Many SMEs want easy and cheap credit from their banks — but it is not a self-evident market failure that this is not always provided to them.
Still, the UK’s Government has asked Tim Breedon (Legal & General’s CEO) to assess how smaller firms can meet their capital needs without simply being dependent upon the banks. The report is due in a week or so.
I have written previously about crowd-funding) which I see as a form of private placement, structured via the internet. This can work for equity — as I discussed in the previous blog — and also for debt issuance. For an example of the latter one can look at the Funding Circle in the UK. So far it has raised about £27 million in lending so far, with the average loan value being a little over £40,000. Ultimately the capital is sourced from retail investors, with their capital spread across various loans. This diversification, across both firms and — importantly — different industrial sectors, should be of great potential value to the Funding Circle’s investors.
Loans can be sold to other investors fairly easily if at par (subject to 0.25 per cent commission), i.e. there is liquidity for the investors, at least until a loan defaults. The interest rates charges to firms vary from 4-15 per cent (subject to a credit assessment of the borrowers is conducted by the team at Funding Circle). Other than this assessment, the same type of challenges that face crowd-sourcing (again, see the previous article) apply here too. The ability to trade debt introduces liquidity justifying a slightly lower risk premium.
The cost issue can be harder to resolve: there’s the cash cost of issuance (what leaks away to lawyers, accountants and other advisers) and, of course, the distraction of management from running the business itself.
It’s important to recognise that Funding Circle is quite different in concept from the modern conception of a bank (i.e. there’s no fractional reserve banking). It is facilitating the private placement of what are in effect corporate bonds, at a reasonable cost (2–4 per cent commission). There is probably not much that the Government needs to do, or should do, in terms of regulatory simplification (unlike with equity) — although Funding Circle may see things differently on that score of course — rather it can stand back and allow the market to make its assessment.
Whilst the above — and everything else that the Breedon Review considers — may need time to grow into the role of being major providers of capital needs of small firms, they do represent market-based solutions to our needs. This is important because it is in sync with the way in which business is done in the UK. A brute intervention to create the infrastructure required for a “hausbank”-style approach akin to Germany’s would be immensely costly and runs the risk of being a poor institutional fit for the British economy.
In much of Europe a major constraint on funding smaller businesses (particularly with risk capital) is the lack of a robust ecosystem to act as a conduit for the capital. An ecosystem here means not just well-designed legal and tax structures conducive to capital investing but also lawyers, financiers and so on with appropriate skills. This kind of ecosystem only grows up when the long-term policy context is favourable (i.e. there’s a clear, long-standing political commitment to building better funding infrastructure — or at least to not messing around with it when it works).
In the absence of such an ecosystem it is harder to route capital into early-stage and fast-growing firms. Europe is witnessing a decline in risk appetites and a crunch in credit which will only exacerbate this situation — but these fast-growing businesses are exactly what are required in order to reinvigorate the economy.
It's an attractive idea to see crowd-funding as at least making a contribution here. This is where a large number of individuals make small investments which in aggregate meet the company’s needs. There are already examples of intermediaries stepping in: crowdcube.co.uk which as of 6th March 2012 listed about 60 opportunities requiring investment from £30,000 up to £1 million, with £100–£150,000 being fairly common.
It can be seen as a variation on the traditional private placement approach, but with the clear intention of remaining below the thresholds set within the Prospectus Directive. A prospectus (under the revised Prospectus Directive) is required if raising at least €5 million or if there are at least 150 investors (which is assessed on a Member State basis). The latter is the issue because prospectuses are expensive. For example, this means that there needs to be a limit on how many investors are involved in any one issue. It’s with this and similar issues in mind that has made many believe that the regulatory framework needs redesign in order to accommodate crowd-funding and similar innovations.
The Entrepreneur Access to Capital Act — currently waiting a Senate vote — aims to bring some extra clarity to the regulation of crowd-funding in the USA by providing an exemption to 1933 Securities Law. The Act as currently drafted would allow an exemption if the funds raised in the previous twelve months did not exceed $1 million (raised to $2 million if the fund-raising were accompanied by audited accounts). The exemption is not complete: warnings and various assurances to both investors and the SEC. Similarly, an individual investor’s contributions are capped at the lower of $10k or 10 per cent of annual income. The latter seems sensible in intent (if rather generous given the likely risk profile of investments and the desirability of investing across a mix of firms in order to diversify away a portion of that risk) but the wording of the Act implies that the issuer (or the intermediary) would need to check, which is likely to prove a practical nuisance (costly and dissuading from participation those sensitive of disclosing their income).
The UK Government is interested and has met with representatives of the nascent industry and has also proposed the Sees Enterprise Investment Scheme, which aims to encourage entrepreneurship.
There are potential arguments against crowd-funding's being a success:
(a) By splitting the investment amongst many parties it is possible that no-one has sufficient skin in the game to make effective due diligence pre-investment and monitoring post-investment worthwhile. Whilst the cost of basic research (e.g. checking a firm’s online presence) is pretty low, so is the cost of faking it. Mainstreaming of the idea in the next few years may open it up to such problems.
(b) Most small firms do not succeed — whilst they may not fail outright, simply failing to grow sufficiently such that a worthwhile exit for the investors can be achieved may disappoint less experienced investors.
It remains an idea that many people are enthusiastic about but it has not yet been conclusively proven. Starting conditions in USA compared to (at least large parts of) Europe are more favourable: higher expectancy of macroeconomic conditions revert to growth (sooner or later), a better track record of fostering innovation and a larger population of sophisticated investors.
Still I think that crowd-funding and similar social initiatives could merit similar treatment in Europe to that proposed in the USA. However reduced investor protection and — no matter how worthy the cause — would be an anathema to many European policy-makers. With the Prospectus Directive freshly revised further change might be seen as unnecessary. Increased use of the concept of up to 149 investors per Member State would enable a well-designed cross-border opportunity a large population of investors to spread capital around to.
In the more financially developed countries in Europe (e.g. the UK) these offerings provide lower transaction costs (albeit still around five per cent of the funds raised). This is important both in cash terms (obviously important when a firm is raising money) and in time (critical where the money is wanted to exploit a new opportunity or idea). They also fill a common equity gap, where more is required than can be sourced internally from the company or from family & friends, but below the level that institutional venture capital is interested in. Where equity capital provision is less developed, crowd-funding could represent an institutional mechanism to short-cut the lack of an ecosystem. Obviously, this brings additional risk relative to markets where there is a pre-existing pool of investors experienced enough to understand the nature of the beast being tackled.