Q & A With Candace Klein, Founder and CEO of SoMoLend

There are a number of crowdfunding platforms out there. What's different about SoMoLend?
Candace: What's unique about us and different from most of the other crowdfunding platforms is that we're focused on local existing businesses. So the retailer, the restaurant, the salon, the gym... Our target is an existing business that's one year old or older that already has some customers and is looking to expand, grow, or seeking capital for inventory equipment and operating capital.

Why is it so difficult for small businesses to get funding right now?
Candace: Of the 27 million small businesses in the U.S. right now that are seeking access to capital, according to the SBA, the Federal Reserve reported in 2010 that 23% who need the money never apply due to fear of rejection. Those who do apply are turned down at least 51% of the time. We spent time speaking with 17 CEOs of regional and national banks and we've asked them why that statistic is: Why is it that of 27 million businesses, 20 million can't get capital? Is it FICO-score related? And the answer was generally, no. The answer was: Banks are generally very limited in the industries they'll lend to. Typically consumer-facing brick and mortar companies like restaurants and retailers are not attractive to banks.

Second, a bank spends just as much time and money underwriting a $10,000 request as they do a $10 million loan request. They said it makes no sense for them to waste their business bankers' time on those small dollar loans. So for those two reasons, banks have just stopped paying attention to small business loans. And you know they consider a small business loan a million dollars. We consider a small business loan $100,000 or less. So there's a big discrepancy.

You've said that crowdfunding is "literally going to change the banking system." How so?
Candace: We have one small business owner who... applied for 16 different loans with 16 different banks, and was turned down 16 different times before coming to us. She was able to secure her financing from her customers and her community. And she's got decent credit! So since then, she's opening a second location. And this is a story we hear over and over again.

We have a restaurant that we just funded with $100,000 last week, and he's opening his fifth location. He's been turned down by every single bank in his city. So when I say that we're changing the banking system -- we're democratizing access to capital. We're finally paying attention to that small business owner who is seeking less than $1 million in financing who tends to just consistently get turned down. And as a result of that, we're now filling a huge gap in the market that the banks haven't been paying attention to -- and that the banks will realize they should be paying attention to. In the long run, my goal is to change the way that banks look at small businesses. My way of doing that is by opening up crowdfunding.
Many companies offer equity in return for capital. But you think loans are a bigger opportunity than equity stakes. Why is that?
Candace: If you look right now at business finance in the United States, you have two markets. You have the equity market and the bond market. Bond is essentially debt. If you look at today's debt and equity markets in the U.S., the bond market is four times the size of the equity market. You see fewer and fewer companies... going public and selling shares. You see more and more companies seeking that capital. So this has been a growing trend for the past 10 years in the U.S.

The general market for debt dwarfs the market for equity. Yet we find no one talking about the debt market when we talk about crowdfunding. Which I find so odd. The media have been so fast to pick up on equity based crowdfunding, and they keep saying that the JOBS Act is legalizing equity-based crowdfunding -- that's just factually incorrect. What the JOBS Act is legalizing is securities-based crowdfunding, which includes both debt and equity, yet no one talks about debt. The debt market's bigger. So at SoMoLend, we're the first company to actually recognize the opportunity for debt in crowdfunding.

Debt is a scary word for a lot of people. What's the incentive for investors?
Candace: I would argue it's only scary when you use the word debt. If you use small business loan, for financing, that makes more sense. Equity is far, far scarier in reality because you're giving up your rights, giving up control. It's the most expensive form of capital that you could possibly take on for your business. And I have done both. I've taken on debt and equity for my companies. Equity is much more difficult to understand. The beauty of these loans -- and we only facilitate debt on our platform at SoMoLend -- is rather than give up any control of their business and their day-to-day decision making, instead you're paying the money back at a competitive interest rate from what you pay a bank. And so it's a much more manageable form of financing for 90% of small businesses.

