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On Crowdfunding and Conventional Lending

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It's no secret that banks have been more wary of lending to small businesses inthe past few years. A 2010 survey by USA Today listing financing resources for companies placed bank loans at 43 percent in July 2010, down from 53 percent the prior year. And small business lending, which peaked at more than $700 billion in 2008, is closer to $600 billion now, according to data from the Federal Deposit Insurance Corp. This is despite a 2011 commitment made by 13 of the nation's largest banks to increase small-business lending by $20 billion over the following three years.

Then, in April 2012, President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law, legalizing equity and debt-based crowdfund investing (aka crowdfunding), aimed at helping small businesses raise the capital they need to launch or expand their operations. Crowdfunding will enable businesses to raise capital online from a large base of individual investors through SEC-approved portals.

This left many banking and financial institutions wondering how crowdfunding will affect bank lending to small businesses. Will crowdfunding crowd out traditional business lending by banks, home equity loans, and credit cards?

In reality, rather than replacing traditional means of obtaining capital, crowdfunding could actually facilitate the process of securing a business loan from banks.

Crowdfunding permits hundreds of eyes to scrutinize a company. The "crowd" is a testing ground, vetting ideas and providing feedback on how to improve the product or company. In the very near future, venture capitalists and bankers may be sending clients to the crowds to get their ideas validated first. Then, after seed funding from the crowd is obtained and the business model is proven, they will fund them.

In crowdfunding, the "crowd" takes the place of a loan officer and makes the determination as to whether a particular business, product or service will succeed by providing the ultimate vote of confidence-their own investment dollars. This makes crowdfunding the ultimate market test for a new product or service. Banks will feel more secure lending to businesses that have successfully raised their first round of capital through crowdfunding, and as a consequence, more banks will be making more loans.

To qualify for raising capital via crowdfunding, businesses will still need to have a solid business plan, meet SEC rules and pass background checks. Therefore, businesses that have successfully raised capital through crowdfunding have been vetted by the portal, and, more importantly, vetted by the investor community.

Crowdfunding also could fill the gap between the capital a business needs and the actual amount a bank is willing to loan. For example, a company requiring $500,000 to purchase equipment might be able to combine $100,000 raised from crowdfunding with a $400,000 bank loan.

Home equity loans and credit cards will still be utilized in situations where cash is needed quickly, simply because preparing a crowdfunding offering takes time. But using credit cards for long-term operations or expansion capital is costly and can get a small business in over its head, leading to higher default rates and bankruptcies. Also, the real estate collapse dried up many home equity lines, and while those lucky enough to still have equity may use it for long-term investments, crowdfunding offers another option.

Crowdfunding will make the biggest impact for borrowers that do not currently fit into traditional funding channels. But crowdfunding also will expand the market for traditional bank products, by giving bankers access to a pipeline of market-validated companies that have gotten over the hardest hurdles and now need capital for long-term expansion and growth.

 

Jason Best and Sherwood Neiss are the founders of Crowdfund Capital Advisors and sit on the boards of several U.S. and international crowdfunding associations. They lobbied in support of crowdfunding measures included in the JOBS Act.

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Comments (1)
Crowdfunding is a great way for startups and other new companies to gain access to capital. In fact, many of the companies that qualify for crowdfunding probably wouldn't qualify for small business loans in a healthier lending climate. Unfortunately, crowdfunding excludes many older and slightly more established small businesses - many of whom don't qualify for bank loans and who desperately need access to capital. There are many other types of financing that are a better fit for these companies. I work for one (The Receivables Exchange) that allows small business owners to finance their invoices by auctioning them in a real-time online marketplace. We need to continue to educate small businesses on their options when it comes to financing.
Posted by NOLAMariah | Friday, November 02 2012 at 10:02AM ET
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