What are the mechanics of p2p lending?

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Cheepnis
Posts: 142
Joined: Mon Dec 31, 2018 11:52 am

What are the mechanics of p2p lending?

Post by Cheepnis » Thu Oct 03, 2019 6:32 pm

Hopefully, as it pertains to this instance, this question and/or answer is not too broad. I'm also interested in whether there are any dirct parallels between this situation and actual peer to peer lending platforms or the stock market.

Here's the sitch:

I'm considering investing in a local business. A former neighbor, now friend, of mine is a gentleman in his 60's who has lived off his sole proprietorship for the past 15 years. He hand makes a "thing" (being intentionally vague) and sells it at Saturday markets. Once when I asked him about business cash-flow he straight-up showed me his entire business/personal budget, which was far more than I asked for. He lives on about 1.85 JAFI's.

Talking to him recently he mentioned he's looking into getting his product manufactured in China. Making it is a very long process and after 15 years he's getting tired of it. However, there are some obstacles to getting it manufactured. First, in order for it to be worth it he needs to order in quantities larger than he can currently store. Second, ordering that many things will take more capital than he has available. Thirdly, there will likely be other unknown-unknown costs incurred while attempting to get this process set-up.

He's not really aware I'm in a position where I could be a potential investor, but he mentioned he has several people he's talked to about that sort of arrangement and that after meeting a fellow (now former) hand-crafter who has a similar product made in China he's more confident in the viability of such a large change. This was all several months ago but I've been ruminating on it ever since.

My question is how does investing money actually work in a direct p2p situation. If I were to contribute $1,000 to this venture, how is a return calculated? How would a return be payed back? Would I essentially be buying 1,000 $1 shares in his SP (each share being roughly 1 thing) and there would be an agreed upon percentage of each future sale I would be entitled to up to an agreed upon ceiling?

That doesn't seem right because in the real world you're never guaranteed returns, but is that because the mechanism of calculating returns is different that I just postulated or because in the real world you can never be certain how well a product or business will do?

I don't even know if those questions are ballpark right now. The researching I've done has all been high-level explanations and I'm looking for a low-level explanation so I can better grasp what this venture might look like. I am confident in his ability to continue making his living this way and figure it could be a fun learning experience in small-scale speculation.

Seppia
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Location: Italy

Re: What are the mechanics of p2p lending?

Post by Seppia » Thu Oct 03, 2019 7:41 pm

Companies raise money in two ways:

Selling equity (= a piece of the business itself) and issuing bonds (= borrowing money).

As a provider of capital, you are either becoming part owner (first case) or a creditor (second case).

The risk in the first case is that the business doesn’t return money or shuts down altogether (so you’re stuck with 10% of a business that’s worth zero). In the second case it’s that debtors aren’t able to repay the money they borrowed.

The upside in the first case is potentially very large (ie this person’s company becomes Apple so your $1000 investment for 10% of the equity is now worth 100 billions), while in the second case is capped to whatever interest rate you e agreed to.

So I would say first you need to decide whether you just want to lend him/her money or if you want to be onboard and involved in his/her enterprising activity.

Cheepnis
Posts: 142
Joined: Mon Dec 31, 2018 11:52 am

Re: What are the mechanics of p2p lending?

Post by Cheepnis » Fri Oct 04, 2019 4:50 pm

Thanks Seppia, that all makes perfect sense in the small scale.

I am not particularly interested in becoming part owner, but let's pretend I was.  If I was 10% owner I would receive 10% of the profits and also presumably put in my 10% worth of labor. The original owner would probably be counting that whatever improvements he could make with the fresh capitol would increase profits enough to offset the 10% he no longer receives.   Down the road I could sell/he could buy back the 10% ownership from me at a profit for me (because the business now has a higher valuation). That all makes sense to me in this small scale example.

I become more confused when trying to extrapolate that logic to the stock market. The term equity as you use it is referring to my stake of future profits, correct? I find it somewhat confusing that common stocks are referred to as equities (as you say, a piece of the business) when I couldn't go out, buy $100 shares of Disney stock, walk up and put a sticker reading "Cheepnis" on a seat of Thunder Mountain, strike a Captain Morgan pose, and declare that seat my own. I think there's a term for the fact that owning a piece of the business /= any claim to anything the business actually owns. This all becomes even more confusing if a stock isn't a dividend payer.