I have my money right now invested in Proctor and Gamble stock as well as a number of other stocks. It hasn't been performing all that well to be quite honest. So I'm now looking at diversifying my own portfolio. And I don't trust my investment managers anymore because they haven't done that great of a job for me over the past five years. I would much rather invest my money locally, where I know my money's going and I can actually have a direct impact on that investment. That is something that... is a phenomenon across the country right now. People are pulling their money out of their invest portfolios right now and are choosing to invest it locally again. So that's one really interesting aspect.

Now, what do we provide? On our platform the interest rates range anywhere from 3-22 percent. The average interest rate though is 7-10 percent. A 7-10 percent interest rate is still better than what I've received in the stock market over the past 10 years. And so I'm getting a better return on my investment than I have been by investing it in the past in other instruments. And, I now am investing my money in places where I already live, work, shop and play. Where I've eaten my favorite spaghetti dinner for the past five years, I can now make a return on my investment by investing in that business directly. And I'll end up buying more spaghetti there as a result. So as an investor, our tagline is: Do Well by Doing Good. Because you do get a return on your investment but you also get to feel good about investing back in your community. So there's a dual element.
What are the tax implications of crowdfunding?
Candace: I would say this is treated as an investment, just as any other investment. I encourage your readers to consult with a tax professional. If you're an investor, it would be treated just like the rest of your investment portfolio from a tax perspective. If you're a business that's bringing in the capital, there are tax implications for debt and equity that differ. But it's treated just as if you were servicing a bank loan. So there are definitely implications.

For crowdfund investing, it's gifting. So you've definitely got taxes on that revenue that you should be pulling into your cost projections. Which I think particularly a lot of artists and filmmakers aren't doing. They're not saying, Oh, if I raise $100,000 on Kickstarter, I need to back out a certain percentage for the taxes I'm going to pay on that money. I don't think a lot of people are thinking through that.
One of the biggest fears out there about crowdfunding is fraud. Are there safety nets?
Candace: Any investment you make has risk associated with it. We're not saying this risk free, absolutely not. There is risk associated with very single investment a person will make in their life. And so yes, the investor is responsible for conducting their own due diligence.

What we can say is that we are verifying that the borrower exists. We pull a criminal and credit report for every owner of every company who applies on our platform. We do verify that indeed their location exists, their website is working, their telephone is working, those types of things. We provide complete transparency on our platform, as well as an open dialogue. So if you have a question about my business, you can ask that question and my response to you becomes public. So there's definitely a transparency of data.

One of the things that we learned about fraud is that while everyone claims the sky is falling and Grandma is going to lose her life savings, I prefer to look at the facts. When you look at crowdfunding and the Kickstarter-Indiegogo model in the U.S., there has not been one single instance of successful fraud on those platforms over five years.

Even my securities commission in my state wrote a letter to the FCC talking about one case called Mythic. Mythic is the only case of fraud in five years in the U.S. And it wasn't successful. In the Mythic case -- it's a Kickstarter case -- there was a company who claimed to be creating a video game. What they had done is they had taken screen shots from other video games and they were never planning on actually developing their own game.

I always quote 'Sex and the City' -- Samantha, when she's talking about becoming famous, says, "First come the gays, then come the girls, then come the industry." Well in crowdfunding, first come your friends and family, then come your general community, then come the niche people all across the country who just happen to care about comic books, for instance. In the instance of this Mythic situation, the gamer community jumped on board within 24 hours of them posting their active fundraiser. And that gamer community uncovered the fraud. Because they knew the games that were being copied and pasted. That entire campaign was shut down within 24 hours, not a single dollar was lost. And so it's interesting because I keep seeing that damn case over and over again in the media, and it wasn't even successful!
So what should investors and businesses do to protect themselves?
Candace: So there's three issues. There's fraud, there's failure, and there's fulfillment. I'm not concerned about fraud nearly as much as everyone else is. I believe that fraud will be less than 1 percent of all deals 10 years from now.

