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.

If a loan isn't fully funded within the auction time frame, the borrower is free to try again. Townshend, who had an A credit rating despite $15,000 in credit card debt, struck out twice before landing a loan. Initially she offered an attractive interest rate, 12.5 percent, but asked for too much money: $25,000. On her second try, she requested $9,900, but at a less appealing rate of 11 percent. Finally, she struck the right balance, asking for $9,500 at 13 percent interest. She also made her loan description more appealing by arranging key ideas into bullet points and providing a detailed breakdown of how she planned to use the money. In three days, she received 77 bids from an array of lenders, including an engineer and a Web entrepreneur, and the loan was fully funded.

All told, it took about a month for Townshend to get the formula right. To help borrowers navigate these shoals, Prosper encourages them to join one of the site's many groups, which are organized around topic areas and serve as a peer-to-peer network. Dozens of business groups, composed of everyone from fashion designers to restaurateurs, have sprouted up in recent months. Townshend, for her part, belongs to a group of start-up founders called the Business Owners Cooperative. "My group leader told me what was wrong with my loan application and how to fix it," she says. "I couldn't have done it without him."

Despite the generally low stakes of the deals, some serious investors have taken notice--including Christine Comaford-Lynch, a serial entrepreneur who started the VC fund Artemis Ventures and recently founded Mighty Ventures, a business consulting company in St. Helena, California. Comaford-Lynch is the leader of a 133-person Prosper group called Business Loans for Entrepreneurs. She helps members craft their loan proposals and addresses many of their business questions. She also keeps an eye out for start-ups that may qualify for venture funding.

Larsen's next move will be to increase the maximum loan amount in response to market demands. Once that happens, predicts Comaford-Lynch, the site will become a virtual credit line for established businesses in need of working capital. "When the site gets to the $100,000 level, it will really take off," she says.

Townshend, for her part, recently made the first of 36 monthly loan payments of $320. She has used the money to trademark the Strock, pay for production in a factory in Lafayette, Colorado, and buy office equipment. So far, Townshend has sold 200 Strocks to animal hospitals. She is still hoping to land a big order from the 600-hospital chain and expects to book $100,000 in sales this year. The next time she uses Prosper, Townshend says, she plans to be a lender.