AccountingWEB guide to alternative finance 2012
One of the ongoing challenges small and medium-sized businesses face is making sure there is sufficient money in their organisations to develop and grow.
Government initiatives over the years have tried to kick-start the flagging business banking sector, but as the banks have become more risk-adverse since the downturn, increasing numbers of businesses are looking to alternative routes for getting access to finance.
As our 2011 guide to alternative finance suggested, raising awareness of the options - both for business owners and their advisers - could stimulate the growth the UK so desperately needs.
An sign of how important alternative lenders will be to the recovery process came last month when the government announced its first £100m tranche of funding for alternative lenders.
This year may well be a tipping point for alternative lenders, so AccountingWEB has put together a guide to likely sources of finance along with key advice and tips from industry experts.
In the coming weeks we'll be looking at sub-sections of alternative finance in more detail. Do join in the conversation and put forward your experiences of the pros and cons.
As with all the following options a convincing business plan demonstrating a clear growth strategy is absolutely essential.
Credit unions and peer-group lenders
Credit unions are non-profit organisations owned by their customers, which helps keep their loan rates low. At a time when many firms are being lured to high cost payday loan providers, credit unions have almost doubled their membership since 2006.
Business owners need to become members before applying for a loan and will often qualify by sharing characteristics with other members.
Some businesses find that they can access finance, support and advice from other businesses in their peer group, known as peer-group lenders. There are many organisations that have been set up to support specific groups of individuals and businesses.
Like gaining access to bank loans, borrowers need to prove their creditworthiness and qualifying credentials when applying to a credit union.
As with many of the options in this guide, awareness is still low in the UK compared to other countries.
Grants, government support and charity finance
Grants to support business development are available from a variety of sources, such as the government, the EU, local authorities and some charitable organisations.
Charities such as The Prince’s Trust offer loans to start-ups and are usually targeted towards specific groups of people based on age and situation.
Grants may be linked to business activity or a specific industry sector with some linked to specific geographical areas, groups of people or sectors that the government wants to encourage.
For a full range of grants on offer, visit Business Link for further information.
Regional bodies, such as the South West Investment Group (SWIG), have provided millions of government investment to small and start-up businesses that have struggled to attract conventional bank funding.
Monies for investment groups are sourced from both the public sector - local authorities, European funds, RDAs - and the private sector.
Invoice factoring & discounting
This route involves selling sales invoices to a finance provider who advances a fixed percentage of the invoice. When the customer pays the invoice the finance provider pays the balance to the seller, less their interest and administration costs.
Gary Cain, director at PS Finance, told AccountingWEB: “Where we see most of our work is through invoice finance. The traditional bank overdraft is typically restrictive particularly for a growing business and more often than not the level of security taken by the bank does not equate to the lend. Invoice finance takes away the glass ceiling an overdraft imposes and grows in line with the business.”
Peter Ewen, managing director of ABN AMRO Commercial Finance, added: “Options such as invoice and asset-based lending are more closely linked to business performance than overdrafts or short-term cash loans and offer better long-term value.
“They are also ideal for the current financial climate as they help businesses to grow organically at a sustainable pace by using the finance locked up in their own assets.”
Anil Stocker of MarketInvoice noted that attitudes to invoice finance where changing within the accountancy profession.
“We noticed that accountants and financial advisers are rightly quite risk-averse. If they were looking at the alternative platform a year or so ago, they would have said, ‘It’s an interesting idea, but not really proven, so let me wait and see how these stories play out’. Following the Breedon report what we’re seeing now are a lot of referrals from accountants for their clients.”
“It's a really useful tool in the armoury of an accountant or financial adviser, because when a client says ‘I've spoken to the bank and they're not being that helpful’, they can look to the alternative players, backed up with the reports and the Business Finance Partnership.”
For MarketInvoice, dealing with accountants was more productive than marketing directly to businesses: “Usually the quality of the businesses they bring through is much higher - they have done research for their client, they're a trusted adviser, and when they come they come in a very erudite way,” he said.
Equity finance: business angels & venture capitalists
Equity finance is a way of raising capital from external investors in return for a share of your business.
The transaction can take many forms, including a share of future profits, but is most frequently associated with sharing the ownership of the business to some degree.
Chris Davidson of UK Funding & Finance, said: “Business owners have a problem letting go of a percentage of the business. It's a really big issue and goes against every reason why you set up, to control your own destiny - you don't want someone else coming in and taking some of that away.
