Oral evidence: SME Lending, HC 204Wednesday 16 July 2014
Oral evidence, 16 July 2014.
Witnesses
Samir Desai, CEO and Co-founder, Funding Circle, Anil Stocker, CEO and Founder, MarketInvoice, and Tony Askew, Chair of the BVCA Venture Capital Committee and Partner at Reed Elsevier Ventures, gave evidence.
Chair
Thank you very much, all three of you, for coming to give evidence. If I can start with a very simple straightforward question. What is it like out there? How difficult is it to compete with the major banks? Who wants to start?
Samir Desai
I am happy to start.
Chair
I will move from, as I am looking at it, right to left so you know who is coming next. Mr Desai.
Samir Desai
For those who do not know, Funding Circle is a peer-to-peer lender. We have lent over £315 million to nearly 5,500 businesses since we launched four years ago and nearly half of that has come this calendar year. From our perspective, as an alternative finance provider, increasingly becoming more and more mainstream, it is a very benign environment to be competing with banks. Obviously they have a lot of legacy issues that they are dealing with but—I am sure this has not escaped your attention—the UK is a very monopolistic market in terms of our banking sector. Funding Circle operates in both the US and the UK. In the US, there are thousands of regional banks that we compete with, whereas in the UK it is pretty much five banks doing 90% of the lending. I would say it is quite a good environment.
Tony Askew
I am here representing the British venture capital industry, which does not compete, per se, with banking. It is an alternative source of financing. Venture capital is very early stage, very hands on, very high risk. Pat, it might have been you talking about a guy with a PC and an idea. That is the kind of thing that venture capital gets involved with, at the seed end of the spectrum. It is very high risk in terms of the returns that you can get. Venture capital is responsible for over 20% of the US economy right now, and 90% of software jobs, 70% plus of biotech jobs and roughly 11% of private industry employment. That has represented a massive impact on the success of the US economy over the years and the success of the reinvention of the US economy. I think the reason we are here today is to interject into this hearing that there are other forms of financing we should be considering as a Government and that the Government can help to stimulate some real growth engines of the economy. I do not think we compete with banks.
Mr Tyrie
Mr Stocker?
Anil Stocker
I am here from MarketInvoice. The easiest way to understand what we do is to give an example of the business that we have helped this week. They are a business that was running big online advertising campaigns for beer companies at the World cup in Rio. They had done all the work. They have invoiced out to these big beer companies and are having to wait 120 days to get paid. In the meantime, they have to pay their suppliers and cover their costs from all the activity they did at the World cup in Brazil. They come to us and what we effectively do is fund that invoice early. We pull that money from sophisticated investors, asset managers, family offices—people who are sitting on a lot of money that they give to the business so they can get on and pay their suppliers, and move to the next project. We funded £200 million through our platform. Some £100 million has come since the beginning of this year, so it took us three years to do the first £100 million and six months to do the second £100 million. We have helped over 600 businesses through repeated transactions—over 3,500 transactions since we launched. I would agree with Samir. I view this time right now as a huge opportunity for us. We are competing in the factoring and invoice discounting market. When I look at the products that the banks have, there are so many negative features about them. There is so much lock-in. There are so many opaque things around the fees. Businesses do not understand what they are going to get charged, how they can exit and what collateral they have to give. Banks are constantly changing the goalposts. Right now I think there is a huge opportunity in the alternative finance market to make everything more transparent, faster and easier, and also to educate businesses that there are more options outside the top four banks that control 80% of the business market in the UK.
Chair
It is still a relatively small share so far compared to total SME lending.
Anil Stocker
Yes, but I think you have to look at the growth rates. We have grown 465% this year compared to last year. Yes, we are off a small base, but I think I speak also for other alternative funding platforms where, if you extrapolate our growth rates, we could become a serious force in SME lending. We will not be called alternative any more; we will be more called mainstream.
Chair
I am going to ask Mr Stocker and Mr Desai at the end of this hearing to tell us the one measure, which is not a public expenditure measure—I am not going to cost the bottom line to the taxpayer—or the one change in how this industry is regulated or structured that would help you most to increase competition.
Mr McFadden
I would like to ask you all some basic questions about size, and what is driving this and so on. I will begin with you, Mr Desai. Do you think this is principally being driven by technological change, or is it being driven by the difficulty of start-ups and SMEs to get finance from the traditional bank lenders? Is it technology, or is it a problem elsewhere?
Samir Desai
I think there are a number of factors. I think technology is definitely a factor. On our board we have a guy called Ed Wray, who is one of the co-founders of Betfair. He always jokes to me that when they started Betfair, it cost them £1 million to buy a server to run that business, but his mobile phone is now more powerful than that server. The costs of technology and being able to use technology have come down dramatically. The other big factor we have noticed is loss of trust and satisfaction with banks. That has helped us, probably more so on the investor side. Funding Circle is made up of 30,000 individuals that lend money to businesses every day. An average loan of, say, £60,000 is funded by 600 different individuals, and the loss of trust and satisfaction, combined with the low returns that individuals are getting on their money, has meant that both they and businesses are increasingly willing to try out new things. I think there are a number of different factors that are going on. What we think is happening now—in the case of Funding Circle and the same with MarketInvoice—is that technology or the internet is starting to disrupt financial services. We have seen that disruption in the book industry and music, and what is happening now is that you have the digital equivalent of lending—digital loan and digital invoice finance—starting to take off. I personally think that is an unstoppable force.
