Crowdfunding is a new type of investment that was approved by Congress last year. The idea is that we should make it easier for individuals to invest directly in small business, and the 2012 JOBS Act sets down some rules for how to do that. Here’s a link to a recent article on the subject, sent in by a loyal reader.
Some have argued that crowdfunding will lead to a boom in small business investment, and there are internet sites sprouting up all over to try to take advantage. And on our travels we’ve certainly heard an earful from small business owners about the difficulty of getting access to capital.
Crowdfunding advocates often offer some variation on a “cut out the middleman” argument. The idea goes like this: The real transaction here is between an investor and a business. The investor is the person with a bit of extra cash, and the business has productive ideas but limited cash to put in. The bank is just a middleman, taking the investor’s money as a deposit and lending it back out as a small business loan. The bank makes money on the spread between these two interest rates.
How exactly can we do better by cutting out the middleman?
One potential argument is that the middleman has market power. A firm with market power can raise prices way above its cost of doing business. Such firms earn high profits by jacking up prices, but this reduces the overall amount of trade in the market. Consider, for example, a bank with market power that reduces the rate it pays depositors and increases the rate it charges to a business. This would increase its spread, and allow the bank to earn higher profits. But it would also make both depositing and borrowing from that bank less attractive. Some depositors would put their cash back under the mattress, and some good projects would go unfunded. If banks are using market power to raise prices, we can do better by cutting out the middleman and getting that cash out from under the mattress and into the hands of a small business owner.
Competition can, of course, fix this problem. An entrant bank could profit by offering a slightly smaller spread, and thus connect untapped dollars with unfunded opportunities. How far down will competition push prices? It’ll push prices down to where the spread charged by banks is just high enough to cover their full cost of doing business. So, to assess whether crowdfunding might work, it’s important for us to understand how competitive the banking sector is.
A second argument is that the middleman doesn’t actually do anything valuable anyway, or that there are more efficient ways to do what the middleman does. If banks don’t do anything valuable, then there’s no value in allowing them to cover their costs by earning a spread, and it would make sense for the parties on either side to cut the middleman out. The investor and the business can also profit by cutting out the bank if it does something but in an inefficient manner. So we also need to ask what banks actually do, and whether they’re adding any value to the borrow-investor transaction.
For purposes of keeping a short blog post, I’m going to focus on this second question: What is the value that banks bring to the business-investor transaction, and is there a better way to do it using the internet?
To start on this, let’s think about what the internet is good at: The internet is good at search. It’s good at helping buyers and sellers find each other, and because of this, internet-based businesses have disrupted many markets where middlemen used to play an important role. Think about, for example, what eBay has done to markets for collectibles. If you were a serious baseball-card collector in 1995, you may have spent a lot of time at card shows looking for that elusive Rich Gossage card to complete your collection of the 1973 Chicago White Sox; card shows and infrequently published newsletters were really the only tools buyers and sellers had to find each other. Now, however, this is really easy.
Card shows existed to help buyers and sellers find each other, but they were doing so inefficiently, at least relative to what’s possible now with internet-based search.
Monster and Career Builder have done the same thing to classified job advertisements. The classified section in your local newspaper helped buyers (that is, firms looking to hire) and sellers (job-seekers) find each other. But both sides of that transaction can now search better and faster using the internet, and newspapers have struggled to replace the lost classified revenue.
Is this what banks do? Is the value-added from a bank simply the process of helping businesses and investors find each other?
Well, no. Banks do a lot more than just make the match; banks themselves decide who receives a loan and who does not. And the banker — not the investor — is on the hook if the business is unable to repay. This suggests that the real value of a bank isn’t in matching; it’s in being able to distinguish a good business from a bad one. This is value added because it requires specialized knowledge and information-gathering skills; most regular folks would have a hard time seeing the flaws in a polished new business plan, but it’s all in a day’s work for a small business lending officer.
Crowdfunding web sites can help businesses and investors find each other; that’s exactly what the internet is good at. But it’s not at all clear that the internet can turn regular folks into effective lending officers. And if the investors can’t easily distinguish good businesses — that is, those with solid business plans who are likely to repay— from bad, it won’t work. And take is from us… there are a lot of bad business plans out there.
We think that the investor side of the crowdfunding market will learn, pretty quickly, that it’s hard to earn solid returns through this form of investing. As a result, we think it’s unlikely that crowdfunding will lead to an explosion of funding for small business. So… don’t rip up your banker’s business card just yet.
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