What I'm more concerned about is failure. I'm concerned about investors not understanding that the businesses they can invest in can, and likely will, fail. Six out of 10 businesses fail these days. I think that investors need to be aware of that when they're making their investments. This is not a surefire thing. And there are inherent risks when investing in businesses.

The third -- and this is more tied to incentive-based crowdfunding and fulfillment -- one of the things that we're learning is that the issuers of these campaigns are woefully under-calculating how long it will take them to fulfill their orders on pre-purchase. So we spend a lot of time educating our borrowers on offering intangible incentives that you don't have to actually ship or produce. Because shipment is always going to be more expensive and take more time. That's something I think a lot of the people who are doing pre-purchase are getting frustrated with. Now it's not fraud -- it's issues with fulfillment.
Ironically, the online, social nature of the platform helps protect from fraud.
Candace: Yes. We're calling this whole crowdfunding space Web 3.0. Web 1.0 was AOL and email. Web 2.0 is social media. 3.0 is actually the ability to invest through social intelligence. So yeah, I think the platform has a responsibility to facilitate an open dialogue. To facilitate the opportunity to have an open discussion and negotiation.

I think the platform should be responsible to at least verify if the business indeed does exist. And so there's quite a bit of responsibility that falls on the platform today. Whether it's regulated or not, our platform does all these things simply because we want to have that competitive advantage. The last thing we want is high default rates on our platform. And we're taking quite a bit of precautions with or without regulation to ensure as low a default rate as possible.
What do you consider your biggest success story?
Candace: Candice Peters. She's the one who applied to 16 different banks and was turned down 16 different times. Her story is a beautiful story. Her husband's a police officer and she is a former flight attendant. She wanted to open up a yoga and TRX studio. She and her husband opened up their facility in a carriage house and lived upstairs with their two children in about 300 square feet for about a year and a half... because they could not get a bank loan. So they self financed the first year. They literally had their beds stacked up three high... a loft bed stacked over the bunk bed, and the kids slept in the bunk beds and she and her husband slept in the loft. And she'd say, "This corner is our dining room, this corner is our living room."

She's now been in business for almost two years. She's opening a second facility and she secured a loan from her friends and family on our platform. I'm so happy we were able to provide that opportunity for her. They were finally able to move into a house and out of their facility. She's expanded, she used her loan to purchase spinning bikes, and she's started a spinning studio upstairs where they used to live. And now she's opening a second facility. I love stories like that.

The second is this restaurant owner. I can't say his name because he's in the middle of his fundraising, but he will close in about a month. He's in the Belgian waffle business. He's got a Ph.D. in economics. Smart dude. Great credit. Could not get a bank loan to save his life. He's opened facilities all over his state and he's now opening a fifth location. He can get a bank loan now, but chose instead to let his customers invest and grow as he grows. He closed at around $100,000 the first night of his campaign by having a friends and family dinner at his restaurant. $80,000 of that came from his friends and family. $20,000 came from his city. During the dinner his employees were coming up and saying, "I want to invest my money." These are servers who make two bucks an hour plus tips who want to invest money back in their employer. How awesome is that? I'm telling you I could be practicing law right now making far more money, but when I see something like that happen, it's magic. Because that is the future of small business finance. When your customers, your friends, family and employees all have an opportunity to invest their money and be part of your success. It's a new form of profit sharing.

