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Crowdfunding: A Real Alternative to Small Business Loans?

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Crowdfunding - An Alternative to Small Business LoansYou want to start a small business or launch a project, but small business bankers won’t give you the time of day. And there’s no way you can raise the kind of money you need from friends and family. Are you doomed to fail before you even launch? Perhaps not. With crowdfunding you may not even have to face the sting of rejection: you can go straight to your fans and clients to raise the funds you need.

Take Patty Lennon as an example. When she decided to launch the Mom Gets A Business Conference, she wanted to make sure she could keep ticket prices within reach for her target audience. She knew that she would need more funding than just ticket sales would provide. “I would have loved to have secured a loan but that wasn’t a realistic possibility,” she says. “Prior to launching my business I had a 15-year career at Citigroup so I am closely familiar with the credit standards banks use when lending to new businesses. I am still in the first two years of business so I would have been considered ‘high risk.'”

Instead, she turned to crowdfunding and was able to raise the money she needed in just two weeks. She now helps other business owners trying to crowdfund. “If they are in a position to get traditional lending I often advocate for that, but with credit standards becoming tighter and tighter, crowdfunding is the key to our startups’ financial growth,” she says.

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Many Ways to Fund

There are four basic crowdfunding models, explains Liz Kulik, co-founder and CEO of ProHatch, a crowdfunding incubator:

Free Credit Check & MonitoringDonations: Donors give money for a cause or event, with no expectation of anything in return. For example, GiveForward.com allows anyone to launch an online fundraiser for medical bills. It has helped families raise more than $42 million in donations for medical expenses including a recent surge in donations for victims of the Boston Marathon bombings.

Rewards: In this model, the person or business trying to raise money offers a reward to those who contributed. “It might be a T-shirt, or they might pre-buy your product,” says Kulik, who calls this an “incredible machine for beta testing products” and “for really developing strength before going for equity.” Popular platforms for this type of fundraising include Kickstarter and Indiegogo, but there are many more.

Lending: Borrowers get loans funded by “the crowd.” This model includes peer-to-peer (P2P) lending and microfinance platforms. Kiva, for example, is a well-known microfinance site where individuals can lend as little as $25 to entrepreneurs around the world. In addition, while some of the popular P2P sites like LendingClub.com and Prosper.com focus on personal loans rather than business loans per se, some borrowers use the proceeds from the personal loans they get through these sites to fund their entrepreneurial endeavors.

Equity Model: Here, a business raises equity (investment capital) from individual or institutional investors, a process that currently operates under strict regulations designed to protect unsophisticated investors. Under the JOBS Act, Congress eased some of those rules, allowing companies greater leeway when soliciting investors. It also directed the Securities and Exchange Commission to issue rules to help protect investors, but the SEC has not done so yet. Once they do, this model is expected to open up these investment opportunities to a wider audience, and allow businesses to reach out to a much larger group of potential investors.

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A Viable Alternative

“Currently to raise money using a Private Placement Memorandum (PPM), you’re going to have to pay an attorney $10,000-$25,000 — and even then you can’t freely advertise the offering to just anyone,” says Garrett Sutton, attorney and bestselling author of Start Your Own Corporation. “It has to be offered to those with whom you have pre-existing relationships. The JOBS Act will allow crowdfunding platforms to facilitate the offering of private placements to the public.” The SEC’s rules will still try to strike a balance between job creating and protecting vulnerable investors.

Chris Camillo, a prominent crowdfunding advocate and author of Laughing at Wall Street, says that crowdfunding can be a viable alternative to a loan for many people who “don’t have access to a loan, [venture capital] or angel funding.” That’s an opportunity for those who have a great business idea but may not have great credit. “Most small business loans are tied to your credit and not to the validity of your business idea, and that means some people are able to start businesses and some people aren’t able to start businesses,” he notes.

Getting a small business loan can require reams of paperwork, credit checks for the owners and principals, risky personal guarantees and even force the owner to agree to pledge their personal assets as collateral. But with crowdfunding, the experience can be much different. “Literally in hours or days an entrepreneur can raise a hundred thousand dollars or more from people who know them or know their market and value their business,” says Camillo.

Musician Kevin Devine, for example, recently raised the funds to produce his 7th and 8th albums using the crowdfunding platform Kickstarter. But before he went that route he says he considered other options. “I tossed around the idea of getting a traditional loan and even looked into approaching some independent backers as investors before I realized that I could literally invite my fans to be investors using something like Kickstarter. We were not only successful in raising the money, but the audience support was overwhelming.” Devine points out he “raised over $114,000 — no credit checks, applications, paying back interest — and I only have to answer to the fans, which is why I make music in the first place. Total win-win.”

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Credit and Credibility

If you have bad credit, can you still raise money this way? “Absolutely,” says Camillo. “There are some filters the government is requiring such as criminal background (check)” for certain types of crowdfunding. And “there may be crowdfunding portals where they may look at personal credit,” he says. But even then, whether or not personal credit is a factor may depend on the platform or whether the entrepreneur wants to disclose it “for a level of credibility,” he says. “Most crowdfunding will be conducted with a person’s social and business network. Credit is more important when someone is trying to evaluate a person they don’t know.”

Kulik agrees: “For equity (crowdfunding), credit may play a role but it’s more about what your business is about: your business model, your management team, your cost, your burn rate.”

There’s no shortage of criticism about what will happen after the JOBS Act is fully implemented, though, including concerns about whether entrepreneurs can execute on their visions once they’ve raised funds, as well as worries about outright fraud. But in the meantime, the number of sites offering one or more of the models above is growing.

After their son Barron was born with a port wine stain on his face, Martha and Grant Griffin decided to write a book to share their message that every child is unique and special. They raised more than $30,000 online to publish their book, Sam’s Birthmark.

Camillo, who knew the Grants, contributed to their campaign. He says it’s that kind of community-based fundraising that will fuel the growth of crowdfunding, and make it possible for others to pursue their entrepreneurial dreams — without going into debt to do so.

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