the developer wanted. When commercial real estate values declined, the entrepreneur would organize a syndicate to acquire properties instead of investing their own money. Martin said the limited partners were typically doctors, pilots, lawyers, or dentists who were wealthy but not financially wise.
“As commercial real estate markets sank, syndicates often made the general partners richer while making the limited partners poor,” Martin said. He continued stating that the word syndication became a tarnished word.
Martin said the concept of crowdfunding is not inherently sinister, but it can be abused similarly to real estate syndication.
“When there are enough crowdfunding disaster stories being told, the crowdfunding movement should subside,” he said. “Not every venture or loan deserves to be funded.”
The market is bracing itself for those horror stories. As new markets and platforms begin and expand, regulation to protect consumers must grow as well. Due to crowdfunding’s complex nature and the likelihood of its continued presence in the future economy, rules are being scrutinized and passed slowly.
Over a year ago, President Obama signed the JOBS Act into law. This was supposedly to allow equity-based platforms to grow. Despite the passing months though, the Securities and Exchange Commission (SEC) has not formalized any rules to allow small companies to sell shares over crowdfunding platforms.
Martin said the JOBS Act of 2012 had crowdfunding in mind when it reduced restrictions on publicly soliciting small investors.
“I think the hope was that this would get worthy entrepreneurs — perhaps a young Jobs, Gates, or Zuckerberg — funded more quickly in order to generate jobs more quickly,” he said.
Not all experts agree that increased regulation is necessary. Iverson said the government should not pursue regulating the industry more heavily than it already does.
“While investor protection is critical, the crowdfunding model itself brings greater transparency and accountability to the investment process by subjecting companies raising capital to the scrutiny of hundreds, if not thousands, of potential investors,” he said.
Despite a potential need for regulation, the positive power of CFPs for future entrepreneurs and the economy is limitless, Kulik said.
“Crowdfunding platforms will help shape the historically amorphous area of pre-institutional enterprise capitalization,” she said. “This is not transferring funding from one source to another, but actually the birth of a new sector of capitalization that will grow to become perhaps the most powerful and flexible and the world.”