Crowd finance 101: ​How does debt-based crowd finance actually work?

March 13, 2017 • By TAB team

As part of our new ‘Crowd Finance 101’ series, we take a look at the nuts and bolts of debt-based crowd finance.

As part of our new ‘Crowd Finance 101’ series, we take a look at the nuts and bolts of debt-based crowd finance.

What is debt–based crowd finance?

Debt-based crowd finance encompasses several forms of online lending. The principle is simple – investors lend money to businesses or individuals through an online platform.

Let’s take a look at the different methods.

Peer–to-peer lending

Peer-to-peer lending, or marketplace lending, dominates debt-based crowd finance.

P2P lending platforms connect lenders with borrowers. Since platforms have lower overheads than traditional lenders, investors can earn higher returns when compared to banking products, while borrowers can access lower interest rates.

Platforms like Funding Circle make it easy for retail investors to lend to companies. Here’s how it works:

The mechanics of P2P lending:

1. Investor registers on the platform and deposits funds.

2. Investor selects loans on the marketplace or lends automatically according to the platform’s recommendations.
3. Investor receives monthly payments from each business they lend to. They also have the option to access their money before the loan expires. Platforms charges a fee for performing credit checks on borrowers and facilitating loans.

Platforms such as RateSetter and ZOPA connect individual borrowers with lenders. They enable investors to spread their risk by lending small amounts of money to large amounts of people, receiving monthly repayments of capital and interest.

Peer–to-peer lending in action

In early 2016, Beech’s Fine Chocolates of Preston borrowed £250,000 via Funding Circle. The 96-year old chocolatiers, stocked in Waitrose, John Lewis and Harrods, borrowed from the crowd so that they could keep pace with demand that followed the broadcast of a BBC TV documentary that profiled their business.

In December 2016, Targa Florio Cars of Chichester used RateSetter’s online platform to borrow £100,000 so that they could purchase luxury cars for their inventory. The cars they purchased were sold on within 6 weeks, booking Targa Florio £18,000 in profit, over and above the rate of borrowing.

So the uses of P2P lending are varied. The results can be extremely positive.

Mini-bonds and Invoice financing

Mini-bonds are issued by companies looking to leverage strong followings to obtain financing on favourable terms. Investors receive interest payments, redeeming their initial investment plus a lump sum of interest when the bond matures.

Invoice financing is used by companies to manage cash flow, whereby they sell unpaid invoices in order to raise funds. Platforms like MarketInvoice connect investors with businesses seeking working capital finance.

We’ll cover mini-bonds and invoice financing in more depth in a subsequent feature.

What are the rewards and risks?

Investors can generate returns that exceed rates offered by traditional banks by lending directly to individuals and companies. On a macro level, society as a whole benefits by democratising finance and utilising capital more efficiently.

Like all asset classes, debt-based crowd financing has its risks. These products are still relatively new and regulatory requirements for borrowers are less demanding than public debt markets. Also, debt-based crowd finance is not protected by the Financial Services Compensation Scheme.

Our view

On paper, debt-based crowd finance is a win-win scenario for borrowers and lenders. Marketplace lenders have enjoyed solid growth over the past decade, but they’re yet to be tested by an economic downturn – or a tightening of regulatory standards that could raise platform overheads and make the economics of marketplace lending less attractive. We’ll have to wait and see.

There is certainly an urgent need for increased transparency. Debt-based crowd finance is a new industry that’s undergone a single (expansionary) business cycle and is subject to a nascent regulatory framework.

Crowdsurfer addresses this need, offering public access to unprecedented levels of information on crowdfunding and P2P lending. It’s an incredibly valuable tool that brings transparency to a rapidly growing market.