Alternative financing models such as crowdfunding, peer-to-peer financing and invoice trading are no longer at the fringes of the financial sector. Increasingly, these and other newly established financing vehicles are rapidly becoming mainstream options for entrepreneurs looking for more innovative and flexible ways to finance their growth.
According to a 2015 study by University of Cambridge and EY, the growth rates of some alternative financing options have been particularly impressive and look set to accelerate. In Europe alone, transaction volumes via alternative finance platforms grew six-fold in three years and were expected to surpass €7 billion (US$7.9 billion) in 2015, making alternative financing more accessible to early-stage businesses.
Necessity: the mother of invention
The 2008-09 financial crisis accelerated the development of alternative financing. Its immediate effect was to cause many of the developed world’s banks to cut back on their lending, particularly to early-stage businesses. The introduction of new bank capital regulations added further momentum because banks were forced to focus on building up large capital reserves instead of lending.
When EY surveyed entrepreneurs in G20 markets 2012, three-years after the crisis, two-thirds were still encountering difficulties accessing finance, with the funding gap felt particularly acutely by start-ups seeking pre-seed and seed funding. While other funding options remained for early-stage businesses – such as investment from friends and family, business angels and early-stage VC – demand for new, more flexible, forms of finance was emerging.
Since then, entrepreneurs have increasingly found alternative sources of finance offer the flexibility they need to support their plans to accelerate growth. As a result, demand for alternative finance has grown quickly, with nearly 10,000 SMEs accessing €385 million (US$434 million) in Europe over three years. Larger amounts of capital are also being raised, and in May 2016 the US introduced new regulations allowing start-ups to raise up to US$1m online within a 12-month period via crowdfunding.
Alternative finance 1.01
There are numerous categories of alternative financing that have emerged to meet the needs of these businesses. Some, such as crowdfunding and peer-to-peer lending, rely on equity or debt financing, while others provide investors with non-financial rewards in return for donations.
- Peer-to-peer consumer lending
The largest category of alternative financing is called peer-to-peer consumer lending, a debt-based transaction between groups of individuals in which mostly unsecured personal loans are assembled to support a business venture. Peer-to-peer lending is being applied with increasing frequency to existing businesses and SMEs to support their growth.
Microfinance, in which small sums are loaned to entrepreneurs in economically disadvantaged areas, is also becoming a popular way to enable businesses to grow. Another small, but growing, category is in long-term debt-based securities that are predominantly being made available to finance renewable energy firms.
Crowdfunding can be based on rewards, donations or equity. Reward-based crowdfunding is now the second largest category of alternative financing. It involves the investment of small amounts of financing from backers in return for the expectation that there will be a non-financial reward, often the product itself or an experience, given in return.Equity-based crowdfunding involves the sale of registered equities, sourced from individual investors, and increasingly, angel groups and venture capital firms.
- Invoice trading
There is also a nascent market in invoice trading, which allows SMEs to sell their invoices or receivables to many individual or institutional investors at a discount in return for working capital.
Each of these alternative financing models offers easy access to investors and businesses alike through web-based offerings and apps.
What are the benefits?
The terms of individual financing arrangements can allow for greater flexibility because they can be tailored to the needs of the individual business, whether that is to finance a start-up or enable an SME to seize an unexpected growth opportunity. For the investor, alternative financing offers the opportunity to be part of something at the grass roots level and build a diverse portfolio without the need for an intermediary.
From a marketing perspective, reward-based crowdfunding provides a great mechanism for entrepreneurs to test their product or service with consumers. In many cases, crowd-funders invest not for equity or economic incentives, but rather because they like and want the product or service. With such an emotional investment in the offering, these investors could also become loyal future customers.
Some early-stage businesses prefer peer-to-peer business lending to bank borrowing because interest rates can be driven lower through a competitive reverse auction process rather than being set by the bank. It is also a much quicker source of lending, can have more attractive financing terms such as no early repayment penalties, and is more transparent and easier to use.
A diverse financial ecosystem
Substantial economic research has shown that access to finance plays an important role in promoting economic development. By helping entrepreneurs and SMEs diversify their funding and plug financing gaps, it can contribute meaningfully to a broader economic expansion.
It remains to be seen how traditional bank lenders will respond to the challenge of alternative financing in serving the needs of their business customers. Already, institutional investors are diversifying their investments through online platforms, and corporates are experimenting with crowdfunding. Banks are also getting involved in peer-to-peer or marketplace lending, so it is clear that the impact of alternative financing is being felt widely even as it moves toward the mainstream.
For alternative finance to continue financing entrepreneurship, the industry needs a supportive regulatory environment. There is substantial variation in regulatory approaches among countries, notably within Europe, and surveys suggest this is having an impact on the industry’s ability to play its intermediary role.
According to University of Cambridge and EY report on the alternative financing sector, an effective regulatory regime must protect investors and beneficiaries alike. This involves a difficult balancing act of safeguarding the public interest by maintaining fairness and transparency, whilst also not overburdening businesses with oppressive compliance requirements, operating restrictions or tax regimes.
Beyond waiting for better regulations, the alternative financing industry can be proactive in many of these regards by spotting potential issues, establishing ground rules for fair operating procedures and helping maintain trust in the marketplace.