Alternative financing options for small businesses are growing quickly. But you need to look closely before you leap.
Small-business lending is becoming big business, with hundreds of millions of dollars raised from new and unique platforms such as crowdfunding, peer-to-peer lending, and marketplace lending. How can a shooting, hunting, or firearms business, particularly one that might have been denied funding from more conventional sources, take advantage of these speedy financing options while avoiding the risks associated with borrowing from these relatively unknown and unregulated lenders?
First and foremost, you need to understand the various options now on the market. The basics:
Crowdfunding employs an online platform to raise small amounts of money for a project or venture from large numbers of people. Only recently has crowdfunding entered the equity arena. Peer-to-peer (P2P) lending involves matching borrowers and lenders through other online platforms. The newer marketplace lending, while largely undefined, encompasses lenders that make loans to higher-risk, lower-income borrowers using micro-finance from larger-scale lenders.
The entire online lending marketplace, sometimes referred to as “shadow banks,” is an emerging segment of the financial services industry that increasingly uses online platforms to lend directly or indirectly to both consumers and small businesses. Borrowers in need of capital are able to gain access to funds quickly, and typically at lower interest rates than those offered by many banks, making them an attractive loan alternative for borrowers. Let’s take a closer look at each segment of this intriguing and evolving source of capital.
Crowdfunding platforms are most commonly known for raising money for worthy causes and special projects. Popular platforms include Kickstarter, Indiegogo, and Crowdrise, which provide reward crowdfunding and, more recently, crowdfunding equity and debt financing. Today, with the permission of the IRS and the Securities and Exchange Commission (SEC), crowdfunding is challenging venture capital and angel funding as an alternative source of financing for many small businesses, including, where permitted, firearms businesses. Equity-based platforms provide backers with shares of the business in exchange for the money pledged. In fact, thanks to the Jumpstart Our Business Startups (JOBS) Act of 2012, small businesses can raise more funds from small investors with fewer restrictions, thus creating more interest in crowdfunding.
New businesses or those in their early stages can pitch an idea to ordinary people as well as wealthy investors who might be interested in investing small amounts of money. In exchange, the business owner offers some small incentive to donors (e.g., a free T-shirt) or a larger incentive (e.g., equity in the business).
The new SEC rules allow businesses to raise up to $1 million online from non-accredited investors in a 12-month period. The compliance (essentially, the federal rules under which lenders must operate) usually required in private fund-raising is waived, though borrowers still must provide financial statements. These statements, however, do not have to be audited. Naturally, the ATF’s “responsible persons” rules, as well as state and local laws, apply.
The amount an investor can invest via crowdfunding will depend on the investor’s income. According to the SEC, an investor with an annual income and net worth of less than $100,000 can invest $2,000, or 5 percent of their net worth, whichever is greater during a 12-month period. An investor with annual income or a net worth equal to or more than $100,000 can invest 10 percent of their annual income or net worth, whichever is greater.
The crowdfunding sites, not the firearms business, must be registered with both the SEC and the Financial Industry Regulatory Authority (FINRA).
Borrowing from individuals and other organizations has also grown rapidly and moved into its own category, often referred to as P2P (peer-to-peer) lending. Much like crowdfunding, P2P lending matches borrowers and lenders through an online platform. P2P borrowers can gain access to funds quickly, and often at lower interest rates than those offered at banks, making this, again, an attractive alternative to more conventional bank loans.
The loans issued are made up of funds from many different investors, ranging from individuals to institutions. P2P lenders underwrite borrowers but don’t fund the loans directly; instead, they act as an intermediary between the borrowing business and institutional investors such as hedge funds and investment banks. Those third-party investors can invest in the loans on online P2P marketplaces, and they, not the P2P lenders, take on the investment risk.
Both individual and professional investors benefit by being able to lend money at a range of interest rates based on proprietary credit scores assigned by each platform. Since investors typically fund only a portion of a loan, they can potentially receive steady, attractive returns with the risk spread among multiple borrowers.
As a borrower, the firearms business interacts only with the P2P lender. After investors agree to fund the loan, the P2P lender transfers the total loan amount into the borrower’s bank account. The business/borrower repays the P2P lender, and they deal with repaying the investors.
As a more diversified set of investors, especially institutional investors, become involved on lending platforms, they are driving what has become known as marketplace lending. Online marketplace lending refers to the segment of the financial services industry that uses investment capital to lend directly to small businesses and consumers. Although the volume is tiny when compared with traditional bank lending, marketplace lending is growing.
Marketplace lenders employ new, largely automated underwriting processes. Some lenders purportedly rely on big data not evaluated as part of a traditional bank’s underwriting processes. However, there has yet to be one consistent, concise definition of what marketplace lending truly means.
The U.S. Treasury has issued a rather broad definition for “Marketplace Lending,” stating that it is: “The segment of the financial services industry that uses investment capital and data-driven online platforms to lend either directly or indirectly to small businesses and so-called consumers.” They go on to say: “Companies operating in this industry tend to fall into three general categories: (1) Balance sheet lenders, (2) online platforms (formerly known as “Peer to Peer” or “P2P”), and (3) bank-affiliated online lenders.” In general, a marketplace lender can be described more concisely as a non-banking financial institution that heavily leverages technology to drive simplicity and speed of process, and serves a two-sided market of consumers and investors.
Marketplace lenders are currently required to comply with federal consumer financial protection laws, such as the Truth in Lending Act, Equal Credit Opportunity Act, Fair Debt Collection Practices Act, and Gramm-Leach-Bliley Act. Peer-to-peer lenders who fund loans through third-party investors (rather than from their own balance sheets) may also be subject to securities regulation. For the most part, though, marketplace lenders usually are not subject to comprehensive federal or state supervision. However, many marketplace lenders rely on banks to originate loans and merely purchase those loans for resale to platform investors.
For these lenders, a borrower may indirectly receive the same regulatory protections as any bank customer. In addition, a marketplace lender that acts as a service provider to one or more banks may be examined by bank regulatory agencies.
Old Or New?
The majority of alternative online lenders lack a brick-and-mortar presence with which to interact with borrowers. This makes it extremely important for borrowers to spend the time necessary to differentiate the models. As previously explained, each type of lender has its own unique business model, with varying revenue streams and diverse motivations for serving their customers.
Bank loans continue to dominate the financing space for small and mid-size businesses in need of capital. But by design, online funding portals are more nimble, enabling them to operate with lower costs by not having to follow the same compliance and regulatory requirements. Crowdfunding, peer-to-peer loans, and the closely related marketplace loans offer an often less expensive source for the funds needed by a firearms business. They also tend to be much faster than funding through a more conventional bank or financial institution. Deciding which alternative will benefit your firearms business and be less costly may require the services of a loan broker or other qualified professional. At the very least, all options should be thoroughly researched on the internet they all utilize. In this case, it surely pays to look before you leap.
—Mark E. Battersby
—Illustrations by Adofo Valle