Following Lord Turner’s warning over the risks of peer-to-peer lending, Jimmy McLoughlin, the IoD’s head of external affairs, looks at the growth and challenges of Britain’s burgeoning alternative finance market
• Businesses hungry for capital seek to raise funds from ‘the crowd’ – or a large number of smaller investors at any one time.
• For start-ups, crowdfunding can mean liberation from the shackles of the big players in the capital markets, high-street lenders or the need to rely on wealthy family and friends.
• There are three main areas of alternative finance which have surged in the past few years: peer-to-peer lending, reward-based crowding, equity-based crowdfunding.
• Britain is leading Europe when it comes to crowdfunding.
• Equity crowdfunding is vital to unlocking the ‘equity economy’ and giving more people a stake in Britain’s entrepreneurial scene.
• For businesses, alternative finance is also emerging from the shadows of its mainstream competitors.
• So far, the government has taken a common sense approach when it comes to regulation – waiting to see how the industry develops before lurching for the heavy-hand of legislation.
• 2016 could be the year when crowdfunding really takes off.
• Crowdfunding is more than just a way to raise money – it can be an excellent way to launch with a big splash or build a closer relationship with your customers and generally get a healthy dose of decent press and media attention off the back of it.
• As the pool of money being poured into crowdfunding swells over this year and 2017, we should expect crowdfunding to become more specialised and business-focused.
• The spirit of entrepreneurialism has never been more alive than it is in Britain today; there is clearly an appetite for a new way of investing.
Bankers have been called many things in recent years. ‘Geniuses’ probably wasn’t one of them. But that is precisely the term Lord Turner, head of the Financial Services Authority throughout the financial crash, picked in February when he issued a stark warning about the dangers of alternative finance.
“The losses which will emerge from peer-to-peer lending over the next five to 10 years will make the bankers look like lending geniuses,” he said. For those who have never dabbled in peer-to-peer finance, it was a scary prediction.
His concerns come as the alternative finance market is booming in the UK. Nesta, a government-backed innovation body working with KPMG, says it was worth a whopping £3.2bn last year. That’s from a standing start just a few years ago.
Encouragingly, most of this money is going towards small and medium-sized businesses, with around 20,000 firms employing fewer than 250 employees raising a total of £2.2bn last year.
Many of these new and exciting products are built on the idea of the ‘wisdom of crowds’ – a well-trodden concept with a loyal following among social scientists. They point to a wealth of evidence that shows groups of non-experts routinely outperform individual experts in various quizzes and cognitive tests.
The most famous example is more than a century old when, in 1906, a group of 800 rural Englanders were asked to guess the weight of an ox at a country fair. When the estimates were averaged out they came within 0.1 per cent of the true value. But how does guessing the weight of a farm animal relate to the world of business?
The idea behind crowdfunding – the most exciting part of the alternative finance mix – harnesses that same power. Businesses hungry for capital seek to raise funds from ‘the crowd’ – or a large number of smaller investors at any one time.
This means instead of going to the bank for a six-figure loan, or a venture capital fund for a million-pound equity sell-off, companies open it up to anyone, and seek to get the money they need through dozens, potentially hundreds or thousands, of smaller investors.
For start-ups, this can mean liberation from the shackles of the big players in the capital markets, high-street lenders or the need to rely on wealthy family and friends. Steven Renwick, founder of Satago, an invoice financing firm, says crowdfunding allowed him to approach his friends “who could spare a few hundred pounds” and get the ball rolling on a funding round that reached £30,000.
His experience – crowdfunding as a first resort – is typical of members of IoD 99 (the new peer-to-peer mentoring network for young entrepreneurs), who say they are as likely to use alternative finance as a bank. On the investor side, the process is equally democratising, opening up the world of business and investing to those with even the smallest of portfolios and treating them on the same terms as the big boys.
There are three main areas of alternative finance that have surged in the past couple of years.
First, the simplest: peer-to-peer lending, where individuals lend money near enough directly to other individuals and businesses usually through an online platform, such as RateSetter, which recently passed £1bn in total lending.
Second, there’s reward-based crowdfunding, which accounted for a slim £42m of the alternative finance market last year. Here, businesses, typically in the earliest stages of their life, ask ‘the crowd’ for money to get their projects off the ground. In return, investors receive ‘rewards’ – usually a first version of the product, if it gets made.
