Let’s face it, the last place most of us really start looking for extra funding for your idea is your bank. Unless you have a long standing relationship with them and a track record of running your own business, the hoops that you need to get through make it unrealistic.
There are lots of reasons for looking beyond the standard means of funding a business such as the bank. The marketplace for alternative funding and borrowing sources has burgeoned in the wake of the economic doldrums that we’ve experienced and it is well worth being creative about ways to fund the business. Even when times are less tough, an alternative channel may offer benefits the banks can’t.
As a freelancer and independent business, the odds are staked against you when it comes to borrowing. Even with a business plan fit for the most pernickity of bank managers, it is very hard to persuade them to lend to you unless you agree to put your home or other core assets on the line.
But perhaps there is an answer. Alongside crowdfunding, which we covered in this article, peer-to-peer lending is gaining a lot of coverage. The magnificent Channel 4 series, ‘Bank of Dave’ followed David Fishwick as he opened his own bank specifically to support local businesses with a 5% bank loan. Boiling banking down to a very personal level, he assessed the potential for peer-to-peer lending. This is a way of allowing deposits to pass from lenders to borrowers without taking deposits. So, technically, it’s not a bank because there aren’t any deposits.
It works by matching investors, who are looking for a more competitive rate of return on their money, with those lending to those who want to borrow, usually at far lower APR rates than the banks.
Who are the key players in the UK?
There are currently only a few major players in the industry, but it is relatively new. Zopa was one of the first off the starting blocks and essentially designed the market for this.
Zopa was the first to look at the idea of reimbursing lenders in the event of a late payment or payment default (more on that in a moment). Funding Circle launched in August 2010, and the UK Government already uses it as a vehicle to lend to small businesses. The last of the big three is Ratesetter.
Really new business, Funding Knight is an option for businesses that have at least two years trading history. They reckon on a return of more than 11%.
How does peer-to-peer lending work?
Each of the peer-to-peer lending companies work in slightly different ways. Stick with us as we try and unpick each of them!
Zopa basically assesses your ‘risk’ and puts you into one of their ‘risk markets’. These are A* (the safest) to B (the most risky). A* savers earn 5.2 per cent after fees are deducted, however those in the B category could get a return of 7.1 per cent after fees. Zopa divides lenders’ money into £10 chunks, so if you lend £2,000 it will be spread across 200 borrowers.
In response to feedback, Zopa has just launched another option called Safeguard. Savers can earn a maximum 5.1 per cent but Zopa promises to make up all the money owed by a borrower, including the interest, if they default, which gets over one of the core worries that people have about lending to a stranger. Tax is charged only on the 5.1 per cent. This is the only option for new lenders, while existing lenders can use all options.
Funding Circle, the biggest peer-to-peer lender to small businesses, works in a similar way to Zopa, with borrowers grouped into different risk categories. They spend much energy on educating their small business base about how to get the best returns. Average returns are 6.2 per cent after fees and default rates. They also have an ‘auto option’ where the algorithm chooses the best companies for you to invest in as a lender.
RateSetter works differently. Instead of dividing borrowers into different risk categories, it underwrites the risk, thereby protecting savers should one of their borrowers default. They manage this by charging a fee that borrowers pay when they apply for their loan. Effectively, this is the safety net. The ‘safety net’ means a slightly lower interest rates for lenders of between 2.4 and 5.2 per cent.
You can typically borrow from £1,000 up to £25,000, but how much interest you pay depends on your credit rating, the amount you borrowed and the period of repayment. Zopa charges 6.4 per cent for a £5,000 loan over three years.
Sounds good. Can anyone get funding this way?
No. The system just wouldn’t work if there were no controls. Peer-to-peer borrowing is not for anyone and many of the lenders have stringent criteria for taking out a loan. Its work knowing that Zopa refuses 80 per cent of applicants while RateSetter rejects 85 per cent.
Is peer-to-peer lending here to stay?
On the one hand, this is a very welcome change to the way people can fund their business or project. But don’t forget that it’s relatively new, and needs to come with a health warning.
A number of peer-to-peer lenders have started up only to close within a short period. It is a hard nut to crack.
We are all burnt by the banking crisis, and it’s important that the new peer-to-peer industry builds confidence in it. Zopa, RateSetter and Funding Circle have launched a self-regulatory body called the Peer-to-Peer Finance Association. It aims to ensure members stick to basic rules on how they conduct business and we will no doubt see changes along the way as they learn from early mistakes and evolve the business models.
From next April the industry will be regulated by the Financial Conduct Authority, but for now, those with complaints against peer-to-peer lenders are currently unable to use the services of the Financial Ombudsman Service to get redress. That’s no protection. So if you are a risk adverse investor, this isn’t for you.
And the potential for freelancers?
Well obviously the same rules apply with regards to your business planning. You may not see yourself as a business, or you may simply be too busy getting your project off the ground or keeping it going on your own without worrying about the niceties of a formal plan. But think about it like this. If you and I meet and I love your idea, I might suggest that I lend money to you to help get it off the ground. I would need to ask questions about you and your business in order to know how you intend to pay it back. That’s just good investment decision making and to be honest, if you can’t articulate your business in those terms, you probably aren’t ready for funding.