Weighing up the risks of alternative finance
Alternative finance is fast becoming the go-to place for business loans, especially as there are so many options to choose from. A host of alternative lenders that provide invoice discounting, merchant cash advances, peer-to-peer lending, crowdfunding and online business loans have been popping up over the last few years offering their services to SMEs and investors, mainly because banks have turned these businesses away.
Since the recession, banks have become stricter with their lending and this has made it more difficult for small businesses to acquire much needed funding. Whether the finance is for company expansion, ‘plugging a gap’ or for future investment, alternative finance providers have been giving what businesses want: capital to grow.
While this type of lending can be a great solution, it’s wise to look at all the risks – especially what might happen further down the line. The FCA recently revealed it was concerned with how certain crowdfunding websites presented information on risk, indicating there was an aspect of ‘unrealism’ and that perhaps lenders were being too optimistic in their wording.
If the borrower were to become insolvent, this could create a number of problems, not only for the directors and alternative lender or investor, but also for the insurer who underwrites the loan. The director of the insolvent company could also be personally liable for the business debt if they agreed to a personal guarantee with the alternative lender.
What is a personal guarantee?
A personal guarantee (PG) is where an individual has guaranteed personally the amount owed will be paid back. This sounds obvious, but in many cases company directors have made PGs with a lender believing that because they’ve borrowed the money for the company, the debt would disappear if the company went bust. Of course, this is not the case.
Risk for lenders and suppliers
When assessing a company for risk, you should bear in mind in that the company could have borrowed from multiple alternative lenders to pay back historic debts at high levels of interest. The issue is, of course, that traditional forms of company monitoring, such as payment trends, might be less effective if companies are just borrowing to pay suppliers. There is no register of personal guarantees and they do not appear on any credit check. In effect, lenders and suppliers will need to take the directors at their word.
A number of insolvent businesses we’ve seen have had at least three or four loans from alternative lenders. Is there a false sense of security due to the possible over-valuation of a personal guarantee?
Many lenders have underwritten their debts with an insurance company. Do these insurance companies realise that personal guarantees are being given out left, right and centre? The risk is if some businesses turn sour, the costs of insuring their debts will increase.
In another twist, it is now possible for companies to insure their personal guarantee. This means the insurer could be insuring both the borrower and the lender. If there is a sudden shock to the economy, such factors may well amplify the consequences, as everyone realises that the risk is not spread across the system.
What does the future hold?
The government will always want to protect the investor in the peer-to-peer lending system because they are not deemed as sophisticated investors. From April this year, peer to peer lending became regulated by the FCA, which will offer some protection to both the investor and lender. However, anyone over the age of 18 is still free to gamble, resulting in a strong pool of available money.
It is important that business owners are aware of the risks and don’t just use alternative finance as a sticking plaster over the real problem. The business may not be viable or the business structure could fundamentally need to change.
Copyright © 2015 Keith Steven, managing director of KSA Group. He has been rescuing and turning around businesses for more than 20 years, working with firms in every industry. He is author of the site www.companyrescue.co.uk.