Small Businesses Turn to Circle Lending for Financing

-- Expert Business Source, 2/5/2008 6:45:00 AM

“Get small business loans from associates, friends or family. Not from a Bank.  Imagine That,” boasts one online lending website.  “Peer-to-peer” or “circle” lending sites are offering entrepreneurs and business owners a new way to borrow money from relatives, acquaintances, or total strangers.  Also available to individuals looking for personal loans, these Internet sites are exploding in popularity, but the question remains:  is this a good way to obtain business financing?

Circle lending sites are essentially a more formal, online version of micro lending, where borrowers and lenders engage in business transactions without traditional middlemen, such as banks.  Sometimes referred to as social lending, theses sites charge a fee for facilitating transactions and helping the parties formalize loan documents, payments, and reports.

Many people know from experience that loaning money to a buddy is a good way to lose both your money and your friend in short order.  Loaning money to a total stanger about whom you have little information sounds foolish, at best.  But while this fairly new model and method of financing seems frought with risk, experts estimate that the default rates are much lower than one might expect.
 
“This level of documentation is one of the reasons that private loans using an intermediary…have less than a 5% default rate vs. a 15% default rate for an informal loan,” writes Helen Modly in “Keeping It Within the Family,”  a February 1, 2008, Morningstar.com report on circle lending.

Individuals and business owners are increasingly turning to this type of financing for a myriad of loan needs:  small business loans, mortgage payments, replacing high interest debt with lower rates, and purchasing items such as cars, motorcycles or home appliances.

“The market for the loans is still relatively small but growing fast, according to Celent, a research firm,” reports Kathy Chu in a December 28, 2008 U.S.A. Today article entitled “Peer-to-peer lending hits its stride.  Chu writes, “Celent projects that $5.8 billion in peer-to-peer loans will be made in the USA by 2010, an 800% leap from the amount this year.”

Circle lending companies generally fall into two categories:  auction and ‘family and friend” models.  Auction sites connect lenders and borrowers through a bid-and-offer process that expires after a specific period of time.  The lender willing to provide the lowest interest rate is the winner of the loan; as in traditional banking, these loans may be repackaged and sold to other intermediaries.  These sites typically feature pictures of borrowers (or the item they’re hoping to buy) with ad-like captions describing the purpose of the loan, the desired interest rate, and credit information about the borrower. 

The “family and friends” model connects people who already know each other, purporting to make it easier and more professional for them to transact a personal loan.  There is no auction, so sites with this model stress that the main benefit is the formalization of the loan, as well as servicing.

Is this a good way to get a business loan?  These sites are still relatively young, so little data exists about how sound or sustainable they are.  If you are considering obtaining financing through circle lending, you should carefully explore all alternatives for funding your business.  Ask yourself the same sorts of questions you would ask when thinking about a traditional, unsecured loan, such as:  How much do I realistically need to borrow?  How much interest can I afford to pay?  What are the terms of the loan?  What if I fall behind on payments?  What happens if I am unable to repay the loan?

Another important factor to consider is whether or not you would be better off with a traditional bank loan, where you might develop a valuable, ongoing relationship with a local lender who can help you and your business in various ways.

Here are a few pros and cons to consider:

Lower rates:  On circle lending sites, you may be able to obtain a lower rate than a typical financial institution might charge you for an unsecured loan.  If you have a low credit rating or other outstanding debt, this may especially be the case.  On the auction sites, borrowers are often able to gain lower rates by stating their case in a compelling or sympathetic way, such as “Help me start my dream business,” or “Need to pay a hospital bill.”

Chu writes in her USA Today article, “Lenders compete with each other to make loans, often resulting in lower rates for borrowers — averaging 10% to 16% — than are available on unsecured bank loans.”

Less Money:  As a small business owner, your financing needs may be in excess of what most of these sites offer.  Chu writes, “Typical loan amounts range from $8,000 to $20,000.”  

The family-and-friends sites tend to involve larger loans, including mortgages.  Because they are between people who are relatives or acquaintances, the amount of the loan is dependent on the relationship, not the site.

No Guarantee:  Numerous articles on this type of lending report that borrowers outnumber lenders, so some loans remain unfunded.

Is circle lending right for you?  As with any type of loan, the answer is:  it depends.  If you have family or friends who want to loan you money through a more formal process, circle lending may be a good way to facilitate the transaction.  If you have few financing alternatives at decent rates, the auction site might be something to consider.  But as always, think carefully about entering into any kind of loan, especially through a new model.

Suzanna de Baca is President of Private Capital Solutions Group.  She is a Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS), 7 Hanover Square, New York, NY 10004, (888) 600-4667.  Securities products/services and advisory services are offered through PAS, a registered broker/dealer and investment advisor. Private Capital Solutions Group is not an affiliate or subsidiary of PAS.
PAS is a member FINRA, SIPC.
Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as tax, legal or investment advice. Although the information has been gathered from sources believed reliable, please note that individual situations can vary, therefore the information should be relied upon when coordinated with individual professional advice.