Mr McFadden
You bring together lots of different people to fund the loan. We talked about securitisation in the last session, which is different loans being packaged up together. Do you have a view on that?
Samir Desai
I think it is very similar to the view that you expressed that there are similarities between what we do and securitisation. As you said, securitisation done right is probably a very powerful thing. We effectively allow thousands of individuals to buy part of a loan, which they have never been able to do. Another way of looking at it is that you are taking something that was only available to five banks—SME lending—and making it available to everyone as an asset class. It is a similar concept. I suppose the main thing is what you put into securitisation as opposed to the actual mechanism itself.
Mr McFadden
Yes. Mr Askew, you began your introduction by telling us what venture capital does in the UK and so on, but again that is quite small, too, isn’t it? The Breedon report said that only 3% of small businesses use equity finance. You have been around a bit longer than the crowd-funding guys. Why has it been so small in the UK?
Tony Askew
I think it has been a systemic problem in this country. I would rate the UK behind Israel, for sure, on this particular point. We like to compare ourselves a lot with the US, but we should be comparing ourselves with other countries first because we have had a couple of stop-start cycles. I think there is more that can be done in the UK to join up. I think a lot of very good thinking and well-meaning initiatives are certainly coming out of Government and from private individuals, but we do not quite have what we in the venture capital industry would call the ecosystem humming in the same way as you certainly have in Israel, and you definitely have in multiple areas across the US. Personally I have invested in the last 15 years in companies across the US and across Europe, Israel and the UK, and what I notice, time and time again, is that we have these sectors or classes that do well over a period of time but, on a systemic basis, this is not as caught up as elsewhere.
Mr McFadden
What do you mean by “systemic”? To describe something as “systemic problem”, what does that mean?
Tony Askew
What I mean by that is just repeatable entrepreneurs planning businesses, being successful, going back and doing it again, and going and doing it again—people who have made money giving their time to help other people to make money themselves.
Mr McFadden
That sounds like a reason why it should be growing. My question was: why is it not growing?
Tony Askew
Part of the reason it is not growing is there have been various issues around incentives and tax policies over many years, but there is a fundamental issue that we have to deal with in education and culture in this country. We have an education system that for many, many years has prioritised law, medicine and the professions at the elite end over things that are more entrepreneurial, which just has not happened in some of the other countries that we certainly invest in. Secondly, historically we have had—if you go back 50 years—a very strong science and development base in this country, but we have never quite latched the commercial engine on that we all hoped for when we had the brain drain in the 1970s, and to the extent that we have had a brain drain in the last decade and so on.
Mr McFadden
Every Secretary of State for industry for the last 30 years has said this.
Tony Askew
Exactly. You are trying to probe me for the reasons, and I think there are many reasons here that we are struggling with as well. At least at the BVCA, we are trying to hook as many of the people up together to try to get over this issue. One of the things that has happened in the last decade is that you have seen a genuine interest in creating entrepreneurialism, a genuine early-stage investor set of very high-quality, well-meaning seed funders and angels that are creating, as you will have read in the newspapers I am sure, the groundswell of start-ups—the gentleman next to me will be able to testify to that as well—that are coming out of the UK. We just need to continue with that momentum, but it is still behind where some of the other “ecosystems” are. One of the funding gaps we see right now is what you call the series B—when you have a company that is robust, with 50-plus people, executing well with good revenue characteristics. There is surprisingly less funding available at that level than on what they call a “fire power” level—the big fund willing to put tens of millions of pounds or dollars into the business to get it going, which you find a lot in the US, Israel and other places. It is this stop-start over a period of time. We are playing catch up, but there is more to be done and that is what we are all working on right now.
Mr McFadden
Mr Stocker, I would appreciate your view on this technology or denial of supply question, but I also want to ask you about growth. You were quite bullish a minute ago when you said, “We do not want to be in the alternative finance space. We want to be part of the mainstream finance space.” I am going to quote your colleague just for speed’s sake. Mr Desai’s evidence to the Committee says: “In due course Funding Circle could represent 10% to 20% of lending to small businesses”. Can peer-to-peer credit funding—whatever term we want to use—get to that kind of level?
Anil Stocker
Definitely. I think we are already seeing it in the growth rates that have occurred over the past three years. If you add up all the platforms’ volume that they will do this year, it will be £1 billion. If you extrapolate forward with the growth rate, by 2018 to 2019, we can see alternative finance contributing £25 billion to £30 billion.
Mr McFadden
What is it about what you are doing that can break the size cap that the traditional non-bank venture capital industry has not been able to break? It has done some good innovative things, but it has never become a commonly used alternative to bank lending. Why are you able to do that when Mr Askew says he has issues?