Those two stories are the ones that are going to become kind of the national stories. Because these are two businesses who've chosen crowdfunding for very different reasons.
Are you seeing any trends in the types of businesses that use crowdfunding?
Candace: It's different for different types of crowdfunding. For reward-based donation and equity-based, it's very heavily skewed toward consumer products: gadgets, things that are tangible that people can see, touch, pre-buy. Those tend to do very well. And creative. So artists, musicians, filmmakers do really well on rewards based. So you've got the creative in rewards and donations. You've got consumer products in reward and equity. And then on the debt side, we're completely focused on consumer-based brick and mortar. So restaurants, retailers, salons, gyms... they may have more intangible products or consumables, but not consumer products like a surf board. That tends to work very well because they have turnover, and they can service the debt.
You helped draft the 2012 JOBS Act, which is meant to crack open funding opportunities for small businesses. Where is it now -- and where does that leave crowdfunding?
Candace: We're in a big standstill right now. The staff have been amazing to work with at the SEC. They've completely drafted the rules, and those have been completely drafted since Nov. 1. They're sitting on the desk of Chairman [Elisse] Walter right now. Chairman Walter is being replaced by Mary Jo White. So we're just sitting, waiting for someone to call the rules for public comment. I anticipate that with the turnover to Mary Jo White, and now Commissioner [Troy] Paredes is going to be replaced in the not so distance future... it's going to be very likely 2014 before we see securities-based crowdfunding fully implemented.

What does that mean for the portals? There were a handful of portals who raised money and started putting tech together on April 5 last year, anticipating the 270-day rule-making period that was actually laid out in the legislation. Many of those portals will be out of business by the time the JOBS Act is actually implemented. Which is a very sad and somewhat scary thing because there are a lot of businesses who are kind of sitting on the sidelines now waiting for this to happen. And many of the technologies that are facilitating those relationships won't even be around. Because they will have spent their investment by that time. So it's a story that's not told very often, and it's one that kind of makes me sick to my stomach.
What do you want to see happen?
Candace: I would like to see the four commissioners of the SEC today call the rules forward for public comment. So we can actually react and get this ball moving. Commissioner Walter can do that today. She hasn't chosen to do so yet. And I think there needs to be a more public outcry for the four commissioners to take action.
What can small businesses do now?
Candace: Do something! We have a formal partnership with Indiegogo. I encourage small businesses to do one of two things: Either go out and do a donation-based campaign today, learn as much as you can about how to raise capital, how to use social media, how to get the word out in the only ways that are legal. That will only serve you well when securities-based crowdfunding comes out because you'll already have a leg up on the competition.

The second thing is, small businesses can still work with companies like ours. Today we can facilitate bank financing and friends and family financing. So it's a great first step to do a campaign with friends and family, and learn how a campaign works... for your most intimate population today, so you can go out in the crowd sometime in the next 6-9 months.
You were a judge for the entrepreneur show, 'Shark Tank.' What are some of the biggest mistakes -- and winning techniques -- businesses make in pitching themselves?

A simple piece of advice is, be as concise as possible, and act as if you're speaking to a third grader. Someone who literally has no idea what your business is. So that brings me to the two biggest mistakes:

People are really proud of the fact that they're an expert in their field. And they speak as if they're a rocket scientist in their field. They start talking in acronyms, thinking that it makes them sound smarter. But in reality it just makes the investor or the judge stop paying attention. So practice your pitch with a third grader. And if the third grader is interested and asks a question, then you know you're ready to go into a competition or talk to an investor.

The second thing I think is a big mistake is that people are so excited about what they're doing that they'll go on and on and on about it. You gotta be short. People have an attention span of about 30-60 seconds. And if you can't fit into 30-60 seconds what it is that you do, you already lost.

As a followup to that, arguing with the judges. People do it all the time. You're not going to convince them. If a judge tells you I don't think you have a market here, don't say yes I have a market. Say, that's great feedback, I'll go back, and if you don't mind I'll provide you with some additional research about my market size. Don't argue with them while you're in the middle of the pitch. Because that argument just makes them angry. They've already said no. And by you arguing, it just makes all the other judges say no too, because nobody wants to invest in an asshole. In 'Shark Tank' I've seen so many of the pitches fail that would have been successful if they'd just stopped arguing. Take the advice, say thank you, that's great advice, I hope I can come back to you in a few months with an answer, a solution, more data. That's the best thing you can possibly do for your campaign.

Candace Klein is the founder and CEO of crowdfunding platform SoMoLend. For more on Candace and crowdfunding, visit SoMoLend's Facebook page, or reach out on Twitter @SoMoLend.