Crowdfunding Main Street is a five-part series that expresses my personal thoughts and research on the magnificent implications investment crowdfunding holds for small businesses, investors, and communities. Implications that can only be realized, however, if our regulators stop defying the will of the people, and rise to effectuate the regulatory reform our Congress mandated to them. A disruption to our private financial markets is coming. A financial revolution will ensue. I hope my writing, if even in a small way, compels you to join. If you haven’t already : )
(Part I) Context, Economy, Industry: importance, magnitude, and a vision of what small business crowdfunding can be
(Part II) Businesses: a new source of capital, financially and socially motivated, a powerful new way to engage and acquire customers
(Part III) Investors: a new asset class, the advent of meaningful investment
(Part IV) Communities: transforming community development and igniting social capital through local investing
(Part V) Industry: Competitive look at who’s who, what they’re are doing, and what to expect
Small businesses, using the definition of firms with 500 employees or less, power our economy. They drove 67% of net job creation over the past 17 years and currently employ 57% of our workforce. It goes without saying, providing them robust access to capital is imperative to a continued and sustainable economic recovery. Unfortunately, the supply of capital for main street small businesses is under siege.
Investment crowdfunding can help. But before we look at how, which I’ll do in great detail, let’s first understand why traditional sources of capital are failing small businesses. Why? It’s simple to blame the banks, but the issue is more nuanced.
The great recession hit everyone hard. But it did a heck of a number on the availability of capital to small businesses, which has yet to recover. Washington hasn’t helped. Quick to say they found the root-cause of the crisis —a banking system thats massive financial leverage and global interconnectedness created profound systemic risks to our modern economy— they swiftly passed Dodd Frank, a comprehensive regulatory reform package dressed up as the antidote to our sick financial system. (Never mind the politically motivated fiscal and monetary policies that incentivized the massive over-leveraging in the first place. By both businesses and consumers.) Broadly, the reform called on banks to fortify their balance sheets through recapitalization, writing on/off underperforming liabilities and assets, and indiscriminately reducing “risky” underwriting behavior. It sounds sensible; after all, the banks were ridiculously over-leveraged. It makes sense, right?
On the surface, yes. But in usual Washington fashion, the policies were designed top-down, never tested, and consequently triggered a litany of perverse and unintended consequences. (Policy makers needs serious schooling in small-batch, test-measure-learn practices; a thousand copies of The Toyota Way should do the trick.) The effectuated rules were one-size-fits-all and drew little distinction between the trillion-dollar JP Morgans of the world and their community banking brethren.
The effect? The tremendous regulatory weight has fallen disproportionately on smaller banks. While mega banks have the resources to shoulder the regulatory burden, it’s breaking the backs of community banks at an alarming rate.
The Systematic Decline of Community Banking
Community banks are defined as banks with $1 billion in assets or less. In 2010, of 157 banking failures, 134 were community banks. And in 2011: 85 of 92. In other words, in the last two years our community banking system has accounted for 90% of all bank failures.
Failure is often healthy, fertilizing new growth. But this isn’t the case with community banks—failure is not seeding new growth. In 2007, 181 new community banks were chartered; in 2011, just 3. Assuredly, a natural and healthy contraction was in store as we recovered from bubbly times. But a 98% decline in startups is not natural, nor is it healthy. Juxtaposing the elevated failure rate with the depresses number of new startups paints the full picture: high death coupled with low birth is a trend line no one wants to be on.
How does this affect communities? Consumers may not feel the immediate pain of this decline, as larger banks swiftly fill in consumer gaps, but the same can’t be said for small businesses. While the roughly 6,800 community banks in America control only 8% of total banking assets, they account for nearly 40% of all small business loans. They punch well above their small business lending weight. Consequently, a decline in their presence has a magnified impact, ceteris paribus 5-to-1, on the availability of capital to small businesses.
Of course, it’s not just the contraction of community banking that is at fault for a decline in small business lending. The regulation has also created a blanket definition of risk that systematically disincentivizes lending to small businesses. It’s top-down, quantitatively egotistical, and qualitatively blind. So, as a small business owner, the substantive relationship you have with your local banker, or the social capital you’ve built within your community over years, if not decades—which propels enormous goodwill, customer loyalty, and economic value— means little, if anything, to regulators.
To summarize: a concoction of perverse regulatory consequences coupled with dilapidated and declining community banking infrastructure has created a deathly landscape for small business lending. And the numbers show it.
Small Business Capital: A State of Peril
The media often references the SBA’s Small Business Economy report as a proxy to measure the health of small business lending in the U.S.. It’s a richly detailed report produced yearly that, among other things, tracks “small loans” to businesses, classified as loans of $1 million or less. The aggregate value and number of loans made each year is captured. The most recent report showed a decline in the number of small loans made to businesses of 22% in the last three years, falling from 27 million in 2008 to 21 million in 2011. In dollar terms, this decline in 6 million yearly loans equated to $104.5 billion (reference source data). We’ve fallen below 2005 levels.
