A new idea for small business lending and support

From my email, from Amanda Brown, she is developing this plan with Ben Laufer:

I am a master’s student at Stanford in Management Science & Engineering and a fan of your blog Marginal Revolution. I have been following it more closely in the midst of COVID-19, especially the conversations about small business financing during the crisis (e.g. today’s post about bridge loans).

I was hoping to get feedback on an idea for a new small business lending platform which would allow community members to fund fractional amounts of a business loan. The thesis is that fractional loan contributions from local supporters would give institutional lenders confidence to fund the full requested loan amount (and that the total amount contributed by peers would supplement traditional measures of borrower creditworthiness, such as FICO score, cash flow, etc., when setting the interest rate). For example, 10% of the principal might come from all the peer investors combined, and the remaining 90% from a single big lender. To my knowledge, nothing quite like this exists. In the wake of COVID-19 shutdowns, it seems especially important for small businesses at the heart of our communities to be getting access to low-interest financing based on peer endorsement.

Adding the “peer staking” element to a small business loan signals to investors that the local community believes in the future success of the business and the borrower’s likelihood of repaying (and peers would also be able to earn the same interest rate return on the principal as the majority funder… so it’s not like crowdfunding, where you contribute but won’t see your dollar again…). The design also increases accountability without the need for a collateral since borrowers would feel a personal responsibility to repay their peer debt-holders, who may be friends, family or customers.

I am wondering what your thoughts are on the idea (and its relevance at this time). If you think it is worthwhile, perhaps you would consider sharing this 5-minute survey with your followers to collect feedback on the idea:

https://forms.gle/Tk2Gweqa5frTacid9

Amanda Brown (aclairebrown@hotmail.com)

Ben Laufer (ben.laufer@gmail.com)

Comments

I don’t completely understand the concept of loans for small businesses devastated by this economic lockdown. The very concept of a loan depends on a cash flow generating borrower and most of the businesses hardest hit by this have no cash flow all of a sudden. And underwriting their future cash flows at this point is fraught with peril. They need grants and donations — not loans. Maybe gift card purchases which are basically loans that can be repaid in a currency that generates margin for the business. Don’t get me wrong I am for anything that helps and have been trying hard to support my local businesses but I worry that loan programs unless they are forgiven don’t ultimately help.

Don't companies normally have reserves? Mercedes (not a small business) has said it does not need government help, and is still paying out its normal dividend. A small heating installation company with five employees is different, but isn't it reasonable to believe that the owner has enough personal savings to keep the business and themselves afloat for at least a couple of months while the employees collect unemployment for those months?

Perhaps, but by the same logic we shouldn’t be considering any bailouts whatsoever. Large companies have more resources, and so should be expected to weather a downturn like this no sweat. I’m looking at oil and gas, airlines, auto industry, and big banks. But we are considering bail outs, so I guess we shouldn’t fault small businesses for not maintaining cash reserves unless we’re going to expect them of everyone.

Here in Colombia, the idea is to give 2-3 month grace periods for small businesses to start repaying their loans.

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No. Most small businesses are very undercapitalized and their expenses are much higher than you assume. A personal savings account is unlikely to have enough money to meet payroll for five HVAC techs

Good thing weaker businesses will be weeded out. Capitalism works if we let it.

Depends on how you define "Weaker". Generally, younger and/or smaller companies are economically weaker than larger ones. And they will likely die. This is not always how we want things to be.

Think about it: by that logic, many startups in Silicon Valley will be allowed to die and we will be left with the larger tech behemoths. Do we think innovation will increase? How about prices? How about service?

But if, by "weaker", you mean a company with an inferior product / service offering (defined as price/performance is lower than other available alternatives), then I can buy your logic.

I agree with you. We want to see younger small businesses thrive. I have no idea what will happen from this government bailout...

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Even without payroll, you have other costs: taxes, property, insurance, utilities, debts for supplies you bought before this happened, etc. All this without any cash flow.

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Short answer: no. Many small businesses are marginally profitable or unprofitable, and exist because the owner is willing to work for very little return. Businesses like that, particularly if they have a lot of employees (like my sister's restaurant, for instance) don't generate much wealth and yet take significant cash flow to operate. Any personal wealth is gone very, very fast.

