Insights

According to CBI research conducted in 2014, SMEs looking for business finance still typically turn to their banks for a solution. Their survey showed that over half are reliant on bank loans for extra funding and a further 36% finance business expansion using overdrafts.

Although these routes can work well for many business types, smaller companies or startups, those seeking finance for something unusual, or companies seeking to ‘disrupt’ an existing business sector can struggle to get the backing they need, either in the form of loans or investment.

In these situations, a small but growing number of businesses are turning to alternative funding options, e.g. equity finance, which currently comprises just 3% of UK business funding. Models such as equity crowdfunding or its lending equivalent, peer to peer loans, emerged as an outcome of the 2007 economic downturn when banks originally tightened up their lending criteria.

They are growing very quickly as alternatives and well worth considering for all business owners. According to the Bank of England, peer to peer lending and equity crowdfunding managed to offset £833m of business funding requirements last year.

This article outlines the main differences between each approach and any pros and cons to be aware of.

• Equity crowdfunding

Equity crowdfunding typically involves the use of websites to attract investors wishing to exchange shares or equity in a business for finance. For a business, it can be an excellent way to raise finance quickly because of the huge potential reach offered by the Internet and investors can be a combination of individuals and institutional or syndicate investors. It does not come without risks, and investors should be aware that they could potentially make significant losses.

In spite of the high risks involved, according to the Financial Conduct Authority, crowdfunding grew in popularity by 410% between 2012 and 2014. In part, this is because it can be highly tax efficient for investors. Many schemes are operated by investment vehicles that are Enterprise Investment Scheme (EIS) or Seed Enterprise Investment Scheme (SEIS) approved and therefore appealing to higher rate taxpayers in particular. The investment companies act as an interface between the companies receiving the investment and the investor, enabling investors to spread their risks by investing smaller amounts into multiple companies, retain the same tax relief opportunities and in the longer term, benefit from tax-free gains.

For a business, equity crowdfunding, either through individuals or with a syndicate, can be highly successful. It has enabled a wide variety of companies to secure significant amounts of finance, for example, Chapel Down winery raised £3.95m in 2014.

In addition to access to finance, business owners often prefer this route because they retain greater levels of control over the process than with traditional VC finance models. Returning to the CBI research, 66% of companies that had used equity finance reported that it had a positive impact on their company and 80% said they would use it again and recommend it as a possible option to other companies.

• Peer to peer lending

In the same way that equity crowdfunding seeks investors using the web, peer to peer lending, which is also known as debt crowdfunding, uses the same approach to secure loan finance, either from individuals or institutions. It is relatively safe for lenders and has been regulated by the Financial Conduct Authority since 1 April 2014.

For the company, the benefit of peer to peer lending is access to finance at lower rates than could be obtained from traditional lenders. Equally, investors also benefit from significantly higher returns and greater security of getting a return than with many other investment opportunities. Just as they would invest in a savings account according to a variety of terms – instant access, 3 or 5 years, lenders can provide funding to their chosen companies for fixed terms, with varying interest rates payable. Companies wishing to secure funding in this way need to be vetted and a risk rating assigned which is aligned to the level of interest payable, with higher risk loans returning higher yields for lenders.

From a tax point of view, peer to peer lending works in the same way as other loans. Companies can deduct loan interest paid from profits in the same way as a bank loan. Individuals lending to companies declare interest income on their self-assessment tax form and tax is payable on all income generated, even if bad debts ultimately ensue.

Demonstrating the widespread acceptance of peer to peer lending, from April 2016, a new 'Innovative Finance ISA' will be available, allowing peer-to-peer lenders to lend out up to the annual allowance within an ISA wrapper, getting tax free interest on any gains. Although lenders are regulated and required to adhere to a strict code of practice, peer to peer lending is riskier than saving with a traditional bank.

With normal savings, the Financial Services Compensation Scheme will pay investors up to £85,000 per financial institution if the institution becomes insolvent (falling to £75,000 on 1 January 2016). Currently peer-to-peer lenders don't have this level of protection, even though they are regulated.

If you would like more information on funding for your business, please contact Simon Paterson by emailing sp@rjp.co.uk.