ALTERNATIVE FUNDING: what’s out there beyond the banks?

Access to finance is fundamental for SMEs who need help to grow, but if a bank loan application is unsuccessful, what other forms of equity finance are available? Nicola Laver provides an overview of the alternative funding options for small businesses seeking finance

The financial opportunities for small businesses, enterprises and entrepreneurs are more wide-ranging than ever before. Where once, an unsuccessful application for a bank loan may have meant no viable way ahead for a growing business – the alternatives for funding and investment are growing exponentially.

According to a report by Nesta1, 20,000 SMEs benefited from alternative finance in 2015. Even government is now pushing SMEs to other, non-traditional sources of finance: on 1 November 2016, the bank referrals platform went live after more than two years of planning and assessment. Where an SME or entrepreneur makes an unsuccessful application for finance, designated banks are now required to offer them the opportunity to have their details passed to alternative lending providers via government designated online platforms (currently Funding Options, Bizfitech and Funding Xchange).

“Banks are helping SMEs to do what they do best – drive economic growth and create jobs,” said Mike Conroy, the BBA’s Managing Director for Business Finance. “It is important though that businesses which are unsuccessful in their application for bank finance have access to other sources of funding. Some alternative finance providers may be in a better place to support their plans. The industry is working closely with Government and the referral platforms to ensure the scheme is a success.”

This scheme will help to match alternative finance providers and challenger banks with SMEs seeking finance – meaning SMEs will have the vital chance to benefit from alternative funding solutions. The Small Business, Enterprise and Employment Act 2015 marked a major step forward in government support for the financial support of SMEs who need help to grow. The Act seeks to improve access to finance through increasing the availability and sources of investment for small businesses. So what are the alternative funding solutions?

Angel investment
Angel investment is a form of equity finance and is increasingly attractive – particularly for entrepreneurs and start-ups who may not have the funds to service regular loan repayments.  ‘Angels’ are typically wealthy investors who invest both money, and their experience and knowledge into a business. They will seek a stake in the business, and will want to be satisfied that the investment is a risk worth taking. Angels invest individually and as a group of angels – each with its own appetite for investment.

Many successful companies grew significantly on the back of angel investment including Zoopla, TransferWise, Innocent Drinks, Amazon and Facebook. The challenge for businesses is understanding whether or not they are ready for angel investment: research and preparation is vital before actively seeking angel investment. SMEs need to convince angels that they are a risk worth taking – that the business has the potential to scale up and become a high growth business and give a healthy return on the investment. This means, for instance, demonstrating that there is sufficient market for the product or service; and showing how you will make money (for instance, demonstrating your understanding of pricing, margins and profit, and financial projections). 

Key to angel investment is the knowledge and experience factor that sets this type of funding apart from the alternatives. Seeking an angel investor means wanting investment of both cash and the angel’s own successful experience and knowledge in the market/sector of the SME seeking it. Business angels, by their very nature, are keenly interested in the business in which they invest – a factor SMEs should be keen to exploit when pursuing angel investment.

Once investment is secured, angels will provide the SME with invaluable support, expertise and advice. They will be keen to see the business succeed as much as the SME itself.

Business angels can be sourced online, and through organisations such as the Angel Investment Network and the UK Business Angels Association. A word of caution: SMEs need to research the angel in the same way as the angel investor will be keen to assess the SME in which it is considering investing. For instance, from the regulatory aspect, the SME should ensure the angel investor/s have self-certified as either a High Net Worth or Sophisticated Investor by the FCA under the Financial Services and Markets Act 2000 (FSMA).

Due diligence involving the financial, legal and business aspects on both sides will be an important step before a deal is sealed.

Asset-based lending
Asset-based finance can be a valuable source of funding for SMEs and has become a main-stream in recent times. In fact, the UK is a leader in Europe when it comes to asset-based finance: a big increase in UK companies are opting to lease equipment rather than use up valuable cash from loans or extended overdrafts.

The market continues to grow, and it seems funders are preparing to take more risks, with the professional sectors particularly attractive to asset financers. The British Business Bank (supported by government) has described asset finance as “the perfect solution if you need new equipment which would otherwise be unaffordable” in its guide to business finance2.

