In November 2011, Congress passed the Entrepreneur Access to Capital Act. The act allows ordinary people to invest up to $10,000 in small businesses not registered with the SEC and is a deviation from previous securities laws that allowed only accredited investors to buy into non-registered businesses. Before 2011, unaccredited investors could only donate funds to these businesses, commonly called startups. House Majority Leader Eric Cantor told Reuters the package of bills would help small businesses gain access to capital and would reduce the regulatory burden for startups.
Crowdfunding as we know it was born.
What Is Crowdfunding?
At its core, crowdfunding is simply a group of people pooling their money to support the efforts of other people or organizations. In a sense, credit union members are the original crowdfunders. Members pool their money via deposits to support the efforts of the credit union. From a wider lens, crowdfunding turns dreams into realities by allowing unaccredited investors, who historically have not delved into such funding, to dip into their pockets and finance various passion projects.
Unfortunately for credit unions and other financial institutions, crowdfunding further tightens an already competitive loan environment. It has become a viable funding source for projects that are too inconsequential or too risky for traditional financial institutions and even offers a way for consumers to address their personal financial needs. Small businesses and individuals that once relied on traditional sources of capital and credit can now turn to the Internet, where the majority of crowdfunding occurs. There, they appeal to a larger audience in the hopes that several smaller contributions will cover their larger need for funds.
In order to effectively compete in today’s changing lending landscape, credit unions must understand not only who their opponents are but also why a member would opt to use one. Sites such as Kickstarter, the world's largest crowdfunding platform, and Lending Club, a person-to-person lending exchange, provide a good place to begin necessary research.
Kickstarter was founded by Perry Chen, Yancey Strickler, and Charles Adler in 2009. It initially gained popularity as a resource for independent artists searching out funding for pursuits in film, music, literature, or video games. A New York Times article from 2011 called Kickstarter “the people’s N.E.A.” Kickstarter is not a store where people go to shop; it is a place where people go to invest. It’s an example of Internet Darwinism, where, as a Kickstarter blog states, “people ultimately decide the validity and worthiness of a project by whether they decide to fund it.”
As the Entrepreneur Access to Capital Act made way for everyday investors to join together to back business ideas they supported, product creators and not just artists increasingly started using Kickstarter to raise money. Despite its increased popularity, though, the site’s focus remains on art. Eight of the 10 highest funded projects by pledge amount are game and film related; however, with more than $10 million pledged, the top funded project is a customizable watch called Pebble.
According to Kickstarter, approximately 44% of its projects are successfully funded. Despite their popularity, though, some of these projects fail to deliver. What happens then? Where does that money go?
An NPR blog post asked this question in September 2012. Days later, Kickstarter responded, saying it verifies that its hosted projects meet a proprietary set of guidelines. After that, it is up to investors to determine for themselves the validity of the projects or the likelihood that creators can deliver on their promises.
The website hosts the projects but is detached from the funding process. All funding transactions occur between the creator and investor; Kickstarter does not touch, much less guarantee, pledged funds. Refunds for failed projects are at the discretion of the creator, and it is up to investors to bring legal action for any creator’s failure to complete a project as promised.
Due to its popularity and loose regulations, Kickstarter may develop into a resource for small businesses and startups. Because Kickstarter borrowers are not looking for loans in the traditional sense, but contributed capital without having to paying interest, credit unions could see their market share shrink as members find lending opportunities online.
The Lending Club
Crowdfunding isn’t just a resource for the arts. The Lending Club puts would-be creditors in touch with cash-strapped individuals looking for assistance. The website started operation in 2007 as an alternative to banks. According to its website, “by allowing our members to directly invest and borrow from each other, we avoid the cost and complexity of the banking system and pass the savings on to you. Both sides can win: better rates to borrowers and better returns to investors.”
Borrowers apply for loans, Lending Club makes the highest quality loan applications available to potential investors, and investors choose the loans they want to invest in. According to data provided by Lending Club, it originated north of $148 million in loans in May 2013, a 70% increase year-over-year. That’s no small feat considering it accepts less than 10% of all loan requests. Although the Lending Club process removes the volatility present in the Kickstarter model, the selectivity forces out the people crowdfunding is meant to benefit: the people who can’t otherwise get loans.
For those the site deems reliable borrowers, Lending Club provides potential investors with an exhaustive report of the risks associated with any investment and grades each loan on a scale from A-G in terms of risk and reward. Factors that influence a borrowers rating include current credit situation, transactional data, behavioral data, application data, credit history, employment data, income, and online footprint. However, as detailed as these grades are, Lending Club warns investors that, “Projected Returns are not intended as a promise of future results and are not representative of the projected performance of any single Note [a small fraction of the total loan].”
While Kickstarter facilitates the meeting between creator and investor and otherwise stays outside the process, Lending Club requires a payment for its services. It collects an upfront origination fee of 1.11-5% of the loan amount from borrowers and an outgoing service fee from investors of 1% of each borrower payment received. Even with Lending Club’s cut, the average net annual return for any loan varies between 6-10%, according to Lending Club.
Lending club poses a threat to credit unions. The site offers borrowers the opportunity to wipe out credit card debt, finance home renovations, or make large purchases; every loan funded through Lending Club takes interest away from financial institutions, especially credit unions that offer these same opportunities. Lending Club takes a chunck out of the credit union lending pie, forcing credit unions to compete a little more for every loan.