“But people have got to face reality that in a down market, when there are risks, you either get 100% of nothing or 51% of £5m - which do you want?”
Business angels are typically successful business people, with a preference for the sector they made their money in, who are prepared to buy a stake of a business and often a seat on the board. Most angel investments range between £10,000 and £750,000.
Venture capital (VC) funding is a form of private equity investment, where a business obtains long-term funding in exchange for a share of its equity.
VC investments are made by companies, drawing on private equity funds set up by large investment institutions and are generally on a larger scale - typically more than £250,000.
For high-growth businesses private equity companies often invest more than £10m and they tend to seek an exit from their investment within five to seven years.
Gary Cain, director at PS Finance, commented on the private equity route: “It’s an option for businesses however the issue here is that directors have to change their expectations in terms of how much of the pie they own.
“A slow-down in the appetite of the banks to lend has seen a growth in peer-to-peer lending and this is an area that has seen some growth in recent times as investors who aren’t seeing a return from their money choose to invest in businesses instead.”
Crowd funding and peer-to-peer
Since the downturn there has been an increase in the number of alternative and crowd funding platforms, which are leveraging cutting-edge technology to create online platforms connecting businesses to new pools of capital.
These innovative platforms allow businesses to raise finance in a revolutionary way and to access new channels of capital which were not previously available.
Clive Lewis of the ICAEW told AccountingWEB that there were lots of new types of alternative finance options coming on stream, such as crowd funding. He explained the process: “You go onto a website, you bid for finance from people and they tell you what sort of rate they would charge to lend money to you.”
The most popular of those is Funding Circle, which has more than £32m to 730 businesses in the past 18-20 months, in sums ranging from £5,000 to £250,000. The online marketplace allows people to lend directly to small businesses, according to David de Koning of Funding Circle: “We're an intermediary really, a way for individuals to side-step banks and get investment money directly into small businesses.”
de Koning explained the process: “Essentially it's like an auction, whereby you would invest your money into FC and businesses will come to us and complete an initial application online. If they pass the initial credit assessment test they will go and be reviewed by our credit assessment team in-house.”
Businesses are given a risk band from A+ down to C. de Koning said: “We typically only lend to the top 50 strongest and healthiest businesses in the UK, so even if you're a C band these are still good British businesses.
“You then go onto the marketplace and investors can come along and bid to become part of the loan. The loans are made up of small amounts of money, from a number of different investors where you may have 300 to 400 different investors who bid at the rate that you're looking for in return.”
The average yield is 8.3% and at the end of the two week auction, FC takes the average loan rate across the board.
In a similar vein to FC, but on an equity basis, is Crowd Cube. If you're looking to give away equity in return for funds, then you can do it that way, but ultimately the mechanism of people investing in different businesses is similar.
Crowd funding is relatively small in terms of the amount of finance the banks provide, but the industry is still in its infancy.
“I like the idea of crowd funding, but I think it's difficult,” said Chris Davidson of UK Funding & Finance. “I support the small time retail investor who I feel gets a pretty bad deal out of IFAs, because they're tied up and take commission. They're not really getting the retail investor a good deal and nobody really does. It's difficult though because you're wondering if it's a collective investment scheme and the nightmare that is the FSA.”
Last month it was announced that lending via the internet had topped £250m, with an increasing number of businesses turning to websites such as Zopa, Funding Circle and RateSetter, rather than more traditional avenues.
Jonathan Russell, partner at ReesRussell, commented on reaching the milestone: “The traditional clearing banks have lost all credibility with small businesses, having decided many years ago that to a large degree they would be treated in the same way as personal accounts except without the ‘free’ banking element.
According to Clive Lewis of the ICAEW, a novel way of financing that is very popular in the US, ‘business cash advance’, is looking to set up in the UK.
Lewis explained: “It relies on businesses which have a credit card stream of income out of which they finance their light finance and then their credit card income, until they've repaid the loan. It’s diverted to a firm who takes a cut out of it and passes back some of the money, and so that goes on until the loan and interest charges are repaid.”
Typically the finance is repaid in four to nine months and is particularly for those businesses in the retail sector where they provide a need to consumers, many of whom are paying them by credit card.
Lewis added: “There are new entrants all the time and of course you got the new banks like Metro setting up. There are new sources of funding, although they still are relatively small, but they're increasing as they get more publicity and interest, and word of mouth.”
