Dr Pierangelo Rosati breaks down the alternative finance models for entrepreneurs and SMEs that have arisen since the global financial crisis.
Small and medium enterprises (SMEs) represent the backbone of the European and worldwide economies. According to Eurostat estimates, SMEs account for more than 99pc of companies in the EU, more than 66pc of employment, 60pc of value added and 56pc of investment. They also represent the main innovation driver in many sectors, and exploiting their full potential would benefit both the economy and society in general.
A major hindrance faced by SMEs in pursuing opportunities for growth, development and entrepreneurial initiatives is undoubtedly access to external financing. Traditionally, bank financing (loans, overdrafts, credit lines) accounted for the overwhelming majority of external financing, with the rest coming from equity contributions from the business owners, and effective debt and credit management with suppliers and customers. Difficulty in gaining access to bank financing was compounded by the global financial crisis (GFC) and it is significantly harder since the introduction of stricter regulatory requirements under the Basel II regime. We all know how severe the consequences of the GFC have been, and the constraints on bank lending have significantly amplified them, with SMEs paying the highest price.
‘These channels are ‘alternative’ in the sense that they are, for the most part, not provided by banks but from individuals and institutional investors’
The recent rise of technology-enabled financial services (fintech) has been able to, if not solve, then at least alleviate the shortage of external funding for SMEs by providing them with valid, alternative financing channels. Such channels, usually grouped under the name of alternative finance, are ‘alternative’ in the sense that they are, for the most part, not provided by banks but from individuals and institutional investors.
The two most successful alternative financing channels are peer-to-peer (P2P) lending and crowdfunding. Peer-to-peer lending, also known as ‘social lending’, is the practice of matching borrowers and lenders through online platforms. Borrowers are usually able to obtain funds quickly, and typically at lower interest rates than traditional financial intermediaries. Our recent research on the UK P2P lending industry, conducted in collaboration with Orca Money, shows a significant increase in the number of loans approved and in the overall volume of lending over the last few years. This appears to be driven by a growing interest of institutional investors in this fintech space.
By comparison, the crowdfunding model consists of raising small amounts of money for a project or venture from a large, potentially geographically distributed pool of people (the ‘crowd’). Again, this is typically achieved using an online platform. Crowdfunding can take different forms based on the benefits afforded to funders. The most common forms of crowdfunding are equity, rewards and donation crowdfunding.
The equity crowdfunding model is rather straightforward and similar to more traditional investment models. Funders are real investors who obtain, in return for their investment, a beneficial interest in the form of a shareholding (equity) in the company. In the case of rewards crowdfunding, funders receive, unsurprisingly, a reward, generally in the form of free products or discounts. Lastly, the donation crowdfunding model implies simply that – a donation – wherein the donor receives no explicit compensation for their financial support.
‘Alternative finance channels generate undeniable funding and growth opportunities for SMEs and entrepreneurs. However, they also present challenges’
Alternative finance channels generate undeniable funding and growth opportunities for SMEs and entrepreneurs. However, they also present challenges due to a limited or uncertain regulatory landscape that companies and regulators must both carefully navigate.
Recent trends and future perspectives of P2P lending and crowdfunding, as well as the opportunities and challenges they create, will be the focus of IC4’s 2nd Symposium in Capital Markets and Fintech, organised in collaboration with DCU Business School and DCU Alpha. This half-day event will take place from 9am to 1pm on Friday, 9 June in DCU Business School, and will bring together leading industry experts and academics who will cover the various facets of P2P lending and crowdfunding.
We look forward to seeing you there.
Dr Pierangelo Rosati is a postdoctoral researcher at the Irish Centre for Cloud Computing and Commerce (IC4) at Dublin City University. Rosati’s research focuses on organisational competences in accounting, finance and data analysis in the cloud.