Brother, Can You Spare a Dime?

The new alternative to banks and VCs: person-to-person lending.

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When Erica Lyn Townshend's dog Buddy cut his paw last November, the vet gave him a clunky plastic lampshade collar to prevent him from chewing on the wound. But Townshend hated the idea of torturing Buddy with the cumbersome contraption. Instead, she sewed an elastic strap onto a long sock, placed the strap around the dog's body, and put the sock on his leg. She dubbed it the Strock.

A few months later, after being eliminated from the second round of the reality show American Inventor, Townshend quit her job at IBM to peddle the Strock full time, forming a company called Best Buddy Pet Products in Longmont, Colorado. She hit pay dirt during her third sales call, at a veterinary hospital that was part of a 600-location chain, when the doctor in charge recommended the Strock to the system's board of directors.

Townshend, who had been making Strocks in her home using a sewing machine, needed money to fund mass production. But both her local bank and the U.S. Small Business Administration turned down her loan applications, citing her lack of income, past credit card delinquencies, and lack of a track record. "It was a Catch-22," she says. "I would have to pay for the inventory up front before the clinics paid me." Then she saw a TV news segment about Prosper.com, a new person-to-person moneylending website designed to connect those who need cash with people willing to lend it. In May, under the username All4Buddy, she landed a $9,500 loan from a group of 77 individual lenders. The money appeared in her bank account two days later.

Townshend is part of a small but growing cadre of business owners taking advantage of person-to-person lending sites, namely Prosper.com and its British counterpart, Zopa.com, which plans to launch a U.S. version this year. For entrepreneurs with poor credit ratings and unproven track records, the sites offer a chance to raise funds when banks and other traditional lenders say no. Lenders on the sites profit as well: In return for taking a risk, they often receive higher investment returns than they would with savings accounts. Still, the interest rates are usually lower than those charged by credit cards, the last-ditch funding source for many start-ups.

Prosper was co-founded by Chris Larsen, one of the co-founders of mortgage and auto loan website E-Loan, with the aim of imitating the microlending model that has been successful in developing nations. "We want to be the eBay of money," Larsen says. Between February and June, Prosper doled out about 1,500 loans worth roughly $7 million. That's hardly enough to scare banks and credit card companies. But the new lending model has the potential to steer customers away from traditional lenders in the coming years, particularly in the small-business segment. "It's a huge market and it's not perfectly served," says Jim Bruene, editor of Online Banking Report. "Small businesses have always had trouble raising cash." Continued cuts in SBA funding could drive demand even more, adds Bruene, who predicts that person-to-person moneylending sites will dole out 124,000 loans totaling $978 million in 2010.

Here's how it works: Borrowers sign up for a free membership in Prosper, which performs a basic credit check and assigns each member a credit rating. Next, borrowers post loan requests, listing the desired loan amount (up to $25,000), the maximum interest rate they are willing to pay, how they intend to use the loan, and the duration of the auction (between three and seven days), along with a credit score and debt-to-income ratio provided by Prosper. Borrowers then sit back and wait for lenders to offer loans at interest rates either at or below the preset cap. If a loan is fully funded, Prosper combines the bids with the lowest rates into a single loan and deposits the cash in the borrower's bank account within a few days. Prosper handles all the back-office work, including payment collections. In return, borrowers pay 1 percent of the loan amount up front and lenders pay an annual fee of half a percent.

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