A major form of asset finance is invoice finance which is increasingly relied on by SMEs. The Asset Based Finance Association (ABFA) says some 80 per cent of asset based finance is invoice finance and has broken the £20bn barrier in the UK for the first time. According to the ABFA, the total amount of lending UK businesses secured through invoice finance hit a record £20.3bn last year (Q2 2016 compared to Q2 2015), up 5% from £19.3bn the previous year.

Invoice finance gives businesses the opportunity to raise finance secured against the value of the invoices issued to customers which are as yet unpaid. It has become increasingly mainstream, particularly with bigger businesses seeking to move away from over-reliance on traditional loans. Many businesses have a lot of capital tied-up in invoices and, as a result, cash flow can pose a major issue.

As for other assets that lend themselves to asset finance, this depends on the business. Assets that can be used to raise money for investment vary from top-of-the-range cars, commercial vehicles and machinery, to specialist equipment, inventory and property – and they do not have to be new to be considered for asset finance.

The lenders consider carefully the assets potentially available for financing, and many also look at the business balance sheet. The lender takes the asset as its security, and the length of finance offered depends on the asset. IT equipment, for instance, might only be considered for asset finance over a two-year period whereas a top-of-the-range Land Rover may be financed over a significantly longer period. The lifespan of the asset must, therefore, be carefully considered if asset finance is a viable option.

Despite the overall growth of asset finance for SMEs, unsold stock and inventory remains an issue particularly in the manufacturing sectors, according to the ABFA. Yet even unsold stock can be a valuable source of security by unlocking the value tied up in stock through asset-based finance.

Crowdfunding is, without doubt, the buzzword of the moment – growing in its popularity not only with SMEs and entrepreneurs, but (with the help of social media) to fund personal projects and campaigns. The UK is a world leader in crowdfunding and it is not (contrary to a common perception) the preserve of startups. Put simply, crowdfunding is a method of raising finance where many people invest a small amount of money in a company or project. The return may be the amount invested with interest, or a product or service.

In the business context, crowdfunding is the source of success for many businesses – due in part to the financial crisis which gave rise to the growth in alternative sources of finance.   Crowdfunding takes different forms, but each has the same aim: to raise money. Some crowdfunders pay money in return for goods or services; debt crowdfunders lend money that will be repaid with interest; and equity crowdfunders buy shares that should increase in value over time.

The Nesta report found that the second fastest growing crowdfunding model in 2015 was equity based crowdfunding, which was up by 295% from £84 million raised in 2014 to £332 million in 2015 (donation-based crowdfunding is the fastest growing model).

SMEs seeking external funding from crowdfunders should exercise caution in choosing the right platform that best meets their business needs. Sufficiently attractive rewards will entice the investors that the business needs, and continuing a passionate relationship with crowdfunders is vital to preserve a healthy on-going relationship – and attract more crowdfunding investment.

Peer-to-peer lending
Peer-to-peer lending effectively brings borrowers and lenders together without a bank involved – usually through dedicated peer-to-peer lending online platforms such as Zopa, RateSetter, Funding Circle, Lending Works and Assetz Capital. Though a relatively new concept, it is a fast-growing market in the UK. The lenders are usually individual members of the public who would take a specific interest in what the SME borrow is offering.

The premise behind peer-to-peer lending is that the borrower and the lender each receive a better return: the lender has a higher interest rate (up to 6.00%) and the borrower pays less interest than it would for a bank loan. A fee is payable for peer-to-peer lending – usually between 2% and 5% depending on the term of the loan.

A borrower then receives the lending (typically between £5,000 and £1m over a period of up to five years) at a fixed rate and a fixed monthly payment. The security may be a personal guarantee or security over a specific asset such as a vehicle, property or machinery. Importantly, the borrower will have no early repayment charge.

A key attraction is that private lenders are in a position to analyse the potential investment opportunity in a way that banks may not. However, although peer-to-peer lending may give savers an attractive return, it is riskier for the lender who will be keen to balance the risk versus the potential return. There are no guarantees to the lender that their money ever being repaid.

The future
The finance opportunities for SMEs are more wide-ranging than ever, and now that the bank referrals platform is live, the future is looking good for SMEs, enterprises, start-ups and entrepreneurs. The market for alternative finance options is clearly robust. If SMEs do their homework and choose the best finance model for their business – there is no reason why business growth and success cannot be achieved.

1  A study by the University of Cambridge and Nesta, in partnership with KPMG in the UK and supported by the CME Group Foundation