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They only give grants, donations and all kinds of legal and economic accommodations, you know, real bailouts if you are a big business. Little guys get loans.

I believe most of the currently proposed bailouts are in the form of loans.

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Basically locally-sourced peer-to-peer lending then? Should be some lessons from the early fintechs whose original business models were p2p like Lending Club, but there are presumably reasons why they pivoted. Also, would guess there would quickly be challenges with adverse selection without investment staying exclusively local or without non-local investors having a clear way to use local knowledge to protect against adverse selection.

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"since borrowers would feel a personal responsibility to repay their peer debt-holders, who may be friends, family or customers."

Not commenting on the lending idea but plenty of failed business deals happen to friends or family. That's why they tell not to get into business with relationships you actually care about.

+1, always be cautious about getting into business relationships with family.

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There is a potential for fraud with the borrower using the loan to pay back people who put up money to “support” them.

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It's not entirely clear to me why the fact a local community believes in a business is a good signal to an institutional investor.

From the institution's point of view, they would probably observe some perverse incentives for members of a local community to loan money to a business for sentimental reasons that aren't reflected in hard financials or any intrinsic value in the business (e.g. a failing hairdresser that provides quality conversation; or a rural town with a pub that is the main activity/social point in the town). This means you'd be encouraging people to invest in riskier bridge loans. Not necessarily a moral hazard, but certainly an adverse selection issue here.

Also, unless the institutional investor acquires priority in case of bankruptcy, it might be the case that local investors are more likely to at least break even and get their money back, which is a considerable risk for the party putting up most of the capital. And in the inverse situation, if the community are last in priority for collecting their debts, then this might dissuade them from investing unless there were already really good financials in the first place.

So, I would generally think that unless a business is profitable enough that a bridge loan from an institution is already a viable option, these businesses aren't any more likely to acquire funding OR you increase risk in communities most in need of these bridge loans.

Well assume you were an institutional investor and two businesses were relatively equal except that one got local community money and the other didn't. You can fund one, which would you pick?

It seems clear that while the local community money in of itself wouldn't be enough, it's still a clear signal that other people who know the local business environment better than you do have put their money on the table.

I'm saying it's not a clear signal about the viability of the business at all! Local community members can put down money on businesses that are completely not viable purely for sentimental reasons disengaged from the ability of the business to payback. Given enforced shutdowns, etc. the long-term economic ramifications of covid-19 aren't clear. Just because local members choose one business over another, doesn't mean that that's a reliable indicator of payback ability.
It's also dangerous to increase and legitimise risky lending practises in general.

I think temporary rental forgiveness/other forgiveness policies are going to provide better relief during this period, and after it allow normal loans to take on the burden of filling in the gaps.
There's too much noise at the moment for lending, and I worry that local community endorsement would just add to it!

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A recap of the ideas in the last few days for the coming bailout without trying to make it look like a bailout:

1. government-backed bridge loans
2. bankruptcy with government backed DIP financing and pre-packs
3. government gives everybody money now with a future earnings-based surtax
4. community based lending to lure in banks

All have their strengths. 1 and 3 have straightforward implementations. 2 would eliminate moral hazard. 4 does the most to build investor confidence.

All have their weaknesses.
1 places the government in the loan sharking business with all its complexities and all of Tyler's points in his earlier post explain why this is bad.
2 is old-fashioned capitalism which most people will reject even though it reinforces market discipline and eliminates moral hazard because investors will lose money. To me a business that can't survive a few down months should be bankrupt but I also know I will be overruled by insider technocrats.
3 forces an additional tax structure that will heavily penalize edge cases many will fall into (make $1 in 2019 and $30,000 in 2020 then owe N*X*30000 on top of normal taxes according to Mankiw's formula). This reminds me of the AMT disaster for stock options a while back where people owed millions for fictitious earnings. Moral of the story: when you write tax law, THINK THRU THE EDGE CASES.
4 requires banks to do a type of due diligence they don't normally do, fraud will be a concern (ie. community astroturfing), and there's no government backstop so banks may not see an incentive to participate given risks.

Short of 2 which I find the most capitalistic solution but least likely to happen, I'd rather see money going straight to people no strings attached. I get that some won't like but it is straightforward to implement, which reduces fraud, and it reactivates the price discovery mechanism that is shut down by all the fear and panic out there. A bottoms up bailout will hopefully quell voter anger over the last couple decades of out of touch technocrat decision making and make people feel like society is working for them.

