Internet users are crowding together to make loans and invest. Should financiers worry?
By the age of 22, Tim Talbot, the frontman for the British band Armstrong, was disillusioned with the usual path to rock superstardom. "We'd gone through the stage where we just toured and toured and played horrible places to 10 people," he says. He and his bandmates decided to focus instead on developing a fan base.
Of course, to do that they'd need a professional recording, which can cost tens of thousands of dollars. Without the backing of a label, that cost was prohibitive. "We're not one of these bands that's funded by our parents," Talbot says. But then he came across an advertisement for Slicethepie.com, a U.K. technology start-up that offers artists and music fans the chance to "help yourself to a piece of the music industry." Within a few months, Talbot had uploaded tracks and persuaded enough fans to "invest" in Armstrong that the band had $30,000 to create their first album. In return, the 1,500 fans who supported the band earn a slice of the record-sales income. No record label? No problem.
Talbot's experience might just be a sign of things to come, not just for funding future records but for financing all kinds of activities. Techno-optimists have long lauded the Internet as a unique facility for democratization: Skype made long-distance phone calls cheap enough for Chinese students, for example, just as eBay unleashed the inner retailer in us all. Both were pinpricks in the vast façade of centralized industries like telecommunications and retail. For the most part, finance has been immune to this trend. To get serious backing for a new idea, you had to follow the money—big companies like banks, venture-capital firms and record labels controlled all the capital. Now Internet technologies allow even very small investors to come together to buy shares in a band, make personal loans that pay attractive returns, or even fund entrepreneurs in the developing world. The phenomenon is called crowdfinancing, a reference to the idea of crowdsourcing, in which many people contribute to a common task, such as writing a Wikipedia article.
Big commercial institutions like banks or record labels make money either because they control the flow of funds from one group to the next, or because they're the ones giving out money in the first place. Crowdfinancing allows anyone and everyone to get in on the act, which is why it's potentially so disruptive. If decisions about making a loan or funding a new band come from the masses instead of a small, centralized group, more people than ever before will have access to money, and at better interest rates, or so the thinking goes. "I don't see much stopping it," says Jeff Howe, a journalist for Wired whose new book, "Crowdsourcing," touches on the topic. Crowdfinancing "is a really powerful model. I could imagine it hitting a tipping point where a lot of money started pouring into it. Then it would just build on itself." For now, the idea lacks mass—crowdfinancing schemes in operation today measure their success by the millions, but operate in industries that like to think by the billions.
Crowdfinancing has a precedent in crowdfunding, a similar movement with a nonprofit bent. The classic case of crowdfunding is Barack Obama's presidential campaign. In February, he set a record, raising $55 million in a single month, 80 percent of which came from the Internet. His campaign has been compared to that of an Internet start-up, in part because of his embrace of new technologies and online services, such as Facebook and MySpace, to build excitement among his supporters (and to get them to open their wallets). "Some people think the Internet is just about transactions, and others that it's just about building relationships," says Gene Koo, a fellow at Harvard Law School's Berkman Center for Internet & Society, and an Obama supporter. "I would say it's both. And the Obama campaign has done a good job of leveraging one into the other."
Obama is in many ways an exceptional candidate, but his online success is replicable around the world. Sites like chipin.com, fundable.org and donorschoose.org are also trying to create communities of civic-minded Net denizens by helping people fund a football team, a student film or any number of other activities, all through small donations solicited from across the Internet. And in 2006 the populist filmmaker Robert Greenwald used the Internet to raise $267,000 for a new film. Most of it came from small donors who pledged an average of $62. It took him just 10 days
Crowdfinancing is different because this crowd expects a return on its investment, which makes the idea appealing to a larger number of people. Probably the purest example of it is prosper.com, founded in early 2006. At Prosper, prospective borrowers essentially auction themselves off to the crowds. They post the maximum interest rate they're willing to pay for a loan for, say, home solar-panel installation, and lenders pool their money and then bid down the rate, based on variables like the borrowers' creditworthiness and loan history. In theory it's a win-win: borrowers pay interest rates several percentage points lower than what most credit cards and personal loans offer, and lenders generally earn a 5 to 10 percent return on their money, much better than parking the cash in a savings account.
