New Venture Lab: Equipping Christian Entrepreneurs

I will be the first to admit that I do not like the use of debt, but this new business model for banking is fascinating (see the story below.)  Now, please don't rush out and sign up for a P2P (Person-to-Person) loan, but do take to heart the lessons here.  This new banking business model has been embraced by several websites that are all scrambling to be the "eBay" of personal and entrepreneurial lending.  In the new Web 2.0 world, we need to be considering what will be next and how we can take advantage of it for our own businesses and entrepreneurial pursuits.  The Internet is indeed in its infancy.

Credit-market carnage makes it all the more important for small businesses to understand the full range of potential sources for capital. A growing alternative to traditional sources: person-to-person lending Web sites.

These sites, with names like Prosper.com, Zopa, Lending Club and GlobeFunder, use social networking tools and other software to simplify the borrowing and lending of capital between strangers and even family and friends. For entrepreneurs, these sites offer an alternative and needed source of capital. For lenders, the fast-growing sites offer competitive rates of return and the opportunity to easily participate in the cornerstone activity of capitalism.

The overall online market for person-to-person lending is still small, as are the size of loans. The largest and one of the oldest sites, Prosper.com, has originated $120 million in loans since it started in 2006. Most loans offered by P2P sites max out at $25,000. With the uptick in the number of Web sites in this market, though, both the size of the market and the loan amount could increase substantially in the next several years. In 2007, several sites, including GlobeFunder and Lending Club, launched; and Zopa, a United Kingdom-based site, expanded into the United States.

In Pictures: Entrepreneurs' Guide To Person-To-Person Lending Sites

The four sites--GlobeFunder, Lending Club, Zopa and Prosper--each estimate that approximately 20% of the loans they handle are for businesses.

"It's not going to replace traditional bank lending anytime soon, but it will be an alternative for some," says Dr. Thomas Meyer, an economist at Deutsche Bank Research in Frankfurt, Germany, and author of a research note on person-to-person online lending. "It certainly won't relieve the entire credit crunch in the private sector because it's a huge difference in magnitude, but it is a growing niche."

For small businesses that often get burned by bank credit scoring models, these sites can help ease the pain with straightforward approvals for relatively small loans.

"Traditionally, you could not get small business financing from banks until you had two to five years of financials to present to them," says Patrick Gannon, a senior vice president at Lending Club and a former executive at Wells Fargo's small business division. A person-to-person lending site, he says, "creates an opportunity for new business owners or someone with a business idea to pursue that entrepreneurial dream and get it financed by people who find it intriguing or the person's credit history to be good enough that people will take a risk on them."

Person-to-person lending, dubbed Banking 2.0, generally allows individuals to lend to each other at a set rate on a certain timetable and offers a mechanism for tracking and payment.

Prosper, Zopa and Lending Club all have mechanisms to transfer money between strangers and employ social networking functions that allow borrowers to tell the story of their need for capital.

"People are basically buying people's stories," says Samuel C. Li, a principal consultant in the financial services practice of PA Consulting Group, a U.K.-based firm. "How many people would lend to a stranger that told them, 'I'm way over my head in debt?' But in virtual worlds like these, lots of people are saying, 'I feel like this person needs help and I feel good about this person.' People aren't making normal credit analyses. There's emotion involved."

Prosper.com employs an eBay or auction-style model and lets potential lenders both determine the interest rate and who gets funded in a several-week bidding process. Zopa.com used the auction model in the United Kingdom, but in the United States where it launched in December, it works directly with credit unions and lets these unions set the interest rate and decide whether to fund. Borrowers can lower their interest rate by asking lenders to purchase certificates of deposit against their loan for rates of 4.25% or below, and credit unions guarantee the CDs. Lending Club also sets the borrowers' interest rate based on FICO scores and determines who gets funded. Once a rate is set, Lending Club matches lenders and borrowers by personal interests through their Web site or via Facebook. Borrowers share their stories, and then have a time window to see if enough lenders are willing to fund the loan.

GlobeFunder and Virgin Money USA don't use social networking mechanisms. GlobeFunder allows borrowers to appeal for funding, determines an interest rate range, and then working with its partners--institutional investors and hedge funds--finds out whether there's enough interest in the loan to fund it. Richard Branson's new venture, Virgin Money USA, which was formerly Circle Lending, facilitates the transfer of money between friends and family. Friends and family members negotiate rates, but Virgin Money sets up payment schedules and legal documents and charges fees accordingly.

Every Web site, with the exception of Prosper, mandates that users meet certain criteria: credit scores of approximately 640 and a debt-to-equity ratio of around 30%. In general, analysts say that small businesses can often get lower rates than they would through credit cards or other alternatives. For example, Renaud Laplanche, CEO and founder of Lending Club, estimates that borrowers on his site pay 12% interest rates on average. Ben Decio, president of GlobeFunder, points to a higher range for his company's borrowers: between 8% and 22%. By contrast, many credit cards charge between 20% and 30%.

There are downsides to these loans, particularly for small businesses. Li explains that borrowers must pay not only interest but principal on every monthly payment. (Bank loans first charge interest and then principal). Additionally, since most of these loans are fixed, paying them down can be difficult for start-ups and seasonal businesses. It's also difficult if not impossible to renegotiate these loans once they're set. "Who do you go to, to renegotiate these loans?" asks Li, who previously worked as a credit administrator at a California bank. "That can be really difficult for small businesses because they tend to have a lot of unanticipated issues."

For lenders, rates of returns on these investments can outpace many alternatives, including savings and checking accounts. At Prosper and Lending Club, lenders must be willing to take the gamble that they'll get paid back at the agreed upon interest rate. (These companies offer no guarantees). Zopa is a safer bet for lenders, as the credit unions certify the loans will be repaid. The interest rates at Zopa max out at 4.25%, which is slightly higher than most checking or money market accounts at major banks.

Right now, default rates at Prosper and Lending Club are relatively low, but that could change with the downturn in the economy. Prosper's CEO Chris Larsen says the rate of default is now around 4.7%. At Lending Club, borrowers with poor credit are excluded and therefore interest rates are lower. The site has only been in operation since mid 2007, but as of now, Lending Club claims to have a 0% default rate and says that only a small fraction of borrowers--0.012% --have made late payments (30 days or more).

What is the potential market for these loans? Analysts predict a huge surge in demand. Javelin Strategy & Research, a Pleasanton, Calif.-based financial services consulting firm, estimates that demand in the person-to-person lending market could hit $159 billion by 2012. Since the risk is born by the lender, it's hard to say what the public's appetite for risk will be. James Van Dyke, president of Javelin, predicts that the supply side will become clearer in the next 18 months as several of the new Web sites mature.

"It's like Paypal and eBay," says Van Dyke. "A few adventurous souls get in early, but most people want to wait and see how it works and take the advice once others have tried it."

By: Maureen Farrell

Source: Forbes.com