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An Introduction to Alternative Finance for SMEs

Anna Business Growth 02 Aug 2016


Ever since the financial crisis it's been difficult for many SMEs to acquire finance as banks look to cut risks and opt for secure investments.

Research by the British Business Bank [pdf] found that 50% of finance applications by start-ups (defined by the study as businesses less than five years old) are rejected by banks.

Small businesses that fail to secure bank loans must either make do with a sluggish and restrictive cash flow, or look for finance elsewhere.

For many businesses, that means reaching out to family and friends for funds, or diving into an overdraft.

Clearly neither of these situations is ideal. One has the potential to scupper your business bank account for good, whilst the other could end friendships or cause family rifts.

In response to this gap in the market, alternative finance solutions emerged.

In the years since the recession, alternative finance has flourished. The amount of alternative finance raised in the UK in 2013 was estimated at under £700 million, but in 2015 this figure had grown to £3.2 billion, according to research from Nesta [pdf].

There's clearly demand for this type of finance in the UK, but many SMEs are unfamiliar with what alternative finance entails - and how to access it.

It's time for an introduction.

Types of Alternative Finance

Given that alternative finance is loosely defined as forms of finance that don't rely on banks or other traditional investment structures, there are plenty of different forms.

The most popular forms of alternative finance include:

  • Crowdfunding. Where a company seeks small investments from hundreds or thousands of people simultaneously through a funding campaign.
  • Invoice financing. An array of finance options that revolve around 'selling' invoices to third parties to gain a proportion of their value immediately.
  • Peer to peer lending. Lenders are matched with borrowers directly through an online platform, usually with favourable rates.
  • Pension-led funding. Money is borrowed from the entrepreneur's own personal pension.

In this article, we'll take a close look at all four of these methods and explain the advantages and disadvantages of each.

 

Crowdfunding


crowdfunding pros and cons
You've probably heard a great deal about crowdfunding. You might even have contributed to a crowdfunding campaign.

Crowdfunding campaigns are pitched by a company to the general public, and typically (but not always) relate to a single project or product.

Businesses run these campaigns to gain small contributions from a large number of individuals - pledges are typically between £1 and £100.

Before we look at crowdfunding in more detail, we need to separate it into three different types: reward-based, donation-based and equity-based.

Equity-based crowdfunding
In this variety of crowdfunding, contributors gain shares in the company. BrewDog's 'Equity for Punks' campaign is one of the more successful equity crowdfunding efforts we've seen.

Reward-based
Most Kickstarter and Indiegogo campaigns fall under this category: individuals 'pledge' money to support projects and gain a number of rewards in return, depending on their pledge level.

Rewards can include brand merchandise, special editions of the product they helped support, or handwritten thank you notes from the business.

Donation-based
Individuals donate towards the crowdfunding campaign and expect nothing in return.

Crowdfunding: advantages

Crowdfunding campaigns are popular in a number of sectors for a variety of reasons, including:

  • Loyal followers. Project backers form a community, acting as ambassadors for your product or brand. They want to see your project succeed, so they'll spread the word.
  • No need to deal with a bank, publisher, or picky shareholders. If you want to retain full control over the direction of your brand, most forms of crowdfunding ensure you remain largely independent.
  • Media attention. A popular or novel crowdfunding campaign will be shared on social media, and you may also be able to snag press coverage.
  • Feedback. Regardless of their success, crowdfunding campaigns will give you plenty of feedback to read, digest, and learn from.

Crowdfunding: disadvantages

Crowdfunding certainly has its problems.

  • Most campaigns are all or nothing. If you don't reach your goal, you don't get any of the pledged funds.
  • Pledge rewards can be expensive. Poorly chosen rewards can be pricier than you expect, and could even cause cash flow problems.
  • Creating an effective campaign can be time consuming. You'll need to prepare plenty of media content for your campaign and plan how you'll get the word out.
  • A failed project can damage your company's reputation and eliminate consumer trust in you.
  • Most crowdfunding platforms have restrictive rules and may not allow you to start a campaign.

Overall, crowdfunding is best suited to companies with an established (or nearly complete) product, particularly companies in consumer tech and entertainment.

It's also recommended if your business has a passionate following - either locally, nationally, or online.