Prosper takes on the responsibility of servicing the loans, so lenders don't have to become debt collectors, too, but it's the site's users who ultimately decide who gets a loan, and at what rate. Prosper makes its money by charging borrowers a 1 to 3 percent closing fee, and lenders pay an annual service fee of 1 percent. Those costs don't seem to be scaring anyone away. The site's 780,000 users have loaned nearly $170 million to each other in the past two and a half years, a trend that's benefited from the credit crisis afflicting mainstream banks. "In the banking world or the credit-card world, it's a very small group of players, and they control the process," says Chris Larsen, Prosper's founder and CEO. "This is the first time anyone with money can participate. It's empowering."
Slicethepie and a similar site, two-year-old sellaband.com, are doing much the same thing, only instead of empowering individuals at the expense of banks and credit-card companies, it's at the expense of the music labels. Traditional music labels spend terrific amounts of money to create popular new acts, but 90 percent of them fail; they end up relying on a small number of outsize hits (think Amy Winehouse) to cover their costs. David Courtier-Dutton, Slicethepie's CEO, thinks that by opening the process to the masses, Slicethepie can achieve a much higher success rate, because funded bands receive their money from thousands of people, meaning they already have proven appeal. And since users buy and sell shares in the site's artists, "it acts like a music stock market," he says. "People say, 'Well, that's not very rock and roll.' But that's all the record labels do: invest money in order to get a return. It's called the music 'business' for a reason." They've raised half a million dollars for 19 artists in the past year, although only two have released albums so far (and sales information is not yet available).
Even the do-gooders are going into business. Microfinanciers, who provide small loans to developing-world entrepreneurs, have long depended on large philanthropies and wealthy individuals for capital. But there's a limit to how much can be raised that way. MicroPlace.org is trying to attract more cash into the industry by offering any investor a modest return of 1 to 3 percent on their loans—about the same as money-market funds currently offer—and thus enabling many more people to enter. "No longer do you have to be a high-net-worth person or a big financial institution to invest," says Tracey Turner, the company's founder. Her 10-month-old site has attracted nearly 4,000 small lenders and recently surpassed $1 million in investments.
There are many others that follow similar models. Kiva, Zopa and Sellaband operate on models much like those of MicroPlace, Prosper and Slicethepie, respectively. And there's only room to grow. MicroPlace may be democratizing the world of microfinance, but what about other worlds? As long as the individual loan sizes are modest (don't expect developers of billion-dollar skyscrapers to go scraping for cash on the Web) and there's a potential for the wise crowds to make better decisions than power players, crowdfinancing has a role to play. "[Even] benevolent elites can become malevolent elites really quickly, either because they lose interest or the power becomes intoxicating," says Larsen. He points to the U.S. housing crisis, which in part stemmed from the greed of mortgage agencies willing to bend the rules. "Spreading [responsibility] out solves that."
It helps, too, when the financial goal in question is something that people can rally behind, just as they've rallied behind Obama. A great idea for a new technology company could spark the entrepreneurial spirit in dozens or hundreds of would-be investors, just as loaning a college student tuition money could excite another subset of online lenders.
But even if it's possible to democratize the student lending business, is that desirable? Certainly, there are benefits to these kinds of sites. For one, more of the value stays with the borrowers and lenders, rather than the middlemen. Larsen points out that banks generally pay 1 or 2 percent interest on savings accounts, but then use that money to make personal loans that can earn well over 10 percent; the bank keeps the spread in between. At Prosper, almost all that goes to the borrowers and lenders. At Slicethepie as well, money that once went to music-label megaliths now stays with the artists and their fans.
Crowdfinancing also incorporates social data to a much better extent than any corporation can. Sure, banks may check references to determine whether to make a loan, but Prosper lets you see important social information about a borrower, such as whether his friends or family trust him enough to loan him their own money. Slicethepie uses reviews and voting to determine which bands warrant producing an album.
These young sites are so far only a blip on the global financial market. Prosper's $170 million portfolio is a mere speck in the $13 trillion U.S. consumer-debt industry. MicroPlace and Slicethepie are both just getting started. And there are obstacles to growth, including red tape.
Based in California, Prosper had to register across all 50 states and with the U.S. federal government to do business. That's an onerous chore for a modestly funded company, and a deterrent to potential competitors. Slicethepie, in order to be fully legitimate in the eyes of the British government, registered as a gambling operation. But that means music listeners in the United States, where authorities have cracked down on Internet gambling, can't participate. Clearly, it takes government time to catch up to innovation in the digital sphere.
Still, crowdfinancing has the potential for shaking up whole industries. The next generation of hot young bands might find themselves asking, "The Warner Bros.? Who were they?"