How to Validate a Startup: A Post-Mortem of an Infant P2P Educational Lending Platform

Hey everyone! Long time, no post. For the last two months Napkin Lab was working on a big idea. Usually, the entrepreneurial ventures that I come up with aren’t anything world-changing and i’m used to hearing mixed reactions from people when I tell them about it. Maybe some are excited, but many might not see the potential or are just skeptical. Well not long ago, I had the idea for a P2P lending platform that could specifically cater to educational lending.

The Idea.

I wondered to myself, why isn’t there a platform that could specifically cater to non-traditional educational programs such as coding bootcamps? It could line up potential investors and show them the possible investments available, and they could then invest in these students. The students get education paid for, and the investors could get a nice 5-8% return on their cash investment. I could take it one step further and create an in-house job placement and assistance program that helps the new grads get jobs after they finish their education. That could even be an additional source of revenue since companies pay big money in finders fees for placing quality talent.

Validation.

I was excited, but didn’t want to get too excited. I have had plenty of failures before and even though I thought it was a good idea that doesn’t mean that it is one. So I took to the internet and started asking around in message boards, social networks, and private groups that I am a member of. I kept it simple and simply asked, ‘If you could invest in student debt, would you?’, and left it at that. I was surprised by the comments. Nearly all of them were positive and nearly all said they wanted to be able to pick the program that the student was enrolled in- specifically, STEM and CS students. They wanted to invest in the next Google Engineers. I was encouraged. I knew that this could be something big. There are $1.4 TRILLION in outstanding student loans, getting just a piece of that pie would be big business.

Next, I wanted to collect more data. A handful of responses from my informal survey was enough data for me to keep moving forward and validating the idea, but not enough to call it validated just yet. So I went about setting up a more formal survey on Typeform asking more questions that went deeper into a person’s preferences for how they invest, what criteria would matter to them if this hypothetical product existed, the degrees and courses they’d want to invest in, etc. Everything I could think of to ask, I did. Not only about a person’s willingness to invest, but also about their demographics and investing traits. I wanted a whole picture of this person so that later on down the road I would have this data available for marketing purposes as well. This kind of long term thinking should be embraced by more startups. I get that simply wanting to get to market to unlock the next round of funding is a big deal for many companies, but if you can start thinking about what you can do now that will be important later on, you can start to collect data and resources that may save you a ton of money or time later on down the road.

So next I sent that survey out into the world… and got 14 responses. I guess getting people to take a survey is a little tougher than asking a single yes/no question on twitter! But I was heartened! Of those 14 responses, around 70% wanted to invest and would be willing to learn more as soon as a platform was available. To me that’s all I needed to know I had to keep pursuing it. The next step was to gather enough data that I could convince investors it was a solid idea and to start research in earnest on the securities laws and competitors that are in this space.

The first was easy. This time I set up a survey using the same questions on SurveyMonkey’s market research platform where you can pay $100 for 100 responses to a ten question survey that is served to the general public. I submitted my survey and about three hours later I had my results.

80% were interested! Yes! This was the data I needed. Now I knew that the potential investors were there and that they wanted to invest in STEM (Science, Technology, Engineering, and Math) Degrees, Computer courses, and Coding bootcamps. I even knew that the majority of them would prefer a marketplace-style model more than any other model I had proposed. This was excellent news!

Digging into the research side of things, I learned about Lending Club, Prosper, Common Bond, and SoFi- the biggest players in the field. None of them really focused on BOTH the educational market AND operated as a marketplace. I didn’t know why that was, but just assumed that 5-8% returns was small potatoes and therefore they didnt worry about it. All I knew was that there was a gap in the market and I was ready to fill it!

About this time I also submitted the idea to the Code Launch Seed Accelerator pitch contest. Lo and behold, they also thought it was a good idea and I quickly won the first two rounds of the competition and moved on to the Semi-Finals! This meant that I had to now actually put together a real investment pitch for the business and give it via Skype to the judges. Preparing for this round meant that I really needed to solidify my business concept and work out some of the major kinks in the plan… like how would it be monetized? Will I operate as a fund-style operation where money is pooled together to invest in a pool of loans, or will I operate as a true marketplace?

To answer these questions as well as try to figure out what an investor might ask me, I turned to a good friend of mine who had previously raised angel capital for one of his businesses. So there we sat, on a rooftop bar on a beautiful sunny afternoon, working on our sun burns and me being grilled on all aspects of this business. A few hours and a few drinks later, we finished up and I went home with my head buzzing. I had a lot to think about. My friend had definitely helped me get inside the head of a potential investor as well as clarified many questions I had, but also opened up a whole other set of questions that I knew I needed to answer.

The next day I sat down to write out what my idea was and answer many of the common questions about it for an email to another entrepreneur. As it turned out, I didn’t end up needing his actual reply to my email- just the act of me writing it out ended up giving me all the clarification I needed to put together a solid pitch.

Clouds on the Horizon.

The next day I woke up ready to go. I had put together a solid pitch presentation, practiced it over and over, and gotten some advice from yet another friend of mine who was preparing a real venture funding round for his own company. I was ready. 12 o’clock came around and I got on skype, ready to blow the judges away. We chatted for a bit, I gave my pitch nearly perfectly, and then came the Q&A round. I had an answer for nearly every question they asked except one: Several years ago, the SEC issued a ruling on P2P lending marketplaces after Lending Club approached them. I knew that this ruling had been made, but I didn’t know how it really affected P2P lending on the broader-scale. The judges honed in on this and asked me why the competitors didn’t use a marketplace model and how that SEC ruling changed things. I had a decent enough answer, but to be honest, I wasn’t 100% sure.

