By Guy Rigby, Head of Entrepreneurial Services at Smith & Williamson

Access to funding is still challenging for the UK’s small and medium sized enterprises, aka SMEs. With most businesses unwilling or unsuited to raising traditional venture or growth capital, and with a scarcity of bank loans and overdrafts, there’s an increasing focus on the alternatives. To an extent, Asset Based Lenders (banks or others who provide invoice or asset based finance) have stepped into the fray and tax-incentivised business angel activity appears to be increasing, but there’s a never-ending demand.

Enter crowdfunding, the process by which people pool their resources to support a cause, often associated with disaster relief or sparked by an individual tragedy, but now increasingly adopted by businesses seeking working capital finance, loans or even equity.

The business crowdfunding bandwagon is now starting to roll. The activity has largely been driven by the internet, which enables campaigns to be spread far and wide or within defined or captive communities. An early example (1997) was the British rock group, Marillion, whose fans conceived and managed a fundraising of $60,000, underwriting the band’s US tour. Since then Marillion have used the technique to fund the recording and marketing of several albums.

Another example of crowdfunding is the issue of retail bonds. In 2010, using a largely captive model (its customers), Hotel Chocolat famously offered a three year, FSA (now FCA)-approved ‘chocolate bond’ to the 100,000 members of its tasting club. Customers were invited to invest £2,000 for a gross annual return of 6.72%, or £4,000 for a return of 7.29% - all paid in regular deliveries of chocolate. This had the advantage of raising the company’s profile, winning it new customers and raising £3.7m in the process. Caxtonfx, the foreign exchange company, used a similar approach with its customers in 2011 to raise a £4m bond and, Mr & Mrs Smith, the award winning travel website and hotel booking service, raised finance through the issue of a 4 year fixed-term bond with cash interest of 7.5%, or 9.5% if the ‘Smith loyalty money’ option was taken.

Using a captive crowd is only half the story, however. The biggest crowdfunding sensation to date was Pebble Technology, a Palo Alto based smart watch company, who used US-based crowdfunding platform Kickstarter.com to raise a minimum of $100,000 against forward sales of its Pebble watch. By the time the offer closed, the company had raised over $10 million from more than 68,000 backers!

For businesses, there are essentially three categories of crowdfunding: reward-based, loan-based or equity-based.

Pebble is the most successful example of the reward-based model so far, where the crowd agrees to donate to a business or project in exchange for tangible, non-monetary rewards such as watches. Simon Dixon, a UK-based entrepreneur who has launched his own crowdfunding site, Banktothefuture.com, says that there’s already an established route to success. “To be successful in crowdfunding, there’s a simple formula, £££=R+SC+E, where the amount of money you will raise depends on the strength of the rewards you offer (R), how much social capital you have (SC) and the emotion attached to your story (E)”.

So far, so good, but what happens when there is debt or equity involved, rather than a promise to deliver products or other non-cash rewards?

There are a number of debt and equity based crowdfunding models emerging in the UK. Some target sophisticated investors and some the wider public. Some simply provide access to a crowd, with funding delivered by single subscribers, whilst the majority encourage multiple participation.

At the more sophisticated end, MarketInvoice has developed an innovative funding platform where businesses can selectively auction individual invoices to a network of high net worth individuals and institutional buyers to raise flexible working capital. According to its press office, over £120 million has been advanced to over 500 businesses. Rather than waiting 30, 60 or 90 days for large customers to pay, businesses can access much needed cash immediately.

Funding Circle, another debt-based model, operates along more traditional crowdfunding lines. Describing itself as “Better for business, better for investors, better all round”, businesses borrow from multiple lenders (aka investors) and lenders can lend to multiple businesses, thereby spreading their risk. The site claims an average net return of 6.1%* for investors, (compare that to rates on offer from the banks!) and easy access to their money, while businesses can benefit from quick and convenient loans of between £5,000 and £1million, repayable over a period of 6 months to 5 years.

As reward and debt-based crowdfunding become better established and understood, equity-based crowdfunding models are growing. These offer investors equity participation in start-ups or early-stage businesses, carrying high risk and the potential for high reward. Facebook’s flotation is a good example of the potential rewards available from early-stage investing, but it’s not for the fainthearted.

Investors looking for the ‘next big thing’ need to understand that the vast majority of early stage investments either fail, or fail to deliver positively.

The best known equity-based crowdfunding platform in the UK is Crowdcube, which imposes strict barriers to entry, insisting that businesses seeking funding must pass rigorous checks. Founded in 2010, it describes itself as a new way to fund start-ups and business expansion by giving entrepreneurs a platform to connect with ordinary people and raise venture capital.

So where to next for crowdfunding? Whilst there are regulatory challenges and there will almost certainly be some challenges along the way, it offers a welcome alternative to the nation’s entrepreneurs.

*Correct as of 19 February 2014, source: www.fundingcircle.com/investors

By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.