Alternative finance is a red-hot topic right now, with the press covering every aspect of how lenders, small businesses, and the government can affect the future of lending. But what exactly is alternative about it? Simply put, it’s a group of individual lenders who all specialise in different areas, rather than funding that comes from a major high street bank – you might also know alternative finance as “non-bank lending”.

What happened to traditional bank lending?

Since the credit crunch of 2007-8, lending to SMEs has drastically declined, and the high street banks are the main culprits – given their diminished appetite for lending. Things aren’t improving from this side either, with a drop in lending every single quarter for the last three years. On top of this, it’s widely believed that traditional lending will never return to pre-crisis levels, as measures designed to make banks stable have made it even harder for them to lend to small businesses.

Why is alternative finance growing so rapidly?

Because the banks are unable to lend to every business — no matter how viable the prospect is — great businesses are slipping through the net. This is a disaster for the economy, and a real setback for small businesses looking to achieve growth. But this is where alternative finance thrives.

We’ve seen an immediate response from niche lenders looking to fill the void, with a wide variety of products now on the market. On top of this, the government is getting heavily involved in promoting alternative finance, and next year, the banks will be required by law to refer rejected businesses to alternative lenders.

The arrival of short-term business lending

Another consequence of the collapse in business overdrafts is the emergence of new types of short-term finance, from alternative lenders who aim to help businesses with an urgent finance requirement. These new finance platforms can help firms that trade seasonally, are suffering from unexpected bills, or have acquired a new contract that they are unable to fund.

For example, firms in import or export may be best suited to trade finance, seasonal businesses could use a cash-based loan or overdraft alternative, and retailers can get finance based on their card terminal turnover. These products are tailored for a specific need, and a business is more likely to be accepted if they match these more specific lending criteria.

The rise of the “challenger banks”

Since the start of the credit crunch, half a dozen new business banks have been set up, and we’re expecting to see more – with the Bank of England increasing competition in SME banking. These competitors will lend in a similar way to the major banks by offering similar products, but the way they compete is by doing riskier deals (i.e. what banks prefer to steer clear of).

Challenger banks will also look into the ‘story’ behind a loan application, for example taking the time to learn about a difficult trading period, rather than having a more rigid ‘computer says no’ approach. The downside is that costs tend to be higher than the traditional banks, and many work through partners (such as brokers or agents) – this has often been a difficulty when highlighting alternatives directly to SMEs.

Innovation through the crowd

A growing sector of the alternative funding landscape is lenders that use online platforms to connect businesses to numerous cash-rich individuals looking to invest. There are several models, but the idea is either multiple investors look for small stakes in a company (equity crowdfunding), or lots of individuals lend with the aim of earning interest on their initial investment (peer-to-peer or marketplace lending).

There are many benefits if your business is able to get onto a platform like this; such as the ability to gain investment from a standing start (i.e. with relatively little trading history), better transparency of costs, and the opportunity to use the platform as a way of marketing your business.

Finding the right alternative finance

Even though we’ve covered a few of the major types of alternative finance, the list is far from comprehensive. Other inventive solutions include: using personal pensions to fund your business, using a solid credit rating to help your firm fund the purchase of new stock, or taking turnover into account when other forms of security are unavailable. The market is so diverse that we’re seeing multiple new products and lenders appearing every year – the only bad news is that finding the right solution can be quite overwhelming!

By Conrad Ford, Chief Executive of Funding Options