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The Brave New World of AltFi

Taking advantage of disruptors to the traditional finance market
Credit&Finance

Disruptors, it seems, are everywhere in the food industry—from foodservice and grocery stores to restaurants and logistic firms. This extends to consumers too, whose purchasing habits have undergone radical changes with the likes of Amazon, Uber, and others offering goods and services with speed and ease. Such disruption is also reshaping how companies seek capital—as startups and small- to medium-sized businesses are tapping into the benefits of an alternate universe for financing.

Alternative finance (known as ‘AltFi’) is a twenty-first century version of banking, using the internet instead of bricks-and-mortar buildings. It has democratized access to not only capital but also investment opportunities, and businesses are turning to these online funding sources at an increasingly high rate. According to the 2017 Americas Alternative Financing Industry Report, over 143,000 U.S. businesses raised approximately $42 billion in funds through online AltFi channels in 2016, boosting the market by 22 percent over the previous year’s record $34.5 billion.

For those fresh produce industry companies having difficulty getting financing the old-fashioned way, AltFi may offer another venue for funding.

A Perfect Storm
The rise of alternative financing as an option for new businesses or those seeking growth grew out of a confluence of factors: the 2008 banking crisis, federal regulations, and technology.

The 2008 financial crisis nearly took down the entire banking industry, and the ability of small businesses to secure loans was particularly affected, as lenders became fearful of adding bad debt. In 2009 the number of small business loans decreased by more than 42 percent, according to the U.S. Community Reinvestment Act database.

Credit was further tightened by the Dodd-Frank Act of 2010 which added 225 new regulations restricting bank investment practices, mandating tight capital requirements, and subjecting large banks to strict stress tests. As a result, small business loans—already under pressure—dried up as big banks approved less than 9 percent of small business loans in 2011.

The regulations also accelerated consolidation in the financial services industry. The number of federally-insured commercial banks decreased from 6,815 in 2009 to just over 5,000 in mid-2017. Many were swallowed through mergers, others simply shut down, and community banks were hard hit.

While banks were pulling back, a fledgling industry less than a decade old was perfectly positioned to offer a lifeline to startups and small businesses unable to obtain capital. Technological advances, driven by digital networks and the internet, enabled entrepreneurs to dive into financial waters, buoyed by investors who saw an opportunity to create value.

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Disruptors, it seems, are everywhere in the food industry—from foodservice and grocery stores to restaurants and logistic firms. This extends to consumers too, whose purchasing habits have undergone radical changes with the likes of Amazon, Uber, and others offering goods and services with speed and ease. Such disruption is also reshaping how companies seek capital—as startups and small- to medium-sized businesses are tapping into the benefits of an alternate universe for financing.

Alternative finance (known as ‘AltFi’) is a twenty-first century version of banking, using the internet instead of bricks-and-mortar buildings. It has democratized access to not only capital but also investment opportunities, and businesses are turning to these online funding sources at an increasingly high rate. According to the 2017 Americas Alternative Financing Industry Report, over 143,000 U.S. businesses raised approximately $42 billion in funds through online AltFi channels in 2016, boosting the market by 22 percent over the previous year’s record $34.5 billion.

For those fresh produce industry companies having difficulty getting financing the old-fashioned way, AltFi may offer another venue for funding.

A Perfect Storm
The rise of alternative financing as an option for new businesses or those seeking growth grew out of a confluence of factors: the 2008 banking crisis, federal regulations, and technology.

The 2008 financial crisis nearly took down the entire banking industry, and the ability of small businesses to secure loans was particularly affected, as lenders became fearful of adding bad debt. In 2009 the number of small business loans decreased by more than 42 percent, according to the U.S. Community Reinvestment Act database.

Credit was further tightened by the Dodd-Frank Act of 2010 which added 225 new regulations restricting bank investment practices, mandating tight capital requirements, and subjecting large banks to strict stress tests. As a result, small business loans—already under pressure—dried up as big banks approved less than 9 percent of small business loans in 2011.

The regulations also accelerated consolidation in the financial services industry. The number of federally-insured commercial banks decreased from 6,815 in 2009 to just over 5,000 in mid-2017. Many were swallowed through mergers, others simply shut down, and community banks were hard hit.