We finished up the Q&A, had a little more small talk and then ended on a good note. The pitch had went well, and i’m confident in the presentation, but I knew that I had to get to the bottom of that SEC ruling.

As it turned out, what that ruling meant was the death of startup P2P lending marketplaces.

P2P lending marketplaces sit in a strange grey area between banks and investment products. This meant that up until that ruling, no one really knew if they should be regulated by the SEC or the CFPB. Then, when companies such as Lending Club and Prosper started to really hit their stride, the SEC decided that it would take the lead and issued a cease and desist letter to Prosper while it determined how to classify the new financial products being created.

This caused tremendous waves in the P2P community and caused every lender to immediately stop issuing new loans while they scrambled to comply with the new regulations. Essentially, the SEC determined that P2P lending products were to be classified as investment products and therefore would now be subject to the 1933 Securities Act. This caused nearly every player in the field who wasn’t already conducting high volumes of transactions to shutdown practically overnight. Even behemoths like Virgin Money immediately pulled out of the market.

According to the Harvard Business Law Review, what changed was that:

“These for-profit P2P loan platforms had to shelf-register each loan (known as a “note”) ahead of any given lender’s investment. They had to record details of each funded loan with the SEC in a “posting supplement” placed on EDGAR (the SEC’s disclosure archive), thus publicly storing the borrower’s data and disclosures for the public to see. Unsurprisingly, these registration requirements were difficult to implement for incumbents, and are nearly insuperable for new entrants.

The SEC’s Order also fundamentally changed the transactional relationships among the borrower, lender, and platform. Prior to the SEC’s Order, when borrowers and lenders matched, “Prosper would signal WebBank, a Utah-chartered industrial bank, to make the loan to the borrower. WebBank would assign the note to Prosper, which then assigned it to the lender.” Effectively, the platform merely intermediated a loan between the borrower and the lender. The transaction has become significantly more complicated after the SEC’s Order. Today, the lender starts the process by signaling interest in a prospective borrower. When the loan receives enough indications of interest, WebBank funds the borrower but assigns the loan to the platform, not to the lenders. The platform then sells a separate debt instrument backed by the original loan to the lenders, who become creditors of the platform rather than the borrower. The approach is cumbersome and exposes lenders to additional risk, as it entirely eliminates any status lenders may have as secured creditors of the platform.”

So basically, the SEC required such a large amount of registration and paperwork (And yes, it is actual paper…) that all but two players left the market all together because they were not well capitalized enough to comply with all the new regulations and continue operating as a marketplace which by design requires a high volume of loans to be issued to become profitable. Currently, Lending Club and Prosper control 98% of the P2P lending market.

Since then, however, the SEC did open up a small loophole called Rule 506 which would allow private placements of loans and investments so long as the platform did not use any “general advertising or solicitation” that may come in contact with non-accredited investors. And yes, using the internet to market these products would be considered “general advertising”. That means that anyone offering products under Rule 506 cannot use the internet to advertise those products… which is pretty much required to get the volume necessary to run that kind of business. This explains why the only other educational P2P lenders I could find were offering private placements instead of a general marketplace. It reduced the paperwork necessary, and they were restricted by the advertising laws surrounding securities.

Following on that, the SEC then issued an exemption to Rule 506(c) which “permits issuers to use general solicitation and general advertising . . . when conducting an offering pursuant to [Rule 506(c)], provided that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors.” So now advertising is ok, but only if it is used for finding accredited investors rather than general investors. It also allows a platform to issue as many loans as it wants without going through the burdensome registration process, but again, only so long as the investors are accredited investors.

The two big players in the area already have the shelf-registration process in place and are able to comply with the paperwork burden which is what allows them to continue to operate on a marketplace model. But newer players have been taking advantage of the 506(c) exemption by only doing private placements to accredited investors.

There it is.

While it would be possible to continue with the business model that I had formed if I wanted to adjust it to a fund-style business model, it cannot operate as a marketplace as I had envisioned it. The only way that this business would have made money was through small fees in servicing and originating the loans so that the interest rates could be passed through to the investors and prevent gouging the students, and that just isn’t feasible if there isn’t a high enough volume being generated.

The fatal flaw in a reclassification of P2P lending as securities that I had overlooked in the initial research process.

So What Now?

I have all this data that says individuals want additional investment opportunities. And I have more research saying what people wished was better about many of the products currently on the market. Securities, by nature, will always require a large amount of work and capital which doesn’t deter me. But it does mean that I have to be very careful about choosing a business in that field to build on. I refuse to take investor money if I don’t believe that the business will have a realistic shot of being profitable. Unlike many of the valley businesses, I don’t build on promises and dreams. I build on solid cashflow and projections that are grounded in real numbers.

For now, I have the data and the foundational knowledge to say that there is an opportunity here- i’m just not sure what it is. I will have to go back to the drawing board to see what other, related, opportunities I can spot. But for now, it means that this particular business idea is dead in this exact form. Perhaps I will be able to find another model that works and would allow me to continue, or perhaps I can find someone who knows securities law better than me who would be interested in having a chat and bouncing around some ideas.

For now though, I am proud of this attempt and what I did accomplish. It shows that I do in fact have it in me to find a good business idea and sell it. I got farther than I ever did before in a pitch competition and successfully convinced many people out there that this was a good idea and to share in my vision.

It means that the next thing will be even bigger and better and I will have the confidence to lead it.

A failure is never a failure if you can be humble and learn from what went wrong.