Avoid crowdfunding if you don't have the resources to create and run a high quality campaign, or if you're selling a service rather than a product.

 

Invoice Financing


Invoice Financing
There are numerous different finance products that involve your company's invoices. Generally, within these types of arrangements your business 'sells' unpaid invoices to the lender who'll then give you a proportion of their full value upfront.

Traditionally, invoice finance is used by companies looking to unlock their cash flow and gain access to additional funds quickly. It's had something of a bad reputation in the past, but the business community now realises that invoice financing can be extremely valuable if used carefully.

As with crowdfunding, there are three different types of invoice financing products typically available in the UK: factoring, discounting, and trading.

Let's look at each of them in turn.

Invoice factoring

Here's how factoring works in the UK:

  • Your full sales ledger is sold to a third party for a percentage of its value - usually between 70% and 90% - which you receive upfront.
  • Invoice management passes entirely to the invoice financier - they'll be responsible for chasing payment.
  • Once your clients pay the financier what they owe, they'll pass the rest of the funds onto you.
  • You will then have to pay a fee and interest. Interest charged tends to be 2-3% above the base rate, and fees are usually charged as a percentage of annual turnover - typically from 0.1-5%.

If the third party isn't able to recover the value of the invoice from your clients, you may again become responsible for this debt - it all depends on whether you have a recourse or non-recourse agreement.

In recourse factoring, you have to buy back unpaid invoices after a certain number of days.

In non-recourse factoring, the third party takes the risk of non-payment.

Therefore, fees will always be higher for non-recourse agreements, and financiers will be much pickier about choosing their clients if they're taking on the additional risk.

It's worth noting that invoice factoring isn't confidential - your clients will know you're using a third party to chase debts.

Invoice discounting

The other 'traditional' form of invoice finance is discounting.

In this variant, you don't actually sell your invoices - you receive a loan with your accounts receivable acting as collateral.

Here's the full process:

  • You invoice clients as normal, but send an invoice copy to your lender.
  • The financier lends you a proportion of the value of the invoice (usually 70-90%).
  • Once the invoice has been paid, you receive the remainder of the funds - minus the financier's fees.

The biggest difference between discounting and factoring is that under a discounting agreement, you retain full control of your books - it's you who must chase payment and communicate with clients.

Depending on your circumstances, this can be seen as a benefit or a drawback.

It's also worth remembering that you'll still need to pay interest on your loan regardless of whether invoices are paid.

Invoice trading

Again, there are plenty of different types of invoice trading, but in recent years the term tends to refer to selective online invoice trading.

This is a relatively new form of invoice finance, but it's quickly gaining traction given its flexibility and low barriers to entry.

  • Your business applies to become a member of an online invoice trading platform.
  • If your application succeeds, you can then submit invoices to the platform.
  • Each invoice is verified by the website. You then set the maximum cost of the finance and specify the credit period.
  • Funders bid on (or buy) your invoice (or a proportion of it), competing on interest rates and perhaps other terms.
  • Once the auction is over, the winning funders send across the loan via the web platform.
  • At the end of the credit period, your business pays funds back to the lender via the web platform. Fees and interest are also paid.

This type of invoice finance contrasts with the other two in that it's selective.

You're not tied into an annual contract - you can choose which invoices you'd like to auction.

Invoice financing: advantages

Although invoice financing can seem daunting, it certainly has its advantages:

  • Extremely fast access to funds.
  • You don't need to use valuable assets as security.
  • Available funds grow with your sales ledger - whereas you might quickly outgrow your bank loan or crowdfunding campaign.

Invoice financing: disadvantages

Regardless, invoice financing has its drawbacks.

  • Some forms aren't discreet and lock you out of crucial client communications.
  • You won't get favourable rates if your books aren't in order or if you've struggled to chase payments in the past.
  • You can't use it if you sell to the public rather than other businesses.
  • It's easy to become over-reliant on this type of finance.
  • Fees and interest quickly add up and starve you of hard fought revenue.

Overall, invoice financing is best suited to client-focused companies needing an immediate injection of funds because of slow-paying customers. It's not a good fit for companies which sell to the public or those who are looking for longer term solutions.

 

Peer-to-Peer Lending


peer to peer lending banner
Out of all the alternative finance options we're exploring in this article, peer-to-peer (P2P) lending is the closest to traditional bank lending.