While banks were pulling back, a fledgling industry less than a decade old was perfectly positioned to offer a lifeline to startups and small businesses unable to obtain capital. Technological advances, driven by digital networks and the internet, enabled entrepreneurs to dive into financial waters, buoyed by investors who saw an opportunity to create value.

The AltFi marketplace got another boost in 2016 when Title III of the Jumpstart Our Business Startups act removed barriers to investment. Called ‘crowdfunding,’ Title III enables nonaccredited investors to participate in capital-raising campaigns within certain limits. Previously, only accredited investors (e.g., financial institutions, business development companies, individuals with a net worth of more than $1 million) were privy to these campaigns.

How AltFi Works
Essentially, AltFi is a financial marketplace where online channels serve as intermediaries connecting borrowers with investors. Everything is done online, feeding into the on-demand expectations and consumer-centric focus that technology has brought to e-commerce.

Compared to the laborious process of bank lending, AltFi involves less paperwork, broader underwriting sources, faster credit decisions, and more transparency. And while credit scores are still important, they are no longer the overriding factor in many decisions.

Online platforms also have the advantage of being more flexible than traditional banks. The latter must weigh not just the creditworthiness of the borrower but whether its commitments to a specific market sector, say agriculture, have reached specified limits.

AltFi platforms are not held to such constraints and can encompass many different models, including rewards-based, equity, and peer-to-peer funding.

Rewards-based crowdfunding
Rewards-based crowdfunding platforms enable small businesses and startups to seek funding from contributors in exchange for a perk of some sort. No collateral or financial statements are required. Some sites approve requests before they can be posted; others do not. Regardless, the agreement is directly between the requester and the donor, not the crowdfunding site.

Companies post information on the platform’s website about their business, the amount and purpose of the funding requested, the perks for contributors, and an estimated delivery or completion date of the project.

Backers do not magically come knocking on one’s door. A successful campaign requires a good marketing strategy, usually using social media. Having family, friends, and customers lined up as donors before the project is posted enables the project to have a head start on funding. As momentum builds, others may be willing to contribute.

Businesses looking to finance operations or equipment through crowdfunding would be wise to shop around. Online platform fees can vary, up to about 9 percent of funds raised, in addition to a payment processing fee of 3 to 5 percent, and a third-party credit card fee.

The fundraising goal usually must be met within 30 to 60 days. Some crowdfunding sites, like Kickstarter, are “all or nothing” systems; that is, if the fundraising goal is not met, no money exchanges hands and there is no charge. Others, like Indiegogo, enable a business to collect the money even if the goal has not been met, but at a higher cost.

Equity crowdfunding
Equity crowdfunding is typically an option for a startup or growing business, where investors can buy shares of a company online. Companies that have successfully raised capital using this platform include Instacart, Dropbox, and Uber. Some platforms only deal with accredited investors, while others are open to those eligible under Title III. Wefunder is the largest equity crowdfunding platform, with more than $27 million raised.

Equity crowdfunding is regulated at both the state and federal level. Funding portals must register with the Securities and Exchange Commission (SEC) and be a member of the Financial Industry Regulatory Authority. Issuers are required to file certain financial documents and updates and all issuers must also abide by federal solicitation rules.

Financial statements of companies raising more than $500,000 must be audited, and crowdfunding is limited to $1,070,000 per year, though there is no limit under other SEC regulations (e.g., offerings under Regulation D which are available only to accredited investors). The minimum amount of an offering varies by the funding portal; on Wefunder, for example, the minimum is $20,000; at StartEngine it is $10,000.

As with rewards-based crowdfunding, companies create an online business profile, citing the reason for seeking funding. The creditworthiness of crowdfunding offerings is up to “the wisdom of the crowd.”

Online platforms only verify the com-pany’s legal standing and compliance with SEC rules. In-depth due diligence is performed, however, on companies seeking to issue securities under other investment regulations.

Costs can range up to 8 percent or more, depending on the portal. Numerous other fees may also be incurred, such as escrow cash management fees, credit card transaction fees, and fees related to amending an offering. These additional fees can total several thousand dollars.

Peer-to-peer lending
Peer-to-peer lending (P2P), also known as debt crowdfunding, enables an investor to lend money online to a business at a specified interest rate for a fixed repayment term. The online platform does not make the loan; lenders tend to be hedge funds and investment banks.

