Community banks are often the familiar faces of the financial services world, and when small businesses seek capital, their neighborhood financial institution can be a promising place to start.
While they continue to play an important role in small business financing, the community banking market is drastically shrinking in the U.S. The Conference of State Bank Supervisors recently released data that found the number of community banks in operation in the country has dropped from about 8,000 in 2004 to about 5,400 in 2018. With analysts expecting this consolidation to continue, the Federal Reserve last year raised concerns about how this shrinkage will negatively impact access to capital for small and medium-sized businesses (SMBs).
According to George Cook, co-founder and CEO of small business crowdfunding platform Honeycomb Credit, this pullback of community banks’ presence has left a significant gap in small business lending that alternative players and merchant cash advance providers have moved to fill.
They’re providing a much-needed service, Cook told PYMNTS in a recent interview, but a lack of transparency and some sky-high interest rates mean these players aren’t quite able to provide the same level of service community banks once could.
But by taking the crowdfunding model and applying it to particular communities, small businesses can access affordable financing with the added benefit of familiar providers of capital.
“We’re trying to turn community members into community bankers,” he said, “and allowing them to vote with their wallet.”
A Local Approach To Crowdfunding
With peer-to-peer crowdfunding sites like Kickstarter and GoFundMe already mainstays in many consumers’ lives, Cook said shifting this model to the small business lending arena isn’t a hard sell, for investors or small businesses. But a key differentiator in Honeycomb Credit’s strategy is to enlist investors within the same area as the businesses they’re funding, which can promote the well-being of Main Street.
This, he explained, is both good for businesses and their investors.
“By getting community members who know the business and vote with their wallet, it unlocks a tremendous amount of qualitative data,” he said. “Does this coffee shop have a good cup of joe? Do they treat their customers well? All of those things are an indication that the community wants to see the business grow and thrive — which, historically, community banks were able to unlock.”
Cook predicted that more small business crowdfunding platforms will likely spring up in the coming years as awareness expands with regards to the JOBS Act and Regulation Crowdfunding, the legislation that came into effect in 2016 that provided an exemption for smaller businesses to sell securities via the crowdfunding model.
“The sky is the limit,” Cook said of the opportunities this regulation opens. “There will be a lot of new players that start finding different niches in the small and medium enterprise space and fun, unique ways to deploy capital to these small businesses.”
A New De-Risking Strategy
As these new SMB financing models emerge, Cook highlighted another important trend that regulations like Regulation Crowdfunding and Regulation A+ are also introducing to the market.
By taking a localized approach to crowdfunding, investors are now generating and gaining access to a slew of alternative data that Cook said is transforming the de-risking process of small business loans. Whether a small business provides good customer service isn’t just a qualifier that can encourage individuals to invest in that business, it’s also a metric that can be used to evaluate the likelihood that a small business will succeed and repay the loan.
“We believe the act of investing from community members is de-risking,” he noted. “We’re seeing that local community members that invest in local businesses are changing their behavior: they’re going to those small businesses more often, telling their friends and family about it, and that’s de-risking the loan in a whole new way, improving the outcomes within a loan portfolio.
“That’s a really exciting and promising way to democratize capital formation for small businesses,” he added.
For platforms that facilitate this crowdfunding, there is also a significant opportunity to capture and quantify this data as more players in the broader small business finance space explore opportunities in alternative data to underwrite loans.
Taking a community approach to small business finance can also support de-risking in other ways, too.
Cook pointed to the ability for local investors and crowdfunding platforms active in particular communities to familiarize themselves and collaborate with other local players, whether they be community banks, community development financial institutions (CDFIs) or others.
This enables a crowdfunding platform like Honeycomb Credit to point a small business in a different direction to another local source of capital if that business isn’t yet the right fit for a crowdfunding model. Cook also said this strategy enables small businesses and a variety of financiers to work together, helping both sides diversify their portfolios.
“There are a ton of opportunities to lend side-by-side,” he said. “CDFIs won’t ever be the primary lender in a small business loan, and a lot of traditional banks have a hard time with smaller loans. They have the appetite to lend to small businesses, but they don’t want to lead. Alternative lenders can lead that deal, lead the due diligence and onboarding process, and unlock additional capital for small businesses.”