Government support for alternative funding
In May the government announced it would provide £100m in funding for alternative lenders as part of the £500m Business Finance Partnership which is available to small and medium sized businesses.
It revealed it will invest directly into small businesses via online finance platforms to stimulate alternative sources of finance.
This move was welcomed by those platforms bidding in the tender process, such as Anil Stocker of MarketInvoice, who said one of the greatest barriers to alternative finance was awareness and added that the government’s £100m commitment to the alternative sector was a step in the right direction.
“It's a really good move by the government because what this is suggesting is that for the first time they're realising all their other schemes - such as Project Merlin, the enterprise guarantee scheme, or credit easing - where they've tried to stimulate lending to the SME market have always relied on the banks,” Stocker said.
“When it gets out into the mainstream press then business owners read about it and say ‘I've never heard of MarketInvoice or Funding Circle’, but let me look into them because the government are at least engaging with them, so why shouldn't I?”
Stocker said the government funding is a good awareness-building exercise, but the company does not rely on getting the funding. “We have a lot of private investors and institutions, asset managers, who are very excited about the asset class and are easily covering the funding that we need each month.
“What happens is that there's this kind of halo effect, whereby government involvement makes more people look at the product both from the investor side and the SME side, and that will help us drive ultimately more funding through the platform.”
On the possibility of additional tranches set aside for alternative finance, Stocker said: “They're in a situation where they want to do this, but they're also conscious of the fact that if there's any failures it's going to be very bad for them and people are going to say why didn't you guys do your due diligence, which is why they're going through this tender process.
There are lots of questions about track record, who's the management team, what's the success been to date, and rightly so because I know if this goes well, there's going to be subsequent tranches, this is just the beginning.”
Chris Davidson of UK Funding & Finance, who recently launched a new funding directory project, also welcomed the news on the £100m government scheme, but added it was very much open to debate whether businesses that apply will get any money: “In my experience business owners are just not set up correctly to provide the information to go and get alternative finance.
“That's one of the biggest things they need to get their head around. Going for a bank facility is relatively straightforward, you need a basic business plan and provided you're in a booming period, the bank would treat you as fairly low risk. But now businesses have had a really hard time having to provide what they see as very intrusive probing into their business, but that's what funders have to do today and that's fair enough”
Davidson’s directory has identified more than 260 small funders, but no one knows who these funders are because they don't promote themselves. “Most people on Google won’t go past page one or two, and you'd think they don't exist. But it's just not the case,” he explained.
Anything that can ease the flow of access to finance to small business is a good thing, including target schemes likes Project Merlin, the National Loan Guarantee Scheme and credit-easing initiatives. These ideas are good, but the problem is fundamentally about the process of how banks operate and process small businesses.
David de Koning of Funding Circle said: “At the same time as banks are saying there is no appetite for lending, we're actually finding the complete opposite. We often see good healthy, growing businesses come to us and they'll say they didn't even both to start the application with their bank because it takes too long. We're an internet-based business so we can move much faster than banks.”
de Koning added: “Whether you cut the cost of loans or set targets for banks, ultimately, it's the nature of the beast, they operate quite slowly, and for some businesses that's fine. Many businesses have good relationships with their banks, but often it's just a case of I'm a business owner, I need access to finance, and I don't need to whole relationship side of the bank for this. I simply need a portal that will allow me to do that quickly.”
Increasingly we're seeing small businesses saying they're happy to have a different relationship with a funding provider.
Peter Ewen, managing director of ABN AMRO Commercial Finance, said: “It’s true that banks are constrained by increasingly stringent regulation and the effects of the Eurozone crisis, but it’s also true that there is a depressed demand for finance from SMEs. Evidence suggests that businesses are wary of seeking additional finance, thanks in part to negative reports that bank finance isn’t flowing.
“Though the creation of the Business Finance Partnership and recommendations made in The Breedon Report are encouraging, it’s clear that there is still much to be done to help businesses understand and access the finance that they need today. The greatest barrier to SME growth is undoubtedly a lack of education around the funding options available and the ways in which those extra resources could be used,” he said.
Rather than a last resort bail out, alternative options such as invoice and asset based lending should be viewed as a way to create financial headroom for growth.
The sector is ready for new thinking and there are many new emerging providers looking to fill that gap.