The problem: You need a small amount of capital such as $25,000 at a reasonably low interest rate, to be paid back over a period of time such as three years.

A complication: You do not feel right about asking friends and family for the money, and your bank (like all banks!) only wants to lend money with real estate as collateral. See for example, my earlier post.

One solution is the online person-to-person lending site called Prosper.

A common solution to the problem above is to finance small business start-up costs through credit cards, which locks your business in to expensive money if you do not pay off the balance every month.

If you have a strong credit history the idea of paying above, say, 12% on a business loan should rub you the wrong way.

And yet, most banks in my experience will not make $25,000 loans unless your business owns real estate or you are willing and able to pledge your own home as security for the loan. How many small businesses own real estate? Not many. The inflexibility of most banks makes small start-up loans to $25,000 a real headache. Enter Prosper.

The site launched in February 2006 and allows borrowers to access an online marketplace of individual and group lenders.

You choose what information to provide, including pictures (highly recommended), and your proposed use for the loan proceeds, and the maximum interest you would be willing to pay. Lenders have 9 days to bid in increments of $50 or more to fill your request, by placing orders at the maximum interest rate or less. Frequently more lenders line up to provide funding to you than is requested, and competition drives the loan interest rate down. A typical funded loan pools together 50 to 75 lenders making tiny loans of $50 to $300 each.

All loans have a fixed-rate, monthly-pay, 3-year amortizing schedule. Your loan is funded to a Prosper account from which you can transfer money within two days. Your monthly payments have to be made to your Prosper account. Prosper then distributes your monthly payment to your 75 different lenders for you.

My Experience

As a test, on my first week after joining Prosper, I entered an order to borrow $10,000 at 7.75%. I included a cute, irreverent, and irrelevant picture of my 2 year old daughter as an identifier on the loan, and I pledged to be a good borrower and to pay back the loan early.
After 4 days I had 86 bidders on my loan, and competition to fund me had driven the interest rate down to 7.70%. (I’m fairly certain my daughter’s photo is responsible for the cheaper rate on my loan.)

Prosper subsequently contacted me to verify my address, identification, and information I provided about my annual income. My strong impression is that the Prosper folks were heavily scripted in their phone requests and probably phoned from a call center in India.
So far, Prosper appeared to me to be the ideal small business tool: It was fast, and offered an attractive borrowing rate of interest. In addition, the loans are prepayable without penalty, and funding can occur within 2 weeks of an application. I even liked that they engaged in appropriate due diligence about me as a borrower.

Unfortunately, a few days after I provided income-verification information, by faxing my business and personal tax returns, I got a computer-generated rejection email from Prosper.
My assumption, although nobody at Prosper verified this for me, is that my LLC’s tax return and Form K1, combined with personal tax information, proved too complicated for the Prosper staff to sift through.

I’m guessing that the staff could not satisfy their verification steps in the absence of a traditional empoyee’s Form W-2 showing wages.

If my assumption is correct, then Prosper is less than ideal for the small business entrepreneur, a person who may not generate a traditional W-2 for him or herself.

In addition, I don’t recommend Prosper.com for any small business owner who is already heavily-indebted or has a troubled credit history. The site will display your credit grade pulled from the credit bureau Experian, and it specifies the number of delinquencies and defaults you have had in the past. The person-to-person Prosper market is efficient at setting high interest rates for risky borrowers, and to pile on yet another high-interest loan is the equivalent of trying to put out a fire by pouring on the gasoline.

I’m left with a few additional conclusions about Prosper. First, small business borrowers may benefit from the Prosper site, but they probably need to be prepared to report employee income in a format easily understood by Prosper’s staff. Finally, the maximum size of the loans, $25,000, makes it best suited for a small part-time or home-based business.

In the final analysis, I’ve yet to find a great source of online capital for small businesses. If your business owns real estate, you’re all set with a bank. If your business is large and has significant cash flow, you may qualify for an SBA loan. But if you’re small and have no real estate, there isn’t an easy answer available.

Make sure to gratefully thank your friends and family who believe in you!