How crowdfunding can unlock SMEs’ potential - Peter Alderdice

Peter Alderdice, senior associate in Shepherd and Wedderburn’s banking and finance team, believes this way of boosting firms’ coffers can plug the funding gap.

Ellon craft brewer BrewDog has famously fuelled its growth through crowdfunding.

Small and medium-sized enterprises (SMEs) are the backbone of Scotland’s economy, yet many face an uphill struggle when it comes to getting a bank loan. The challenges of accessing external funding are felt most keenly by start-up businesses and companies in the early stages of expansion.

These growing firms often have few assets to offer as security for lending and cannot demonstrate their creditworthiness for loans through past performance because of their limited trading history.

Analysis from the World Bank Group, a global partnership working for sustainable solutions that reduce poverty and build shared prosperity in developing countries, reveals the importance of SMEs for job-creation and economic output, with studies demonstrating a positive correlation between the size of a country’s SME sector and the health of its economy.

However, it is estimated that 16 per cent of SMEs in developed countries are unserved or underserved by traditional sources of finance. Many such SMEs could use external funding productively to boost jobs and deliver growth in the real economy.

Figures from the Scottish Government estimate that SMEs account for 99.3 per cent of all private sector firms in Scotland and, with 1.2 million workers, provide well over half of all jobs in the private sector.

Against this backdrop, alternative models of sustainable lending are needed to provide better access to external funding for SMEs. One innovation in financial technology – or fintech – that is helping to close the financing gap is “crowdfunding”. This is an alternative source of finance, facilitated through a digital platform, which unites individuals or businesses wishing to raise money, and investors wishing to invest it.

‘Marketplace lending’

When the finance is provided in the form of a loan, it is commonly referred to as peer-to-peer lending or peer-to-business lending. Unlike banks, which receive money from depositors and lend that to consumers and businesses, the operators of crowdfunding platforms do not take deposits or lend themselves. Instead, they act as brokers or intermediaries, generating income from the fees and commission they charge the borrowers and lenders using their platform.

Initially, crowdfunding platforms were focused on enabling retail investors to connect directly with borrowers but, more recently, financial institutions have started using them to invest in bundles of loans. This latest development goes by the moniker “marketplace lending”.

There are also equity-based crowdfunding platforms that match investors to firms wishing to raise finance by issuing shares, rather than by borrowing money as a loan. The first crowdfunding platform was launched in the UK in 2005 and, in the early years, there was very little regulatory protection for consumers and businesses using them.

Operators of these platforms were regulated only for certain debt administration activities, generally leaving their core business of running an online marketplace to match prospective borrowers and lenders outside the scope of regulation. By 2014, a set of rules for regulating the UK crowdfunding sector had been introduced, and the Financial Conduct Authority (FCA) was appointed to oversee and enforce those.

The regulations were updated by the FCA last summer to improve protection for those using crowdfunding platforms to invest or raise money. Also last year, the jurisdiction of the Financial Ombudsman Service was extended, and small businesses can now ask it to adjudicate on certain disputes. The scope of the regulations is complex and many protections are targeted at safeguarding consumers rather than businesses.

From the perspective of investors making loans, it is important to understand that, unlike deposits at a bank, loans made through a crowdfunding platform are not protected by the Financial Services Compensation Scheme (FSCS). Some platforms offer a contingency fund that can make discretionary payments to investors if a borrower defaults in repaying their loan, but the recent failure of some high-profile platform operators highlights that the protection afforded by such funds should not be equated with that overseen by the FSCS.

In December 2019, plans were unveiled for pan-European rules to provide a robust supervisory framework encouraging more confidence in crowdfunding platforms. Whether the UK will align itself to these post Brexit remains to be seen. When compared with the volume of bank lending in Scotland, crowdfunding still marks a small segment of the market, but a report issued by the Financial Stability Board in January notes that it “is growing rapidly”.

As collaboration between financial institutions and crowdfunding platforms accelerates through marketplace lending, it is hoped that the rapid growth in crowdfunding will help unlock the potential of Scotland’s unserved and underserved SMEs.