This is inspiring innovation, which might not have taken off without investment from would-be customers. Joanna Montgomery, for instance, created a product called Pillow Talk, which allows people around the world to feel each other’s heartbeats – she’s targeting couples in long-distance relationships and managed to raise $124,000 (£88,000) last December.
Furthermore, Hackaball is combining digital and physical play while teaching children to code as well. There is also a fair share of more bizarre products, including a company seeking more than £15,000 for a Jesus-shaped toastie maker, an anti-Zombie soap (“why take the chance?” asks the founder), and the world’s first pizza museum.
These are exciting and eye-catching developments, but when Kickstarter arrived in the UK from the US, the first company to benefit was Good & Proper Tea. Americans were so giddy about the irony of the campaign starting with a British tea company that they backed it to considerable levels. Good & Proper Tea’s founder Emilie Holmes decided to add another boost by looking to equity crowdfunding.
It is equity crowdfunding that arguably holds the most potential to transform the business landscape. Equity-based crowdfunding sees individuals invest directly in companies in return for a stake in the business.
Investors can either pick the companies they like themselves and invest, or use aggregator funds to spread investments across several companies – in the same way exchange-traded funds work for bigger listed companies.
Businesses raised a total of £332m though equity crowdfunding in 2015 – a small drop compared to established lending routes, but a three-fold increase on 2014.
Alternative finance and the ‘equity economy’
It is no exaggeration to say that equity crowdfunding could be the most revolutionary finance product of this century. Jeff Lynn, CEO of Seedrs, one of the UK’s largest platforms, says the industry could be worth £5bn in the UK, and £100bn worldwide, by 2025.
It should also be no surprise that Britain is leading Europe when it comes to crowdfunding. “There is something in the UK’s mindset that is open to embracing innovative financial services”, says Lynn.
“The fintech boom is broader as a result of that.” This is undoubtedly good news. Equity crowdfunding is vital to unlocking the ‘equity economy’ and giving more people a stake in Britain’s entrepreneurial scene. It might also help nudge the UK away from a society where private wealth is dominated
by home ownership and towards a more well-rounded approach to building wealth.
With more than half of people around the world saying that the pace of technological change is too fast, allowing people to take a direct stake in the benefits of that transformation, by owning a part of the new economy, is a good way to boost support for innovation.
For businesses, alternative finance is also emerging from the shadows of its mainstream competitors. In the financial crisis, new sources of capital were seen as the preserve of companies that had been shunned by the banks. But this is no longer the case. One in five members of IoD 99 say that equity crowdfunding will be vital to their business over the next 10 years. Around two-thirds of them will use it.
Tomorrow’s businesses will clearly be heavily reliant on equity crowdfunding. So getting the framework right is crucial. Last year ended strongly for the industry. The Camden Town Brewery, a poster child for the sector, was sold to brewing giant AB InBev for £85m. Investors made a 70 per cent return on their investment after just six months.
The first few months of 2016 have been shakier. As the economy has stumbled, and more and more investors pile in, attention has turned to the prospect of failure and fears about ‘dumb’ money in the market. The Times has taken a key role in highlighting the recent failures of Crumpet Cashmere and Rebus Group – companies that have lost £1m of investors’ money between them. Lord Turner is not alone in raising fears about potential losses.
So far, the government has taken a common sense approach when it comes to regulation – waiting to see how the industry develops before lurching for the heavy hand of legislation.
Were ordinary, small-stake investors to lose chunks of cash in a series of failures, however, they might be tempted to change that. This is where the rise of so-called ‘armchair dragons’ – investors with little background and patchy knowledge of the companies they buy shares in – poses a real challenge for the industry. Platforms have been fantastic at attracting the interest of new customers and of establishing themselves as a credible source of finance for businesses.
Now they need to make sure they are putting as much focus into explaining the potential risks to customers who may have little, or no, previous investing experience.
These are, after all, complex and high-risk investments and the majority of start-ups do not succeed. Communicated clearly, there is no reason that articulate explanation of this should deter investors, but it might encourage them to do more research and become more engaged, which would be for the good of the entire industry.
If we look through the dangers, and trust the platforms to get it right, as they have done so far, then 2016 could be the year when crowdfunding really takes off. Luke Lang, co-founder of Crowdcube, calls JustPark’s record equity crowdfunding round last year a “watershed moment” for the industry.
The app, which lets people lease their driveways and garages as parking spaces, wanted just £1m but eventually raised £3.7m last spring. One-third of those who invested in the company were users of the service, and investment amounts ranged from £10 to £500,000 – showing the sheer spread of investors crowdfunding can attract.
