Equity Crowdfunding, Debt Based Securities and P2P Lending – the New Ways to Finance the UK’s SMEs
It is now 6 years since Equity Crowdfunding was created in the UK. In the current market, where capital is increasingly difficult to find for start-ups and early growth companies, the latest Bank of England (BOE) figures for net lending from the UK’s High Street banks to SMEs, show October’s figure fell by £400m. In the 6 months to October 2017, the average had grown by just £100m per month. The per month growth rate in lending to SMEs is getting perilously close to zero. The BOE classifies businesses with an annual debit account turnover of less than £25m as SMEs.ⁱ
Surely then, now is the perfect time for Equity Crowdfunding and Debt based lending to step up and fill the gap? Both of these new lending models have been enabled by the universal adoption of the World Wide Web and would have become a force even without the 2008 crash. But the crash has catapulted them into the limelight now. Are they ready?
Peer-to-Peer (P2P) lending allows companies with a trading record, or assets to a certain value, to borrow from a P2P platform. This P2P platform in turn takes in money from the HNW or accredited investors and ordinary punters – which is the final resource used to lend. The platforms can offer specific company-by-company deals or an amalgamated approach where loans are grouped and offered as a package, thereby spreading some of the risk. The loans are of fixed term and an agreed rate of interest, which would normally partly reflect the risk. I see current returns of around 5.5% p.a. mark. Default levels are low and, even in the odd case where failure occurs, the P2P lender has either a personal directors’ guarantee or a first charge over assets. The money lent is not included in the Financial Services Compensation Scheme (FSCS), even if the platform is FCA regulated – so a loss is a loss. Platforms in this category include Funding Circle and Thin Cats.
Funding Circle makes various statements on its website – and these show impressive growth since the beginning, in 2010. The company has lent over £3b to 40,000 businesses globally. Bad debts have, however, been on the rise, showing signs of our weakening economy. Figures quoted by the company indicate that bad debts as a percentage of the overall lent was at 2.1% net of recoveries, up to 2016. Recoveries, where Funding Circle is able to reclaim part or all of the principle through access to assets, is around the 45% mark. Indications are that taking in 2017 results will show the failure rate rising. Of course, all lending incurs risk and spreading that risk is the best way to nullify it.
I have heard plenty of claims that P2P lending incurs the same risk as Equity Crowdfunding but little of the reward. It is currently too early to tell what the reward will be from Equity Crowdfunding. Early claims by some platforms have proved ill informed, but there will be some large ROI along the way. Failure rates differ depending on whether you use one of the retail platforms or the more holistic, slower growth sites. At this time, it’s impossible to say that either facility offers better returns, but as we will see later, Equity Crowdfunding can offer more than a financial reward.
The Alternative Finance Industry, which covers all three areas discussed here, plus consumer P2P lending and crowdfunded invoice financing, is set to be worth £12b by 2020 in the UK. There is no doubt that P2P lending, as carried by the likes of Funding Circle, will be a major part of that. Compared to Equity Crowdfunding, P2P lending has a much larger slice of the cake.
As far back as 2015, the Organisation for Economic Co-operation and Development (OECD) showed its concern for financing of the SME sector –
“While bank financing will continue to be crucial for the SME sector, there is a broad concern that credit constraints will simply become ‘the new normal’ for SMEs and entrepreneurs.
"It is therefore necessary to broaden the range of financing instruments available to SMEs and entrepreneurs, in order to enable them to continue to play their role in investment, growth, innovation and employment.”
As part of the new broadening, the UK Government introduced the Innovative Finance ISA or IFISA. This new investment tool is likely to bring considerable changes to both the Debt and Equity based Crowdfunding sectors.
For example, P2P lending is not allowed to be included in an IFISA, nor is it included in the FSCS, as mentioned above. Debt based securities, issued by an FCA regulated platform, are included in the FSCS and are allowed in IFISAs. That makes them an awful lot more attractive than the P2P loans.
Debt based securities are essentially bonds issued by the borrower, against company assets. The debt is over a fixed term and at a set interest rate. Scrutiny under IFISAs means that these debt based vehicles are less risky than P2P loans and far less risky than Equity Crowdfunding. However, as you might expect, they also offer a lower rate of return. One recently issued by Kevin McCloud’s HAB Capital plc for an initial £10m, has an annual return of 4.8% over 5 years. If UK bank rates rise, this might prove a shade low towards the end of its term. In theory this bond is liquid, it’s quoted on the Gibraltar SE, an exchange recognised by HMRC. However, it comes with a warning that it may be hard to find buyers without taking a hit. Still, some liquidity is surely better than none.
It seems that debt based securities have a friend in the Government and will form a major part of that £12b in 2020. They are not much use to the pure start-up or very early stage business.
Which brings us onto Equity Crowdfunding. As a source of investment for early stage and start-up businesses, Equity Crowdfunding stands alone. Sure, it is relatively high risk and must be part of a mixed portfolio, but it has things that no lending or debt based security option offers. It allows people to invest directly into businesses that interest them – to be hands-on involved. And sometimes it offers rewards. This may sound glib but carefully thought out rewards can lead to a successful campaign in their own right. Take, for example, the restaurant chain that needs £350k for expansion. It already has a good client base and can offer them a unique rewards system. This is just like the Kickstarter or Indiegogo rewards based money raising system. So, clients can get shares in the company and benefit from its possible success, but they can also get back most of the money they invest by using the rewards over time. It is pre-selling – pure and simple.
Both the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) favour investors using Equity Crowdfunding. Neither is available via the debt funding options.
One thing seems certain – SMEs continue to struggle for funding. A recent report produced by Close Brothers suggests that under half of the participants felt able to access funding using their preferred route. More interesting perhaps is the fact that, of those who had secured funding, 26% said they were unsure how to use it. This trend is backed up by many of the results we can see in the Equity Crowdfunding industry – a lack of knowledge in how to build a business. There must be opportunity here for the better Equity Crowdfunding platforms to deliver a much more holistic funding package. One where the companies not only get the money but also some mentoring to show them how best to use it. One which helps to build sustainable companies.
Equity Crowdfunding is the only funding route that could deliver this effectively and it’s another reason why companies should consider using it. Sensible entrepreneurs will look at the options and, as in any investment portfolio, they will choose a mix. Getting the right mix is the clever bit.
ⁱ Source: http://www.bankofengland.co.uk/statistics/Documents/mc/2017/oct/moneyandcredit.pdf
16 January 2018
Who is Dexster?
Sometimes controversial, always trenchant, Dexster is Growthdeck's resident blogger. Dexster will bring you his/her views on the crowdfunding scene covering a wide range of topics, including the growth of the equity crowdfunding industry, the risks faced by platforms, how businesses are faring, what investors need to look for when choosing a provider and much more.