Over the last few years, there has been a significant increase in the number of companies using alternative sources of finance in order to fund their businesses. The increasing switch from bank lending has arisen as a result of a number of factors, which include the loss of confidence in our banking systems and restrictions from high street banks in respect of sources of finance available to SMEs.

Emerging from the market to provide these alternative sources of finance are companies offering lending services known as ‘Peer-to-Peer’ or ‘Crowdfunding’. The idea is to match individual savers and organisations with companies that are seeking debt or equity finance outside of the banking system. With the SME market alone predicted to top £1bn of lending in the UK by 2016, the alternative finance sector is fast becoming the SME choice of raising finance, used by start up companies and established businesses alike.

There are a number of advantages for businesses using alternative finance, including:

• spread and diversification of financial risk;
• fast decision making with funds potentially becoming available within days;
• greater flexibility with the funds, i.e. can repay loans early without penalty;
• competitive borrowing rates;
• less stringent security requirements.

The key players in the market are the likes of Funding Circle, Crowdcube and Platform Black, each tending to specialise in a key area of finance whether it be term loans, property lending, equity or working capital. There are also limited levels of regulation, though this is expected to improve as the market grows.

The size of funding is typically at the lower end of the overall finance market, with average loans around the £50k mark and ranging from £2k to £3m in size. Approval rates vary depending on the nature of the product with working capital applications particularly successful.

So how does this market work? Each product type has its own application and approval process, which generally operates in a similar fashion to traditional corporate banking. However, the mechanism for raising the finance and agreeing interest rates is quite different.

Let’s have a look at one of the key products in more detail: business loans.

The initial criteria involves a minimum turnover threshold, credit checks and provision of accounts, forecasts, cash flow, business plan etc. Underwriters will then establish a risk profile based on this and any existing lending or fixed outgoings. Some key players utilise a middle man who will undertake business visits and put forward applications for funding. Other agencies will leave the lender to establish the risk themselves.

The likes of Funding Circle operate a bidding process whereby successful applications will be listed on their ‘marketplace’. Investors will then start offering money at an interest rate they believe to be an adequate return. In essence the lowest rate wins the auction to fund the loan – a little like eBay in reverse! The whole process can take as little as a few weeks; a clear advantage over high street lending.

Levels of security (such as guarantees and charges over assets) differ dependent on the size of loan and the relative merits of each business, but unsecured loans can reach levels of up to £500k.

So what’s the cost to a company? Arrangement fees range from 2 to 5% and investors can earn average returns of around 6%.

Funding Circle alone have to date funded loans in excess of £375m and have over 32,000 investors registered to lend. With the expectation of these products being available as part of an individual’s ISA allowance, thus generating tax free gains, there is little doubt this market will continue to grow quickly in the coming years.

Should you wish to discuss Alternative Finance in more detail please contact your Barnes Roffe partner.