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The following excerpt is from the staff of Entrepreneur Media's book Finance Your Business. Buy it now from Amazon | Barnes & Noble | iTunes
Venture capital may be the hot, sexy funding route that helps a few businesses and grabs a lot of headlines every year. But it turns out another type of funding works out better for most entrepreneurs: microfinance. Microfinance loans are small loans typically in the range of up to $50,000 in the United States, with an average loan amount between $9,000 and $10,000.
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Non-bank lenders such as Accion USA provide loans that average just $7,000. Here’s the funny part: The businesses they lend to have a survival rate that’s twice the national average. Repayment rates are on par with traditional banks, too.
Why do micro-borrowers do better than owners who use traditional bank loans or credit cards? Here are three reasons:
1. Better vetting. Microlenders tend to spend more time getting to know a business owner one-on-one, which usually doesn’t happen at major banks. These microlending institutions often take bigger risks on unproven startups, but because they take the time to learn a lot about the person seeking the loan, they form a more personal connection. With those closer ties having been forged, entrepreneurs will go the extra mile to avoid disappointing the person who approved their loan.
2. Support groups. Most microloans are made in a group setting. The business owners in a lending circle support one another and, in some cases, are financially responsible for each other’s loans. This web of interconnected responsibility helps keep them on track and provides moral support.
3. Smaller loans. When entrepreneurs only have a small sum with which to start their businesses, they watch every dime carefully. Too often, landing a big loan can lead to profligate spending rather than growth and productivity. Small borrowers also don’t get delusions of global domination — they take it one careful step at a time, so they don’t stumble into overexpansion.
Inside PayPal’s microlending program
As the owner of Crisloid, a maker of high-end backgammon, checkers and cribbage sets, Jeff Caruso knows that if he buys more raw materials in late summer, he can make more money during the holidays. The problem is coming up with the extra cash. That’s why he borrows from PayPal, which began issuing single, fixed-fee loans of $1,000 to $20,000 to qualifying customers in 2013 through its Working Capital program. (The cap was raised to $60,000 in 2014 and was $97,000 as of this writing.)
Caruso has taken out three business loans through PayPal’s microlending program, borrowing $10,000 to $15,000 a pop — $35,000 in all. He uses the money to meet his Providence, Rhode Island-based company’s fourth-quarter spike in demand, which helped revenue exceed $500,000 in 2014 for the first time.
“Come August, if I can take $12,000 and turn that into finished goods, it’s all going to sell,” Caruso says. “It helps us finish the year that much stronger.”
Since launching the Working Capital program, PayPal has paid out more than $1 billion, granting loans to over 60,000 U.S. small businesses. In 2014, PayPal expanded the program to the U.K. and Australia.
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More than half the borrowers use PayPal loans to buy inventory, says Darrell Esch, the company’s vice president and general manager of PayPal’s SMB lending. Other popular uses for the money include temporary hires, warehouse expansion and website overhauls. Esch adds, “It really helps merchants grow.”
How it works
PayPal lends approved borrowers up to 18 percent of their annual sales made through the platform (with a $97,000 limit), the equivalent of one month’s processing volume, according to Esch. There’s no due date on the loan; instead, PayPal automatically draws payments from a borrower’s account when a sale is made, until the loan is repaid. (Borrowers get a reprieve on days with no sales.)
Borrowers can elect to designate from 10 to 30 percent of their daily sales as repayment; Caruso, for example, chose to repay 15 percent of daily sales and has paid off each of his loans in three to five months. Borrowers can make extra payments or pay a loan off early at no additional charge.
“Once the loan is paid in full, you can come back and apply again,” Esch says, noting that about 80 percent of people who close loans take out another one.
PayPal loans run from 2 to 11 percent APR of the money borrowed. The higher the percentage of each day’s sales that goes to repayment, the lower the loan cost. If PayPal tries to retrieve a payment after a sale but the account balance is insufficient (presumably because you moved the money elsewhere), the platform will withdraw the necessary funds the next day, Esch says. There’s no charge for these “catch-up” payments.
Loan applicants must have at least $20,000 in sales through PayPal during the previous 12 months and at least 90 days of processing history on the platform. “It doesn’t take long to build it up,” Caruso says. (Esch points out that PayPal doesn’t prohibit borrowers from using other transaction platforms.) PayPal also checks applicants’ identity and credit history.
Just be sure you don’t get in over your head. Caruso suggests initially borrowing less than you’re approved for and repaying at a lower percentage. “Start small,” he advises. “Make sure you know your margins. Plan what you can handle for a repayment so you don’t choke yourself.”
Startups offer microloan options for entrepreneurs
Microloans actually started as a solution for impoverished borrowers in underdeveloped countries. These borrowers typically lacked collateral, steady employment and a verifiable credit history, making them difficult candidates for traditional financing options. Microloans have been successful in helping to support entrepreneurship and encourage economic growth in these developing nations.
In more recent years, microlenders have been establishing themselves all across the United States. Some microlenders are finding creative ways to improve and streamline this already simple process by offering unique services.
For instance, TrustLeaf.com extends microloans through crowdsourcing. What makes TrustLeaf.com unique is that business owners only borrow from friends and family. Their campaigns aren’t publicly available, protecting the borrower’s privacy.
Borrowers simply set up a campaign on TrustLeaf’s site, providing all the necessary information about their business and select the loan terms. Potential borrowers can pick from a few lending options with different interest rates, minimum amount due and various repayment terms. The borrower and the lender come to an agreement about which loan terms make the most sense for both parties.
Related: The Number One Reason Banks Deny Loans to Many Small Business Owners
Once the borrowers have set up their campaign, they can invite friends and family to view it. “Friends and family don’t like to haggle because it makes them uncomfortable,” says Daniel Lieser, co-founder and head of business development for TrustLeaf. “Having this system in place prevents those awkward conversations of attempting to collect money when it’s due because it’s all laid out on our platform. Funding comes straight from the lender, a peer-to-peer system.”