The picture is bleak. But it gets even bleaker. While popular with the press, the SBAs report, by design, does not make a key distinction. It accounts only for the size of the loan, not the size of the borrower. Big businesses can easily take out loans of $1m or less, and they often do, so this invariably skews the data. What we need is data that captures the size of the business.
Thankfully, the Federal Financial Institutions Examination Council (FFIEC) provides it. It tracks loans made to businesses with revenue of $1 million or less, regardless of loan size. It paints a more accurate picture of the depressed state of small business capital formation.
When adjusting for business size, as you can see, the picture turns darker, much darker. At its peak in 2007, 13.5 million loans were made to small businesses. Loan origination then fell off a cliff: down 20% in 2008; 42% in 2009; and another 31% in 2010. It strengthened in 2011, rising 20% to 5.1 million loans, but this was hardly a recovery. As far back as 2003 —pre-dating the explosion in credit— small business loan volume was 8 million a year, nearly 3 million more than in 2011. Bank financing, the living water to so many of our small businesses, is barely 60% of what it was—8 years ago.
I’ve aggregated and formatted the source data from the SBA & FFIEC reports in a Google Spreadsheet. You can access it here: TheCrowdCafe: The State of Small Business Lending
It’s clear that we need structural change to accelerate the recovery in small business capital. Many are strongly advocating for the reform of Dodd Frank and smarter regulations that don’t take a bat to knees of our community banks. Washington can’t just follow habit and throw money at the problem, announcing “bold” new programs with flashy acronyms, shortsighted incentives and the like. The problem is structural so changing the input will have little effect on the output — the system needs changed.
There’s more we can do. And now, enter crowdfunding. This is one thing our policy makers, in conception, got brilliantly right: the JOBS Act. Given regulators (the SEC and FINRA) respect the clear intention of the JOBS Act, it will empower us to take matters into our own hands. It —investment crowdfunding— represents the ultimate bottom-up solution. And where banks have stepped out, by intention or perverse regulation, the Crowd can step in.
Making Sense of Crowdfunding Law: Title II & III of the JOBS Act
There are two sections of the JOBS Act that hold relevancy to investment crowdfunding, Title II & Title III. They are often mistakingly lumped together when referencing investment crowdfunding, but the issue is far more nuanced, and it’s imperative to understand the distinction.
Title II: “Accredited Crowdfunding” (Estimated Implementation: Q1 2013)
Broadly, Title II lifts the ban on general solicitation and advertising of security offerings to accredited investors (high income/net-worth). Effectively allowing for crowdfunding from accredited investors. While well beyond its Congressionally mandated deadline of July 2012, many are optimistic we’ll see rules implemented by the end of Q1 2013.
For wealthy investors, Title II delivers enormous value by leveraging the internet to break down physical and financial barriers to investing in private businesses. Today, only ~10% of accredited individuals invest in the private markets. Largely because it’s such a frictional and onerous process. Particularly in more rural areas —anywhere between the coasts really— it’s super difficult to invest in private companies because angel investing infrastructure is extremely limited, if not not non-existant.
This all changes under Title II with accredited crowdfunding. The internet will become the backbone of a new private market infrastructure. Ubiquitous, and geographically indiscriminate. Offering a nearly frictionless experience, an accredited investor will be able to jump onto his/her computer and discover, engage with, and invest in private companies, anytime, anywhere. Live in Zanesville, OH? No problem. Geography becomes negligible, you can seamlessly discover and invest in private companies from your hometown to Oregon. Don’t have the risk tolerance to write a $20,000 check for one investment? No problem. You can invest as little as $1,000, even less, in startups or small businesses that catch your interest.
These dramatic improvements in accessibility and efficiency will motivate accredited capital off the sidelines and into private businesses in a big way. We should be psyched for Title II and accredited crowdfunding.
But shame on us if we let it suffice, and leave Title III, the true democritization of our capital markets, to drown.
Title III: True, Democratized Crowdfunding (Estimated Implementation: Q1 2014)
Title III rules, which include myriad provisions to protect investors, allow anyone to invest in private companies, regardless economic class. A deadline for implementation was originally set for January 1, 2013. This of course didn’t happen and early 2014 now seems to be the new expectation.
