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Is peer-to-peer lending unsafe for SMEs?

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It’s a truism that if something is too good to be true then it probably is. Peer-to-peer lending and crowd-funding sound as if they might be in that category.

Harnessing the power, reach and message of the internet to bridge the post-Lehmann funding gap for business and usher in a brave new world of business finance, brushing away all previous barriers and cutting out the rapacious middle man. Surely it can’t be that simple can it? 

Peer-to-peer lending and crowd-funding in fact covers a multitude of sins which fall into three main categories: pledging, lending and equity funding.

Pledging

At its most basic there is a simple pledge or gift. I’ve seen that most frequently in the context of bands where money is raised from fans and contacts to cut a record, essentially money is given away. 

There is no investment. This model is more like a donation. It works well in a limited number of circumstances but it isn’t going to change the world. 

Some models include an advance purchase of a product or service, Kickstarter has been very successful with its pledge/advance purchase model and it works well for creative projects. 

Lending

Then there is a lending structure. Funding Circle offer general peer-to-peer lending to businesses, and MarketInvoice allows businesses to borrow from individuals against the security of their invoices. Peer-to-peer lending has arguably been the most successful of all “crowd-funding” initiatives and perhaps offers the greatest potential. 

A loan offers the lender some security – their loan must be repaid and, in the event of an insolvency, they at least rank ahead of the shareholders / owners / partners in terms of getting some money back.

The flip-side of a loan (from the lenders point of view) is that a lender doesn’t own part of the business. So they don’t have any of the rights that an owner might have and, crucially, they don’t have the possible huge upside that an owner has if and when a business makes it big. 

Lending is a safer option for the lender, but it doesn’t give the potential for growth that some investors are looking for. 

From the borrower’s point of view, a loan carries risk as a loan requires repayment. Peer-to-peer lenders generally operate on the basis of repayment over a given term. 

This can impact on the cashflow of a business as monthly payments have to be met. Even if a business is trading successfully the burden of loan repayments can bring a business down if cash is tight and enough cash cannot be found to repay. 

An unpaid lender whose money is due can put a borrower company into liquidation. Peer to peer lenders generally appoint a third party who can enforce loans on behalf of the lenders to the fact that a business is dealing with lots of lenders does not mean that the loan is less likely to be enforced. 

Equity

So that leaves an investment in the equity of a business (shares) as the third alternative. This may be where the future of crowd-funding lies but it does carry some risks.  Entrepreneurs need to tread carefully.

First of all there are stringent financial services regulations that need to be observed. This means taking advice, being very careful about what you say to whom about the money you need before you’ve taken advice and, almost certainly, means using an FCA regulated crowd-funding business. Seedrs and Crowd Cube are both now regulated. 

Secondly, you need to pick a crowd-funder with a track record and, ideally, with expertise in your sector. The sectoral expertise is not always what it might seem or as important as it might appear to be. But you should consider it.

Thirdly, consider picking a crowd-funder which uses a nominee or trustee structure to invest. This sounds like a boring legal point. It isn’t. For future funding rounds in your business, you don’t want to be hamstrung by dozens, possibly hundreds of investors with tiny individual holdings. This could, possibly, prevent future funding and severely restrict your future ability to raise money. At its worst it could result in the business collapsing. 

You need a single, reliable shareholder which future investors, whether institutional or business angels, feel confident dealing with.

So, in short, crowd funding offers lots of opportunities and undoubtedly forms part of the future. But like anything new it also has traps and pitfalls for the unwary. Don’t be afraid of it, but don’t be afraid to question either. 

Jonathan Thornton and Guy Wilmot are partners in the corporate and commercial team at Russell-Cooke LLP.

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