Lenders in the P2P category typically target mid- to near-prime borrowers (those with credit scores between 600 and 700). Debt instruments can be straight interest-yielding securities or offer conversion rights into common shares (equity); they can be secured against company assets or unsecured. Like equity crowdfunding, P2P is regulated under Title III.

Peer lending proponents cite the ease and speed in which one can get a loan: an application can take as little as 10 minutes to complete. Platforms assess risk and determine a borrower’s credit grade using data-driven algorithms including traditional underwriting statistics, real-time business accounting, payment and sales history, online customer reviews, and other nontraditional information—even standardized test score like SATs. Qualified applicants can get a funding decision usually within 24 hours.

Borrowing limits vary by portal, with some like Funding Circle offering up to $500,000. The loans are generally available for 36- and 60-month periods. Business lines of credit are also available. Interest rates are based on the strength of the borrower’s credit profile, as are loan origination fees that can range from 1 to about 7 percent. Launched in 2007, the Lending Club is the largest P2P platform in the United States.

Invoice trading
Businesses wanting to free up capital tied to unpaid invoices can look to online trading platforms, also called peer-to-peer invoice trading. These platforms are a hybrid between invoice financing and peer-to-peer lending. The invoices are sold to an online community of investors at a discount for cash but without some of the traditional aspects of factoring.

At BlueVine, which offers credit lines from $20,000 to $2.5 million, there are no lengthy contracts and businesses do not have to commit all their invoices.

Produce Pay is a company that specializes in agricultural cash flow solutions for growers and distributors. The company operates differently than a platform like BlueVine. “We ask growers to commit to a certain volume at the beginning of the contract,” explains Produce Pay’s James Alexander, who handles credit underwriting and capital markets. “They put up a deposit; if they hit that volume, they get the deposit back,” he notes.

Produce Pay’s invoice platform enables grower-shippers to get paid up to 80 percent of the shipment’s value once it is accepted by the distributor. “The value proposition to the grower is ship today, get paid tomorrow,” Alexander says.

The company operates within the confines of the Perishable Agricultural Commodities Act. Produce Pay takes title to the goods and resells them to the distributor. Growers enter shipments into Produce Pay’s system, the distributor enters when the shipment is accepted, and the money is wired to the grower, less a 1 to 1.5 percent service charge.

Distributors benefit, too, since it eliminates the need for advances. “We are not a lender,” stresses Alexander. “We are a supercharged distributor that can offer other distributors leverage.”

Produce Pay works with growers that average about $2.5 million in invoice value and must pass a credit check using eight data sources. Online application approval usually takes an hour if all needed documentation is in order. About 75 percent of applicants are approved.

The Good, the Bad, the Ugly
The rise of AltFi options has certainly benefited startups seeking seed capital as well as businesses unable to get loans from traditional sources. In addition, ordinary people can invest money in projects on a direct basis, something rarely available in the past.

AltFi is not without its critics, however. Businesses with poor credit histories pay a high price for loans on AltFi platforms, while attorneys and accountants point out that rewards-based crowdfunding carries various federal and state tax implications as well as legal issues.

On the lending side, critics worry that naive investors seeking the ‘next big thing’ may be vulnerable to losing their nest eggs. What’s more, investors may be unable to sell their shares, since equity crowdfunding lacks a liquid secondary market.

Don’t Count Banks Out
While online platforms continue to grow, they are no longer seeing the triple-digit growth enjoyed a few years ago. The slowdown has been attributed to the greater availability of bank loans at lower interest rates, as banks have rebounded from the dark days of 2008 (including a rollback of most Dodd-Frank restrictions).

Banks are also scrambling to compete with online platforms by joining forces with FinTech companies or building their own. The 2017 Global FinTech survey found 53 percent of responding U.S. financial institutions were already engaged in partnerships with FinTech firms, while 88 percent expected to increase partnerships over the next three to five years.

Eastern Bank, a mutual community bank in Boston, developed its own online business-lending platform that boasts a two-minute application process and instant loan decision for Massachusetts small businesses seeking up to $100,000. The bank has spun off its technology incubator and is licensing the platform software to other banks.

A Fad or Here to Stay?
It’s undeniable that online platforms have revolutionized the financial services industry and improved the operational efficiencies of lending—but will they continue to grow and evolve? And more importantly, will they prove more resilient than traditional banks during the next financial downturn?

Regardless, the future of financing is forever changed, and some businesses are already reaping the rewards.

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