If money raised through platforms triples again then it will close in on a total of £1bn this year – and Crowdcube just celebrated is 250,000th investor – as appetite for crowdfunding from both companies and investors shows no sign of abating.
Many customers will have been attracted by the tax breaks on offer to people investing in small and young companies through the Enterprise and Seed Enterprise Investment schemes (EIS/SEIS).
The IoD’s report, Opening the Equity Economy, launched last year, outlined how we think government can make the most of these schemes, encouraging people from outside London and the south-east, and lower earners, to make use of them to offset up to 50 per cent of their income tax for any investments they make into young companies.
Just last month, Passion Capital, the VC firm, announced it would invest £4m into the app-only challenger bank Mondo. Alongside this there would also be £1m worth of crowdfunding on Crowdcube, with individual investments being capped at £1,000 “to give everyone a fair shot”. Despite these limitations the entire £1m was subscribed for in just 90 seconds.
The community spirit Mondo has captured, by capping investments and giving customers a first chance to own the business, runs through many crowdfunding campaigns. Crowdcube’s Lang is keen to emphasise its investors are looking to have both a social and an environmental impact with their investments, rather than just make cold, hard returns.
The Camden Town Brewery deal, for instance, wasn’t cheered by everybody in the crowdfunding community despite its financial success. BrewDog, the Aberdeen-based craft beer firm, which has also been a big advocate of this form of finance, immediately stopped stocking Camden Town beers and declared “it was nailing its colours to the mast”.
As the industry develops, this trend – for community campaigns not foul-mouthed tirades – looks set to continue, and we could see the emergence of hyper-local campaigns, with individuals from one town, city or region investing in a local business or project.
Kirsty Gilchrist, founder of SoLoCo, which provides advice to start-ups on raising money, thinks these developments highlight how crowdfunding is more than just a way to raise money. “It is the ideal marketing campaign that introduces a target market to an entrepreneur,” she explains.
As Mondo and JustPark discovered, it can be an excellent way to launch with a big splash or build a closer relationship with your customers and generally get a healthy dose of decent press and media attention off the back of it.
The platforms, competing to have the most exciting and successful launches, will promote the businesses that choose to use them, amplifying the message and helping companies not only reach potential investors, but future clients and customers.
Mark Jennings from Shaken Cocktails, which raised £121,000, said his crowdfunding campaign was intense. “You almost suspend other aspects of the business, but you have to bear in mind that you are not only raising finance but running an intensive marketing campaign. At the end of it we were left with a small army of brand ambassadors who had invested as little as a tenner.”
Most of the companies raising funds on crowdfunding platforms are consumer-facing, so this marketing bonus makes sense. As the pool of money being poured into crowdfunding swells during this year and 2017, though, we should expect the sector to become more specialised and business-focused – for instance, doctors, researchers and scientists investing in medtech firms, or engineers, construction experts and estate agents buying up shares in real estate companies.
These things are already taking place, but look set to become more prominent in the coming years. If it does, this will also address the arrogant fears over ‘dumb’ money in the market, as the crowd is large enough to cater for segmentation into separate camps of expertise.
As it stands, EU rules state that small companies can only raise a maximum of €5m (£3.9m) in any 12-month period without issuing a potentially hefty investment prospectus.
Marcus Stuttard, head of UK primary markets and head of AIM at the London Stock Exchange, says “for smaller organisations, for example those coming to AIM, the cost of producing an admission document which is the equivalent of a prospectus can be in the low tens of thousands of pounds.”
Last November, Jonathan Hill, the UK’s European commissioner for financial services, championed the sector by announcing plans to increase this limit to €10m and allow companies with a turnover under €200m to get simpler and cheaper investment documents.
This is a good start – the limits haven’t been looked at since 2010, before the equity crowdfunding industry even got its boots on. However, if this is to become a billion-pound industry over the next couple of years then these thresholds and requirements need to be under constant review.
The spirit of entrepreneurialism has never been more alive than it is in Britain today. Last year there were more new businesses started than ever before, and decent labour market rules along with a world-leading attitude makes the UK a hub for ambitious start-ups.
Too few, however, are scaling-up. Equity crowdfunding could be the ideal solution, and with the market growing at an astonishing pace, there is an appetite across the country for a new way of investing.
This will be a big year – but don’t take my word for it … just listen to the crowd.
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