How Should Alternative Finance be Defined?

A few days ago, Ryan Weeks wrote a comprehensive piece on the emergent debates in alternative finance and I’d like to continue where he left off. But do give Ryan’s article a read; it encapsulates the various fault lines in the nascent industry well.

a man smiling for the camera

His piece focused on three areas of some debate, viz., does/should alternative finance refer only to companies with a ‘p2p’ element? What is the difference between p2p and crowdfunding? And finally, will one aggregator emerge to rule them all? I want to add to the first question, and in doing so touch on the second. I’ll stay as far away as possible from the third as I can until the government returns from its consultation on referring rejected SMEs loans.

The point I hope to make in the next few paragraphs is that alternative finance cannot pivot on a distinction between direct and p2p finance. The fatal flaw in such a p2p-centric definition of alternative finance is that it focuses on only one element of how finance might be alternative – whether funds are provided directly by one company, or by the many through a platform. Surely, there must be other characteristics, beyond volume of funders, which could make finance new or alternative?

For example, important as the debt vs. equity element of the p2p/crowdfunding debate – as summarized in Ryan’s article – may be, is it not equally a case of putting 21st century lipstick on a very, very old pig? Business owners have been weighing the risks and rewards of both debt and equity as long as both have existed. And would not a type of financing that defies this dichotomy be at least as new and alternative as using the many to fund the one?

Enter, revenue-based finance (RBF). For the sake of space let’s strip RBF to its bare essentials: capital is lent to a business in exchange for a share of the business’s future revenues. Crucially, revenues are only shared until an agreed amount is repaid. Thus, the structure relies on three parameters:

  1. A total amount to be repaid by the business, agreed upfront

  2. The percentage of revenue to be repaid each period

  3. The payment frequency – usually monthly, weekly or daily

Let me give an example here of a business borrowing £50 000 and turning over £600 000 annually (£50 000 monthly):

  • It is agreed that £60 000 is to be repaid

  • It is agreed that the business pays 10% of monthly revenues

Thus the business pays 10% of £50 000 each month and the advance should take 12 months to repay in full.

But, say revenues plummet to £30 000 a month and remain there. Under an RBF model, monthly repayments become 10% x 30 000 = £3 000, and it would take 20 months to repay the £60 000. Likewise, higher revenues mean the advance is paid off quicker than the 12-month expected period.

Why is this genuinely alternative? Let’s touch briefly on the conundrum faced by a business owner in choosing between debt and equity – risk vs. reward (ah, that old chestnut). Debt is attractive as it’s non-dilutive, but fixed payments and liens on business and personal assets make it a relatively risky prospect for small businesses. Selling equity overcomes this risk, but at the expense of diluting the owners’ share; this means less control, and ultimately less upside if the business is successful.

The innovation RBF presents is incorporating positive elements of both debt and equity. Like debt, RBF is non-dilutive; that is, business owners never lose ownership or control of any part of their business as their obligation to share revenues is discharged once the full amount is repaid. However, RBF does not subject business owners to the risks associated with debt. Repayments ebb and flow with a business’s revenues, preserving cash flow, reducing risk and providing flexibility – just like equity, but without diluting the owner’s share.

So RBF presents a credible alternative to both debt and equity by reducing a business’s risk while keeping control wholly in the hands of the business owner.  This is not to say that forms of financing that fit within the traditional debt-equity paradigm are not new or alternative. Rather, the (verbose) point I make is that a narrow, p2p-centric definition of alternative finance commits an enormous error in excluding some types of direct finance. In fact, using the volume of funders as the definitional linchpin for alternative finance would do active damage to the industry. By focusing on only one means by which the industry provides innovative and beneficial solutions, we exclude a host of other authentically alternative types of finance. In doing so, we limit the industry’s capacity to serve the borrowing consumer or business.

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