Report – The Perfect Financial Storm: Emerging Innovation in SME Alternative Finance

Introduction

In one generation, the world has shifted much of its behavior onto technology enabled social platforms and networks. Academics have been focused on how this digital economy is changing relationships, communication and marketing. What isn’t receiving enough attention is Finance 2.0 – the revolution in financial models being driven by innovation from outside the traditional banking and financial world.

Alternative Finance is the term used to describe socially driven models of cooperative financial activity that are not mediated by institutions. This includes peer-to-peer lending, consumer-to-business lending, crowdfunding, crowd finance, and even foreign currency exchanges and hedging done without traditional institutions. The global market for these services is still small – probably just under 10 billion USD in 2015 – but with growth rates being measured in 10-15% per month for some platforms, these models will evolve into substitutes for some forms of traditional finance and force changes in the behavior of banks and lending institutions.

These platforms hold particular promise for SMEs due to their lower transaction costs, speed of transactions, and favorable interest rates. It is not known how many SMEs are currently using the platforms – this is the subject of ongoing research – but the total volume of SME loans in the past 6 years in the US is greater than $1.5 billion. With this sector growing at more than 100% a year in the US, the potential disruption to small business lending could be significant.

Small businesses can now use online loan platforms to secure business loans and receive a decision in less time that it would take them to drive to a bank. Small businesses will soon be able to arrange lines of credit, trade invoices, secure loans, lease equipment, swap currency, and even hedge risk without ever engaging with or needing a bank or traditional lender.

Previous research into the effect of successful crowdfunding on SMEs has show both immediate and long-term effects from using alternative finance. Simply put, crowdfunding combines a marketing effort with a funding round and can lead to substantial media exposure, new employee or partner recruiting, and seems to affect the confidence and business plans of existing firms. Research also shows that non-equity crowdfunding success yields immediate increases in revenues (not including funds from the crowdfunding) of over 20%. Those firms who are successful also find themselves on the onramp to further funding – angel groups, VCs, and lending institutions pay close attention to crowdfunding and more than 28% of firms who had been successful at crowdfunding had closed a subsequent financing round within six months of their crowdfunding. For these firms to move from having no access to capital to having investors invite them to pitch literally transforms these businesses. With this increase in revenues the average firm hires 2.2 new employees – a statistic that has been found in more than one study. Alternative finance seems to be the most efficient way to accelerate SME growth and lead to job creation.

Alternative finance emerged in the UK, in part due to their highly monopolized banking system. It quickly spread to Europe and then to the US. There are now nearly 100 active alternative lending platforms and over 1,000 crowdfunding platforms worldwide with multiple platforms emerging each week. Governments have varied substantially in their reaction – from the passage of the JOBS Act in the US which allows for general solicitation of private investments — and which will eventually allow equity crowdfunding from average consumers, to a fairly hands off approach in parts of Europe who treat this as merely a new form of cooperative firms.

The promise to disrupt traditional finance and spur innovation and job creation has not been lost on Europe and the UK. The British Government is considering legislation that will mandate that banks refer potential borrowers to alternative finance if the bank turns them down. The EU has launched several major projects studying alternative finance and will soon invest tens of millions in Euros to spur financial innovation and help small businesses. The countries with the longest history of watching alternative finance emerge see its potential and are literally investing in these platforms. They see the disruption about to occur and believe that alternative finance is key to economic growth.

These platforms – really emerging new markets – do carry risks. The business models assume rapid uptake by consumers willing to either invest in firms or lend these firms money. There is literally an insatiable demand from institutional investors to supply loans – but the retail side of the market is slowly evolving. There is also political risk inherent in the possibility that major banks and financial institutions will lobby for legislation that create excessive regulatory burdens for these new marketplaces and removes much of their financial advantage.

Lenders may not understand if these loans should be treated as cash accounts or bonds. There is almost no data about the expectations of lenders. As the markets mature, more and more institutional actors are entering it – by investing in the firms, securitizing loan portfolios, and by creating partnerships with these firms. The question remains how a multi-trillion dollar loan market and tens of billions of dollars early stage equity market will tolerate a massive threat to their business models. Alternative finance is like Uber or AirBNB – creating massive opportunity and rendering traditional models obsolete. The difference is that much of the “traditional” business models here are required by regulation – will these institutions claim unfair competition? Will the government want financial markets disintermediated?

The landscape of small business financing is changing. Today, for a startup in the US, especially one with a consumer-facing product, the first finance option being considered by many founders is crowdfunding. Angel networks and venture capital firms are starting dozens of syndicated investing networks and crowdfunding platforms, and the landscape of seed finance has been forever altered by crowd funding. These changes deserve focused attention, and carry with them significant changes in the way risks are shared and managed. This white paper, commissioned by the Markle Foundation, lays a foundation for discussing and debating the meaning of these changes.

 

To download the full report, click here.

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