This is some 101 level stuff, but seems to me most everybody writing about investing assumes what a stock actually is and why it's worth anything at all is understood. If a stock is in fact a "piece of the business" but it doesn't pay dividends and I'm not entitled to anything the business actually owns, how the heck is it worth anything at all?

I've read quite a few books on the the stock market/investing, as well as most of investopedia and the bogleheads wiki and the picture is still super fuzzy. If I don't think about it too hard most everything makes sense, but the reductionist in me never stops.

anesde
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Re: What are the mechanics of p2p lending?

Post by anesde » Fri Oct 04, 2019 7:35 pm

It’s a matter of scale. If you own $100 of Disney which has a market cap of $230.8B you own an infinitesimal small fraction of the company. You still own it, but given your tiny fraction you don’t command enough to warrant making any decisions.

A better comparison would be that your friend is looking for $1m of capital and you offer him 1 cent. He may take it but you wouldn’t expect any say in any of the proceedings would you?

If you bought 10% of Disney (for $23.8B) then you would start having some say in what direction the business decides to move in. Note you wouldn’t have any direct say in what colour to paint Thunder Mountain in, but that’s because those powers are likely delegated to a certain management team. You could influence how the company is structured and/or who runs that management team.

The problem with (many) stock market investors is that they don’t appreciate that they are actually investing in businesses. However (unless you buy a majority or significant minority share) you don’t typically have much influence over the operations of that business. This contrasts with your local example, or any example involving a controlling share in a small business.

What (smart) stock investors do is evaluate not only the sector a company operates in and it’s past track record, but also the quality of the management team and the direction the company is moving in. It’s useful to evaluate charts and technical pricing but fundamentally a business needs to have a good plan and needs to be executing that plan well. That’s why proper management is paramount.

In your case it would revolve around your friends ability to execute, and what other resources he needs to be successful. You could provide financial capital in the form of equity and get a say in how the company executed its strategy. Your return would be governed by how successful the business is. Or you could provide a loan in the form of debt where you get a (potentially) lower fixed return in return for less risk. You would demand some sort of collateral over your funds, which could include security (land or other assets) and/or step in rights to the company if things go sideways. The general rule is debt always gets paid first, with equity making (potentially outsized) returns is the company is successful.

The premise is the same no matter what type of (business) investment, it’s just the details get more complex depending on the size or asset class.

anesde
Posts: 92
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Re: What are the mechanics of p2p lending?

Post by anesde » Fri Oct 04, 2019 7:57 pm

Also, for what it’s worth on your initial post here are some thoughts that I would have on due diligence required before investing:

1) Who does he know in China? Which factories has he spoken to, what’s the estimated price per unit, and what’s the lead time and capacity required to fill his orders?

2) Who are his current customers? Would his customers be turned off if they knew that the product was no longer locally hand-made but now outsourced to an overseas Chinese factory? Would his pricing suffer? Alternatively would he gain new customers via scaling up? Has he tested his thesis at all and can you independently verify?

3) What’s his plan for storage of the larger quantities he now has to take on? Is this a perishable item that cannot be stored, or requires a special form of storing (i.e cold storage) that is more expensive?

4) What additional management resources does he need to scale up? Will he be hiring more people and if so for what roles and who does he have in mind? What are the recurring internal management costs beyond his estimated capital required to initiate the expansion?

5) How does he envision the investment structure? Are you aligned in this view? Will you incur any legal or other DD costs in your analysis? If you opt for equity would you be a silent partner or take on an active role? If the latter what skills or other resources are you bringing to the enterprise?

6) Who in a similar business, or business model, do you know that can shed light on the “unknown unknowns” that you reference? How much contingency is he planning for? Are you (and any other) investors comfortable with injecting additional equity in the future?

7) Will he be raising any debt, and if so for how much, at what rate, and against what security?

...etc

I know you didn’t ask for it (and perhaps all of the above is already obvious to you) but it may help if you decide to move forward. Best of luck!