Some claim that providing equal accessibility to private markets is bad news for non-accredited investors. It’s certain to be over run by hucksters who prey on non-sophisticated investors they propose. This is nonsense. And I’ve published extensive data that disproves this notion, drawing from the outcomes of platforms abroad where this is currently legal to varying degrees. Not to say private markets will be devoid of risk, not at all. But the right to knowingly accept this risk, and invest in it, is absolutely ours. I can accept risk and buy a house. I can accept risk and walk into a casino. It’s positively insane that I can not accept risk and invest in a business down the street.
Unfortunately, the trajectory of Title III is troubling. It’s been habitually delayed, the SEC & FINRA have offered zero visibility into its progress, and there is great concern that excessively burdensome final rules will undermine the components needed to support a robust and working marketplace. That being said, I do remain hopeful. There is a collective voice of accountability, growing in strength, and impossible to silence, that will not rest until our private markets are democratized. Law be damned if it must.
So let’s run with this, setting aside the political nonsense. In the grand scheme of things, can crowdfunding really become a meaningful new source of capital for small businesses? Can it really put up of a fight against the depression of bank lending? Absolutely. And thanks to a pioneering crowdfunding platform in the UK, we already have the proof.
A Glimpse Into the Power of Small Business Crowdfunding: Learning from the UK
FundingCircle is a UK debt-based crowdfunding platform that launched in August 2010. Under the auspices of a supportive regulatory regime, as of today, it has crowdfunded over $110 million, across 1,370 loans, to traditional small businesses. It’s a truly democratized marketplace, liquidated by investors both accredited and non. And it’s growing ferociously. By my calculations it grew 12% month-over-month between November and December this year, an compounded annualized growth rate of 290%.
The UK Government isn’t blind to the profound implications of this. Thousands of small businesses being democratically funded by investors and all. While our regulators stalling is causing countless entrepreneurs to go un-funded, and job creation foregone, our friends across the Atlantic recently announced it will invest 100 million pounds in peer-to-peer financial marketplaces in the UK, $20 million of which will go to FundingCircle.
If FundingCircle’s growth continues to track comparably to LendingClub’s, a peer-to-peer marketplace for personal loans here in the U.S., it will pass the $1 billion mark in 3-4 years. This is just one platform, championing one model (debt), and operating in one, relatively small geography. Now imagine what an entire industry could do in the U.S. In fact, let’s do just that.
One Future of Small Business Crowdfunding in the U.S.
Let’s imagine. The SEC and FINRA come through. They lay out delineated, crystal clear and sensible rules. Rules that ensure all platforms adequately disclose risk while rightfully allowing investors to accept it. With complete regulatory clarity, crowdfunding platforms are given the freedom to innovate. Many fail in the fiercely competitive market, where good intentions hold little weight against technical experience, managerial aptitude, and deep pockets. Those that succeed emerge championing a diverse array of crowdfunding models, facilitating debt, equity and revenue-share transactions across different verticals, geographies, and affinities, each uniquely servicing varying needs and wants of businesses and investors.
A few stand-alone crowdfunding marketplaces, vis-a-vis FundingCircle, thrive. Powered by deep proprietary technology that algorithmically and expeditiously supports investors in measuring and understanding risk, these transactional platforms are high-volume, have secondary marketplaces, and are largely liquidated by institutional capital. (Of course, small capital is welcome too.) Big money flocks to this newly accessible alternative asset class —small businesses— for its high-impact, high-yield attributes.
But this model exists as only one of the successful manifestations of crowdfunding. Other innovators capitalize on the recognition that, at its essence, crowdfunding represents not just a platform or marketplace, but a tool. A tool that leverages the internet to bring disruptive efficiencies to the fundraising process. In the hands of private sector innovation, it’s used to augment existing ways of capital formation, as well as create new ones.
Crowdfunding platforms build expansive and colorfully diverse distributed partner networks. Partners include cities, banks, CDFIs, SBDCs, microlending organizations, service providers, and others in the small business ecosystem. A city crowdfunds a managed investment fund, giving residents a frictionless way to take stock, and identity, in their local community. A local bank crowdfunds $20,000 from the individuals to secure, and de-risk, a $100,000 new-business loan. Other public and private lending institutions follow suit. And a progressive University integrates crowdfunding into a holistic support program that serves businesses in its community; it’s powered by faculty and students of all backgrounds, who in return gain invaluable applied experience.
The list goes on, and on. And it’s not so hypothetical, many are in the works today.
We need to continue to fight tooth and nail for a supportive regulatory framework. The opportunity cost of a half-baked Title III is simply too great to absorb. Investment crowdfunding stands to unleash innovation into our financial markets like we have never seen before. Platforms will collectively create a nationwide funding infrastructure —supported and strengthened by partners across every plain and valley— that allows us all to invest in the private businesses we trust and believe in. Small businesses funded, jobs created, and communities meaningfully connected. The future we can have, and the future we need. This is the small business revolution.