Jannah Patchay of Agora Global Consultants looks at alternative financing options and the benefits to investors
It is often said that small-to-medium enterprises (SMEs) are the engines of growth in an economy. Every year, thousands come into existence; some destined for an early grave, others persevering through the initial challenges facing any business – bringing a product to market, developing a brand, building and retaining a client base, attracting investment – particularly in light of current market conditions, to flourish.
The painful truth encountered by many of these start-ups is that a good idea, well-defined business model and strong management team sometimes just aren’t enough. Access to capital for both investment and cashflow management is vital.
In the post-2008 financial environment, banks are (not unreasonably) reluctant to lend to high-risk borrowers, and where such financing is available it is often prohibitively expensive. Interest rates of 15-20% are not uncommon and financing costs can substantially impact the bottom line.
Meanwhile, in a different segment of the market, another group of participants is faced with a challenge – what to do with their savings? With retail banks offering typical APRs of 0.1% – 1% on the more generous offers, the returns fall well below inflation rates, let alone any prospect of capital growth.
And in a beautiful demonstration of the forces of supply and demand at work, a few canny entrepreneurs have found innovative and mutually beneficial ways to bring these two groups, SMEs in need of financing and savers in search of growth opportunities, together. Whilst platforms such as Kickstarter left many observers scratching their heads – why would an investor give money to a start-up, oftentimes in exchange for no apparent tangible benefit other than a sample product and their name in the credits? – this new breed cuts out the old intermediaries to directly address the needs of both investors and businesses in which they are investing.
Peer-to-peer lending platforms such as Funding Circle, and crowd-funding platforms such as Seedrs and CrowdCube, are introducing sophisticated new models to lift the alternative financing sector to a new level and offer a viable alternative to the traditional model in which banks act as intermediaries by taking deposits from savers and lending to borrowers. At first glance, they may appear to bear little resemblance to their antecedents. However, a closer inspection reveals that the market challenges both faced by and addressed by the newcomers are very familiar to the traditional market operators.
Return on investment
Fundamentally, every investor wants a return on their investment. Preferably a guaranteed return – witness the enduring popularity of bonds and fixed-term deposits with savers – but a higher level on risk may be acceptable if they deliver higher performance. The new breed of platforms can deliver the goods but in slightly unorthodox ways. For example, investors in a company wishing to take a new product to market and seeking funding via Kickstarter do not receive equity, nor do they receive any form of repayment. However, they are often the recipients of the first batch of product. This creates a virtuous cycle for the start-up, which is guaranteed not to be left with a mountain of unsold stock, as well as a source of free marketing (consumers who like a product will tell their friends about it).
Funding Circle, which matches savers to a portfolio of businesses wishing to borrow, offers returns from 6.3-9% depending on the borrower’s credit profile, an impressive step up from typical savings account rates that is also well below typical business loan rates.
CrowdCube and Seedrs both offer a more traditional route for investors through an equity stake in the business, through which dividends can be paid and exit via a sale achieved.
In any market, liquidity is essential – the ability for investors to dispose of assets and take P&L in cash. Whilst these instruments are hardly going to be as liquid as those listed on a main market, this is a well-known challenge for SME markets and both lending and equity-based players are taking steps to address this. Solutions include provision of a limited secondary market function whereby investors wanting to exit may re-sell their holdings to another platform member. Innovative product structuring can help to encourage liquidity. Funding Circle allows investors to manage risk and diversify their portfolios across many small loans, and to auction these micro-loans off.
While investors may have different risk appetites, in order to continue attracting investors, a platform must be able to demonstrate a certain level of success on the part of the businesses it introduces to them. Here again, the model of investor-who-is-also-customer reinforces the growth prospects for a business. Some platforms pre-screen SMEs who come to them for funding, while others take the view that market forces know best and allow any business to advertise itself, leaving it up to the investors to judge the relative merits of a business model. Most encourage businesses to provide extensive and detailed documentation to support their bids for financing, including publication of business cases, accounts and financial projections.
Additional Services / Market Infrastructure
It is simply not sufficient to facilitate an equity sale transaction resulting in the investor holding a number of share certificates and the business holding some cash. Seedrs now acts as a custodian for shares, manages the payment of dividends from businesses to investors, and provides a secondary market for investors wishing to exit – a full-fledged market in miniature. This is the sort of value-add service that lowers the barriers to entry for investors, by making it easy and transparent for them to use the platform.
While their business models are new, the market structures evolving around the new breed of alternative financing platforms are familiar. They may be creating new opportunities for historically neglected market participants – start-ups and ordinary savers – but the shapes and patterns follow a well-worn, tried and tested path.
©BestExecution | 2013