It does, however, have a key difference: there isn't a bank involved.

Instead, the 'middleman' is a web-platform. Popular business P2P services include ThinCats and RateSetter.

These platforms match lenders with borrowers based on individual requirements. Typically, borrowers borrow small amounts from numerous different lenders - but the platform manages all this for you.

The P2P platform also manages the loan and its repayment for its duration.

The Financial Conduct Authority regulates the P2P lending market, meaning platforms must abide by strict regulations. These measures protect lenders and borrowers alike.

P2P lending: advantages

P2P lending certainly seems more efficient that standard bank loans - and this fact is reflected in its advantages.

  • Interest rates for borrowers can be lower than those offered by the banks in some circumstances.
  • P2P lenders may be willing to take on more risk than banks.
  • The process is usually fast.

P2P lending: disadvantages

It isn't all good news for borrowers - P2P lending does have its disadvantages.

  • Applying for P2P loans follows much the same process as bank loans. If you have poor credit or your business isn't profitable, you'll struggle to secure a P2P loan.
  • Sometimes interest rates may not actually be favourable - particularly when coupled with any extra charges.

As you can see, now that the P2P lending industry is well-regulated, there isn't much difference between bank loans and P2P loans. Perhaps the main difference is that the funds from a P2P loan will end up in your account quickly!

Therefore, P2P lending works well for businesses who wouldn't struggle to secure a bank loan but want the funds fast. Avoid P2P lending if traditional investors see you as a huge risk - some P2P lenders may be willing to take risks that banks won't, but you'll pay for it through high interest rates and fees.

 

Pension-Led Funding


pension jar
Pension-Led funding is a relatively complex form of alternative finance where business owners can draw on their own pensions to fund their business.

To access pension funds as a business, either a Self-invested Personal Pension (SIPP) or Small Self Administered Scheme (SSAS) is required.

Setting up these schemes is relatively complex - you should enlist the expertise of a financial advisor and pension scheme administrator throughout the process, but before you've even started you need to determine if pension-led funding is viable for your business.

First, consider the two funding options available:

  1. A fully secured commercial loan from the pension fund to the company.
  2. The pension scheme purchases assets (usually intellectual property) from the company and leases them back.

Typically the government only approves loans from pension schemes if the following conditions are met:

  • The loan doesn't exceed 50% of the fund's overall asset value.
  • It should be fully secured.
  • The term is no longer than five years.
  • The interest rate must be over 1% higher than the base rate.
  • Regular repayments must be made throughout the loan period.

It's also unlikely that the loan will be approved if your business owes money to another pension scheme.

Carrying out all the necessary admin usually takes between one and two months.

Pension-led funding: advantages

These schemes are becoming more attractive to business owners. Here's why.

  • Interest payments go back into the business owner's pension scheme, instead of to another party.
  • Funds from underperforming pension schemes can be unlocked and made more productive.
  • Intellectual property is an underused asset class that these arrangements take full advantage of.
  • Aside from the regulatory requirements, it's the business owners themselves who decide whether the risk is worth taking - not banks or other third parties.

Pension-led funding: disadvantages

Despite their increasing appeal, it's worth being aware of the disadvantages of this type of finance.

  • You're putting your pension fund at risk - as well as your business.
  • Administration and setup costs can be significant, as you need to pay advisors and administrators.
  • You can't give your business preferential treatment and change repayment dates just because business isn't doing as well as expected.

Overall, pension-led funding works best for business owners with hefty pension funds who are confident in their business growth and want to fund short term expansion. Avoid pension-led funding if you're after a long term solution, aren't willing to risk both your pension and your business, or if you don't want the hassle of setting it up in the first place.

Which Solution Fits Your Business?


It's important to consider all your options.

None of these solutions are perfect.

All of them carry risk.

As with every funding decision, it's important to understand your goals, business objectives, and any current obstacles.

  • Is finance really the solution, or is something else holding the business back?
  • Which funding type will help you meet your targets?
  • What kind of interest rates can you afford?
  • How can you improve your standing with investors?

Although this article might have left you with more questions than answers, the most important takeaway is this: banks aren't your only option.

Alternative finance is quickly becoming mainstream.