What is alternative finance, exactly?

Unfortunately, things have only got worse, with lending to firms by the UK’s largest banks continuing to fall in every quarter for the last three years.

What happened to traditional bank lending?

It’s no secret that lending to SMEs by traditional high street banks collapsed immediately after the credit crunch back in 2007.  Unfortunately, things have only got worse, with lending to firms by the UK’s largest banks continuing to fall in every quarter for the last three years.  Worse, there is every reason to believe that bank lending won’t return to pre-crisis levels, as measures designed to make large banks more stable will actually make it more difficult for them to lend to small firms.

What is alternative finance, exactly?

With traditional bank lending to the UK’s vital SME community in decline, it’s hardly surprising that alternative finance has become a hot topic. Not a week goes by where alternative finance doesn’t feature in a national press article or a government announcement. So what is alternative finance? Put simply, alternative finance is any type of funding that doesn’t come from a major high street bank. In fact, a common technical term for alternative finance is “non-bank lending”.

Why is alternative finance growing so quickly?

Alternative finance tends to thrive where a firm’s needs are too urgent or complex for traditional bank lending, or where the firm is too early-stage or challenged to fit conservative lending criteria. Dozens of alternative finance products and providers have stormed into the gap left by the banks, often focused on niches such as early-stage businesses or particular sectors. The government is also putting a lot of effort into promoting alternative finance, and from next year the major banks will be forced by law to collaborate better with alternative lenders. A survey of 1,000 firms by one lender found that two-thirds of business owners think this initiative will lead to more firms getting funding.

The rise of new “challenger banks”

Since the credit crunch, half a dozen new business banks have arisen, with more in the pipeline as the Bank of England seeks to increase SME banking competition. Typically offering similar lending products to the major banks, they compete by doing riskier deals (for example, higher loan-to-value mortgages) or by being more willing to look at the ‘story’ behind a loan application (for example, taking the time to understand a difficult trading period). As a result, costs are typically higher than traditional high street bank lending, but still often very reasonable. Some challenger banks won’t accept loan applications directly from firms like yours, as they may only work through partners.

New (and old) alternatives to overdrafts

A recent analysis by Funding Options found that small business overdrafts have almost halved in recent years, and they’re unlikely to return to previous levels. As a result, new lenders have arisen offering alternative facilities that businesses can draw down when they need to. These new lenders monitor the business either through expert relationship managers or by mining innovative new data sources on your business performance.  Invoice finance, a more established financing solution often referred to as factoring or discounting, is also an excellent alternative to traditional overdrafts.

The emergence of short-term lending

Another impact of the collapse in small business overdrafts has been the rapid emergence of new short-term business lenders, helping firms with urgent finance needs (for example if you’ve landed a new contract or need to carry out emergency equipment repairs). Some lenders use new data sources, such as your card payment receipts or trading through sites such as eBay, to make better and faster lending decisions. Annual interest rates are typically much higher than from a bank, but loans are typically for short periods, and relatively small as a proportion of your overall turnover.

Innovation through the crowd

Currently, a small part of the alternative funding landscape, new online platforms that connect businesses seeking finance with hundreds of cash-rich individuals are growing very quickly. There is a wide range of models, but the market splits into either lot of investors taking small stakes in your company (equity crowdfunding), or many individuals lending to your firm to earn interest (often called peer-to-peer or marketplace lending).  Benefits of these new finance products include better transparency on your costs of finance, and opportunities to raise the profile of your business.

Finding the right alternative finance

Although we’ve covered the main types of alternative finance, the list above is by no means exhaustive. Other innovative alternative business finance products include unlocking your personal pensions to fund your business or using the strong credit rating of your firm to fund the purchase of new stock. The good news is that alternative finance is a diverse market, with literal dozens of products and hundreds of providers. The bad news is that finding the right solution can be hard!

Conrad Ford is Chief Executive of Forum of Private Business partner Funding Options, recently described by the Telegraph as “the matchmaking website for small businesses and lenders”. With the free Funding Options service, you can quickly search dozens of alternative business finance providers.