Given that microenterprises and small to medium businesses create nearly all of the new jobs in the US economy, their economic health is vital to the United States. The Markle Foundation commissioned this exploratory study to analyze how, where and why small businesses were turning to new alternatives in finance to fund operations, manage cash flow, and seek capital for expansion.
Variously described as online lending, crowdlending, crowdfunding, marketing lending and alternative finance, there are literally hundreds of new options confronting small business owners who are seeking capital. Unfortunately, even among consumers of these finance products, there is a great deal of misunderstanding about the financial products and their relative benefits and risks. This report begins with a review of these mechanisms and then discusses the data that was collected.
Through a combination of structured interviews, review of existing data, surveys and original data collection from a small number of platforms, this report sought to explore:
This report is one of the first to provide demographic data about the alternative finance industry. It does not attempt to address the broader policy and regulatory questions that have emerged about the growth of the industry. After a brief review of models and the history of alternative finance, the majority of the paper is dedicated to a review of each business model and the available data about users of those business models.
Available data demonstrated that many of these platforms and models launched or focused early efforts on the South and Midwest, though growth patterns show substantial national uptake in 2013 and 2014 with the majority of growth occurring on the coasts. A fairly robust amount of data was collected about the race of applicants for equity and debt finance through these platforms, and failed to show apparent racial bias. There was a slight over-representation of black business owners in the debt finance category, and a similar over-representation of Asian business owners in equity transactions, but no striking racial bias was apparent. Some of the difference in debt finance of black business owners may simply reflect the racial demographics of the Southern United States where due to limited access to capital and many failed smaller banks, SME face additional challenges in accessing business credit.
Through interviews with microcredit and CDFI agencies, it is apparent that some firms are using alternative lending too early in their evolution. Many alternative lenders are willing to make loans to essentially the subprime business market (personal FICO scores as low as 500). However, there is also a growing trend for SMEs to utilize alternative lenders due to two benefits – their ability to issue credit based on off balance sheet measures as well as the speed of their loan approval processes. Platforms admit that many early customers had been rejected by banks, but as the industry matures, and especially over the past 18 months, more SME business owners are preferring alternative lending over banks, and believe the speed and ease of access to capital allows them to capitalize on business opportunities they would be lost during the multi-week process of bank lending.
Substantial data was provided about the education, training, and years of experience of applicants for alternative finance – including equity finance through Regulation D and Regulation A. This data shows that the majority of applicants for both debt and equity transactions are college educated, and many have business or technical degrees. This data suggests that alternative finance is appealing to a broad array of businesses owners. The industry makes the strong point that their business models require that the loans be repaid since securitization of reselling of these loans is just emerging in some markets. Many platforms carry the debt on their books and must make profitable loans.
The majority of firms applying for financing are “main street USA” firms such as service, food and retail establishments. They are not primarily technology startups. Other research has documented a nearly 30-year pattern of decreasing bank lending to SMEs (Mills & McCarthy, 2014), and the fact that many customers are traditional small service firms, restaurants and from medium to small cities, suggests that the early growth of alternative finance may have been in response to substantial challenges in accessing capital.
From interviews and discussions with regulators and policy advocates, it is apparent that the industry is still viewed with skepticism, and despite a lack of support in the data provided for this research, there are concerns that minority owned businesses may be put at risk through reliance on high interest rate Merchant Cash Advance lenders. Billions of dollars are flowing through alternative finance platforms that focus on refinancing existing consumer debt such as Prosper Loans and LendingClub, but their institutional backers have not shown as much interest in the SME space. There is limited interest among large institutional investors in the equity crowdfunding space. Given that many SME are financed on personal credit or home equity, this report briefly discusses the growth and opportunities in these marketplace lenders.
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