Cheepnis
Posts: 142
Joined: Mon Dec 31, 2018 11:52 am

Re: What are the mechanics of p2p lending?

Post by Cheepnis » Fri Oct 04, 2019 8:52 pm

Thanks for the thoughts, anesde. While I won't go into specifics on each point, I have thought about and have answers for many of them. A couple quick points.

Pertaining to 5: Not sure he would have an answer to the first question and I wouldn't know my ass from a hole in the ground on the second. While I wouldn't be comfortable doing this without some sort of formal contract, I have no idea what an actual structure would look like.

Pertaining to 6: The unknown unknowns I'm worried about are only in relation to getting the product produced. I assume there will be hitches getting the process set up. As I said in my OP he has an acquaintance who has been through the process, but I have not met/talked with them and that is something I would definitely like to do before actually embarking on this venture.

Pertaining to 7: Potentially only as much as I and perhaps a few others are willing to credit him! If the cookie crumbles in that direction, that is.

anesde
Posts: 92
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Re: What are the mechanics of p2p lending?

Post by anesde » Sat Oct 05, 2019 3:36 am

The structure could be whatever you want it to be - that’s the beauty of directly investing in a small company.

Given the size and scale you’re describing I would think a Limited Liability Company (LLC) would be the best path (assuming you’re in US, but most other countries have a similar option). Within the LLC you would be a member (or director, sometimes different terminology is used). Your friend who’s actively running the business would likely be the managing director.

In terms of valuation and how much your equity buys in the business I would expect your friend has some ideas already (he should anyway if he’s serious about expansion). If not, or if you don’t agree, there are various ways to value an enterprise but they all focus on the same things -

1) How much has the company made historically (if applicable)
2) How much and when is the company anticipating to make in the future
3) Your own cost of capital (i.e what’s your target return)
4) Your own investment horizon (i.e how long do you want to tie up your money/when do you want a return)

You can take this as far as you like in building a financial model, but given the size and scale yours doesn’t need to be overly onerous. At a minimum you should make a spreadsheet that considers the above and run some sensitivities - i.e what if it takes longer than he thinks, what if the factory cost is higher, what if the sale price is lower, what if storage costs are higher, etc.

Once agreed and your equity is properly valued (say $100k is buying you 50%) you need to finalise how the business will be run. This is typically handled In a document called the Operating Agreement. There are templates for this online, but they are unique documents that cover the operating requirements of your specific business. The extent of your active role in the business would be defined there, as well as any limitations on the managing director. For example, what he can and cannot do without consulting and getting the agreement of the other members/directors, or at least financial limits on expenditure or cutting new supply deals.

This is the type of stuff that may sound very complicated but in reality it’s a bit more like learning a new language. Once you know it you can apply it across many different ventures and it will help you in making your money make money.

I suggest starting small with capital that you can risk losing as the best way to learn (for me at least) is to do it. Perhaps not this specific venture, but something. There are alternatives to earning a return with a lot less effort (i.e index investing) which have their place but I personally like understanding what I’m investing in and how best to influence its success.

anesde
Posts: 92
Joined: Wed Jan 09, 2019 8:32 am

Re: What are the mechanics of p2p lending?

Post by anesde » Sat Oct 05, 2019 3:46 am

Also to clarify - your post title implies that you would be debt (i.e “lending”). To be honest in what your describing I’m not sure that would be the best option for either of you.

If your friend can secure debt for his business via a commercial lender (a bank) then they would likely give him much better terms then a private lender. Unless he’s leveraging his personal connections (family or close friends) for better terms it’s likely that a bank wouldn’t give him a loan on the business without proof of concept. He may secure a personal loan (with recourse back to himself so is the business fails he’s still liable) but probably not a commercial one.

If that’s the case then giving him a loan on favourable terms (low rate) is placing a lot of trust in your friend for a risky investment. Instead of mitigating your risk with a higher return or sufficient security you’re doing it via trust. This can be a recipe for disaster. I would argue if you trust your friend enough and really believe in his ability/business you’re much better off being equity and sharing in his (hopefully) outsized returns once successful.

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