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Nah, forget about it. The supply side is dead right now when you need it most. Everyone needs their own money, no one will donate anything to charity (which is what this is) in these times. Except maybe my wife who did because she has a cushy government job.

This is nonsense masquerading as cynicism masquerading as skepticism. Many, many people will and are donating to charity. If people only donated when they had no problems, then ... well, there would be no such thing as donating.

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I'm not sure I understand this bit: "peers would also be able to earn the same interest rate return on the principal as the majority funder… so it’s not like crowdfunding, where you contribute but won’t see your dollar again"

I don't see the difference. If the business fails, why would you see your dollar again?

It sounds similar to Funding Circle in the UK, except the proportions are different. Institutional investors (usually the British Bank of Investment) top up the last 20% or so, while the rest is crowd funded.

The problem with Funding Circle has been the liquidity of the secondary market. It's very difficult to get your money out quickly if you want to put it somewhere else. I've been trying to sell my small investment of £500 into Funding Circle since July last year, and £200 still remains to be repaid. I doubt I'll see more than £50 of it, given current circumstances.

In short, I love the idea, but it suffers from a lack of network. Or from a backstop, such as government.

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Iff the Fed truly flushed the system with funds and created expectations normal economic activity would soon resume (inflation expectations somewhat greater than the 2% target) banks would have the the ability and incentive make bridging loans. In such an environment, the proposal could help. Absent that, I doubt it could work

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Great comments! I'm reminded of a community savings & loan, ishades of Bailey Building & Loan, but for local businesses not home mortgages. I wrote the following about microlending in an email to Tyler: "if there are mechanisms in place to efficiently and securely facilitate those investments. Invest in the entrepreneurs and local businesses you want to support! Are there equivalents of Kiva.org that are active in communities around the States? Perhaps microlending can be facilitated [by] local municipalities and community partners (even online communities such as Facebook (hello!), nextdoor.com, yelp)."

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If Congress is determined to support "business" then why not tax credits at a pretty high percentages of its payroll. To the extent that this prevented it from making its staff unemployed, that would reduce unemployment insurance making the net fiscal outlay not that much greater.

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Even if you could find a way for the peer investment component to work, banks might choose to see peer investors as owners and want to underwrite them (slowing down or making the process impossible), or they'd want the peer investors subordinated to bank/institutional debt. You'd have a lot of new territory to work out. Not totally sure how this is different from PE investment. Is it just different bc lenders are peers?

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This idea would bias institutional funding to businesses that serve a wealthier clientele or entrepreneurs with wealthier peer networks.

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not a bad idea, but how is this much different than if a business crowdfunded the 10% they needed and then went to the bank for the remaining 90%?

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I ran a similar concept with Able Lending with very low default rates. Ping me if you want to discuss (mkorke@gmail.com)

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I swear a I heard about a similar community lending program within the last year that was happening somewhere in the developing world. It might have been a guest on EconTalk. I was thinking it was Mauricio Miller, but I couldn't find it in the show notes. I wish I could remember because there might be some existing data that you could leverage.

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News that might be helpful:
An idea flying around social media in my small city is to patronize the local restaurants we like for curbside, explicitly to help them pay bills. A few restaurants permanently closed this week but most of them did not have a history in the community. Despite rhetoric to be kind and helpful and forward-looking, I don't know what the actual revenue to restaurants looks like this week. Some people have posted pictures of their take out food to encourage others to do likewise.

Another suggestion people have made is to pre-pay for future appointments with your favorite provider of haircuts etc.
Perhaps a more sophisticated version would be to allow a customer to commit to, say, one haircut a month from a provider for a year as soon as they are allowed to. Could this be constructed so as to let the provider borrow against the promised future income?

The most tidy idea I have heard is for residents to purchase gift cards from establishments that they like. Cash goes to business owners today and smooths the low-revenue period out. If the business owner eventually decides to close the business permanently, then I think no one expects them to refund gift cards, so they don't worry about liability. "Gift card" and "pre-pay" is equivalent, but I suppose gift cards refers to restaurants and most small-time service providers don't have a "gift card" system in place.

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