How new lending models could be dangerous for Australian businesses
Disruption of financing models carries risks and opportunities
Over the past decade, we’ve seen so-called disruptors changing the way things are done in many industries including finance, and the outcome is a new lending landscape that has both positive and negative implications for SMEs.
Traditional models of financing have involved businesses seeking a secured loan from a bank. This legacy model has often been difficult to access for SMEs, as loans usually required the security of collateral that SMEs have not always had. As a result, startups and other SMEs have often found themselves unable to access bank finance at all.
While it’s widely recognised that SMEs are important to the national economy, playing a vital role in innovation, growth and employment, the emergence of new lending models now make it possible for businesses to entirely avoid banks in their efforts to obtain business funding.
However, with access to debt funding now easier for SMEs, the problems inherent in borrowing for business remain. For businesses already suffering from cash flow problems, borrowing can cause even greater short term crises. When SMEs with higher risk profiles access debt, they will inevitably be subject to higher interest rates than traditional bank rates.
Whether it’s to access debt or other sources of funding, industry disruption is also leading to a turbulent policy and regulatory environment, and experts have also raised concerns around the new models over transparency, investor risk awareness and consumer protection issues.
So what are some of the most common new ‘disruptive’ finance models?
Peer to peer (P2P) lending
P2P lending offers unsecured loans requiring no collateral, often in an online marketplace where the P2P platform acts as an intermediary between SMEs and individuals or organisations bidding to lend, with the P2P marketplace making their money on commissions or transaction fees.
The P2P platform is attractive to investors who can make many small investments and diversify their risk, as well as being attractive to SMEs who do not need to provide the security of capital (eg their personal house) to access the lending. Compared to conventional bank loans, alternative lenders offer faster and less stringent approval processes but the business pays a premium with higher interest rates.
However, small business experts still advise that borrowing is generally a bad idea for SMEs. So instead of acquiring debt, SMEs are encouraged to look at alternative options that exist for obtaining equity funding. Here, there is the benefit of not requiring regular repayments and interest rates to service a loan. Private equity funding also offers SMEs benefits beyond the purely monetary. For example, business angels and venture capital firms are regarded as contributing to the success of SMEs through the experience and networks they bring, which can accelerate growth. They are regarded as playing a key role in the professionalisation of a company from the beginning.
Angel investor / business angel
Angel investors are high net worth individuals (and sometimes investment funds or institutions) who contribute funds to an enterprise in exchange for an ownership stake in the firm. They provide capital without requiring the provision of security to companies across their life cycle from seed financing to mergers and acquisitions.
The angel investor is usually a very experienced business person who is willing to take on the entrepreneurial risk in exchange for a higher return. With their business acumen and skills, they can greatly add value to a business, whether in terms of evaluating business plans or offering personal mentoring and one-on-one support.
Business angels are often involved at early stage while later stage capital sourced is more often acquired from venture capital firms.
Similar to business angels, as well as offering equity financing, VC firms typically bring a wealth of technical and managerial expertise to your business. This means access to strategic, financial and marketing advice, support in hiring key staff, and help with exit strategies.
Increasing in popularity is the use of crowdfunding platforms for business equity or investment funding. With crowdfunding, individuals or organisations invest in startups in return for equity, as a method of raising external finance from a large audience instead of a small group of specialised investors.
Crowdfunding heavily utilises social networks, often with the entrepreneur setting out details of the business activity and requesting funding under certain terms and conditions. The entrepreneur does not use an intermediary to seek funding and sources funds directly.
Finding the right finance model depends on many factors, such as how much money is required and what for, how quickly it is needed, how long it will take to pay it back, how long you have been in business, the current financial shape of your business, and how much collateral, if any, you have. Your answers to these questions will determine whether you will be best suited to a bank loan or alternative forms of lending or finance.