Funding Startups Using Loans

Today I received a nice note from a reader about the company, Prosper. I previously posted about this company back in February when it launched. Since inception the company has had a flurry of activity and interest. Individuals in seek of higher interest rates and return on their money have flocked to this site. Individuals have even used it as a way to raise capital for startups or early stage businesses. My reader points out that this is a new and innovative way to raise capital.

While from an entrepreneur's point of view I feel that scrappy startups need to bootstrap their funding needs in creative ways, from the point of view of a lender, I don't agree that raising money in this fashion is the best way:

First of all, financing startups is a risky endeavor that should only be left for those with the financial wherewithall to withstand complete loss of investment. The individuals who use Prosper are largely those that expect a solid return from their investment on a regular basis in the form of a monthly payment. Given the high rate of failure of startups, the default rate would be too unacceptable for the lending base.

From the point of view of someone who cares about the integrity of the capital formation process, I believe that startup or private equity funding should only be provided by those who can afford it. When individuals lose their shirts, they do not play the game anymore. When insitutions and high net worth investors lose their entire investment, they continue to fund companies at different vintages, despite the gyrations of the markets. Thus, what makes the engine of entrepreneurism run is the financial backing of those who will come back time and time again.

If you look at the amount of private equity investment over the last several decades, you will see that the data bear this fact. Angel investing peaks in hot markets and declines in down markets. Institutional venture capital also has its peaks and valleys but not as dramatic.

I also don't believe that debt is the best way to raise capital for a new enterprise because equity should be the greatest motivator for the investor, not debt payments. This is an entire topic on its own that I will save for a later post.