Broker guide to crowdfunding

We were delighted to be featured in this article from Bridging & Commercial, published 6/10/2012

Broker guide to understanding crowdfunding

As a growing number of businesses turn to crowd funders as a route to source finance, B&C has taken a look at the alternative lenders offering these types of loans and specifically investigated the difference between crowdfunding and peer-to-peer lending

SMEs are the key to economic growth; they account for nearly half the UK’s GDP and employ around 60 per cent of the UK’s workforce. Bank lending to SMEs has shrunk and many believe that certain initiatives, such as the Government’s Funding for Lending Scheme (FLS), are failing to inject liquidity.

Business Secretary Vince Cable has stated that, “as businesses are continuing to struggle to get credit from their banks, developing alternative lending channels is essential so firms are less reliant on banks”.

Mainstream banks are continuing to struggle to meet the business investment needs of UK small businesses and many peer-to-peer and crowdfunding sites have emerged as a result.

P2P sites started to appear in the mid-2000s as a way for savers to earn higher interest rates by lending to other people, instead of putting their money in a bank account. Margins are slimmer than with a high street bank, but P2P sites are now thought to provide between just under £200 million a year.

What is it?

P2P lending is a financial transaction which occurs directly between individuals or ‘peers’ without the intermediation of a traditional financial institution. P2P lending aims to maximise the benefits for both lenders and borrowers, and is an online way of letting investors either lend to personal borrowers or businesses, often start-ups.

Yet these alternative lending processes do differ: P2P finance is generally for more established SMEs whereas crowdfunding is seen by many as a better option for start-ups and less established businesses.

Crowdfunding is different from P2P lending as it is a way to raise finance by tapping into a ‘crowd’ of like-minded people willing to invest smaller amounts of cash in exchange for rewards and a stake in a business.

How does it work?

Prospective investors can search through the listings on sites. These opportunities are ranked by risk and given a small profile which is then advertised on the said crowdfunder’s website for investors to determine whether they’d like to bid to be a part of a deal. In many instances, investors bid with the lowest interest rate they would be prepared to go down to in the bidding process.

Crowdfunding is closely related to P2P lending. Both financial models enable capital to be raised through online campaigns. Crowdfunding is about a crowd of people pooling money together, while P2P lending doesn’t necessarily require a crowd of small funders, but could for instance be from one individual.

P2P lending is a form of private lending and occurs when individuals loan money to others without going through a bank or traditional intermediary. Lending in this way has been popularised by the internet because linking borrowers to lenders is much faster and one can reach a large audience instantly. Using the these internet sites, borrowers can get better terms and access to more capital than before, and lenders can have access to a larger number of lending situations and earn higher returns.

With crowdfunding, businesses can access capital that they don’t have to pay back, but rather provide rewards for those who give money as a donation to the project. One’s chances of raising capital through crowdfunding are much higher than with P2P lending.

Although very similar to crowdfunding, the main difference then between crowdfunding and P2P lending is that the latter is for loans, not contributions.

These more unconventional means to get either a decent rate of return on an investment or an attractive loan rate are becoming so prominent and effective one has to take note. Matching up borrowers and lenders online, these finance providers essentially act like a broker sourcing deals at better rates for both respective parties.

Are there any drawbacks?

There has been criticism of the models with some consumer groups believing that consumer protection standards are simply not good enough, and some say that those lending money on some sites will not be protected by the Financial Services Compensation Scheme. Therefore, many are keeping a good eye on the Peer2Peer Finance Association, the UK trade body set up to ensure that the sector maintains high minimum standards of protection for consumers, to see what measures and checks on the sector they will implement.

The Managing Director of new crowdfunder, Daniel Rajkumar, told B&C that for both types of finance the administration of connecting many parties together is an operational efficiency enabled by the internet.

Daniel said: “Peer-to-peer and peer-to-business lending are debt-based arrangements where a loan is formed by connecting borrowers (either an individual or a business) to a network of investors who all pledge amounts and interest rates to match their investment risk appetite.

“Crowdfunding is more relevant to equity-based arrangements where a return on capital invested is not guaranteed and the borrower will usually give away equity in his/her business or a product or service as a form of repayment. This is quite often employed by start-up companies or to fund individual projects and has found favour with the creative sector, for example video gaming in America.”

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