Anil Stocker
We are not doing exactly the same thing. Finance is a very broad sector. You have equity, debt, asset-based finance, invoice finance, factoring and mortgages. There are some things the banks do very well, and mortgages is one of them. Banks like to go into sectors where they can grab a lot of collateral. Banks view everything as, “How much collateral can I get for the risk that I am taking?”
Mr McFadden
Yes. We talked about that in the last session.
Anil Stocker
You talked about that in the last session. What I think platforms such as ours and Funding Circle are doing is taking a whole new approach. We have better data now than ever before. We have a chance to redefine completely how we think about these products. We can introduce new products. We are not saddled by branches, big bloated infrastructure, cost bases and people. We can start afresh and build products. Businesses are voting with their feet. A business can leave MarketInvoice any month they want with no termination fee, yet they keep on coming back and using us. That proves that we are building products and also that there is demand for new financing products. The banks will say, “We want to lend but no one is asking for a loan.” That is because the products they offer are not desirable and not the ones that business owners want. They want to come to the next generation of finance providers such as ourselves, and that is how we can build sustainable models.
Mr McFadden
You are pretty bullish about size then in terms of the potential share of the market? If this 10% to 20% is correct, are we looking at a five-year timescale for that or less?
Anil Stocker
I think we can have a meaningful impact in the next four or five years.
Mr McFadden
I have been quoting your evidence, Mr Desai.
Samir Desai
Yes. Companies such as Funding Circle and MarketInvoice are backed by the venture capitalists that backed Facebook, Twitter and companies like that. These are networks. As Anil said, we have been called “small” for many years, but we are doubling to trebling to quadrupling every year and eventually that leads to very big numbers. The analogy I like to use is that if you look at big businesses, they do not have to borrow from banks. They can go to bond markets or equivalent syndicated loan markets and borrow the money directly from big investors. Platforms like Funding Circle allow smaller businesses to borrow directly from investors as well. If you look at bond markets or syndicated loan markets, they can be anywhere between 20% and 40% of finance markets, or even higher in the US. There is precedent for this in larger business finance. There is precedent for it in other markets like online music and online books. There is no reason to believe that it will not happen in this sector as well.
Mr McFadden
If the Chairman will indulge me, I want to ask one more, which is about the Government’s role in all this. Perhaps I will put this to you first, Mr Askew. The Government has tried various schemes over the years to support venture capital, such as the Seed Enterprise Investment Scheme. Can you give me your views on that? Then I am interested more generally in what you think of Government efforts in this area. I am not making a partisan point here, but I suspect that they have tried various schemes that are often not well known, and it has been quite difficult for the Government to design something that hits the sweet spot here.
Tony Askew
Yes to the last point, very true. Two of the most successful instruments have been the one that you referred to, SEIS—Seed IS as people call it—and EIS. I think that is one of the things that has led to this rather good state we are in at the moment, where the very early stage of capital is far easier to come by now than it was certainly five years and definitely 10 years ago, when the boom and the bust had finished. I think what Government can do typically is set the right taxation frameworks and level those out. There are pockets around early-stage finance where, if you look at the regulation, it does not make sense. We could spend a whole afternoon on that and there are people who work on this day to day. Individually, they do not seem that big an issue, but when you take them as a whole, it creates this framework for an entrepreneur where they do not quite understand enough about the various different formats of the financing. It gets very confusing and I think we at the BVCA try to simplify that with standard terms and conditions across forms of investment documents, so that if you want to raise early-stage finance, you are not reinventing the wheel each time. As I said in my preamble, I think the ecosystem here is a few years behind some of the others and we are getting there. What can the Government specifically do to address this issue of the later-stage funding, which I mentioned to you as being beyond? We are unusual in this country in having these massively fragmented Government-backed pension funds. In aggregate, each is very small; they do not have the capacity or the expertise to think about early-stage alternative investment. You put that against what happens in the US, particularly, say, with CaIPERS, which is mostly public money. These are vast funds and they are able to allocate a very small portion, so on a risk-weighted average on the whole fund, it is a very small amount. But, of course, a small amount of venture capital goes a hell of a long way. If you take a £1 trillion fund and allocate 0.5% to venture capital, that is an enormous stimulus that you give the venture capital industry. That is precisely what happens with these large pension funds in the US. We have nothing similar here. There is one very simple thing that would not change much at all, because you would still have the pension funds and you would still have the pension arrangements for teachers, firemen and so on, but actually thinking about how you could start to pool together these so far untapped sources of financing is something that would be very interesting to explore.
Mr McFadden
That is interesting. This is a diversion, but some of our public sector pension funds are what they call “funded”, which means a fund exists, and others are “unfunded”, which are just paid every year out of people’s taxes. I will leave that one there.
Samir Desai
Do you mind if I chip in?
Mr McFadden
Go ahead. The exam question is: what can the Government do?
Samir Desai
One of our biggest bug bears is that there is a major tax distortion that puts individuals that lend to small businesses at a huge competitive disadvantage to banks. We have been lobbying for a number of years to get this changed. Let me explain what it is. If an individual lends to a business and that business goes bad, they cannot offset any of the losses against the interest or tax. To put it in a very simple scenario, if an individual lent at 5% a year to a selection of businesses and 5% of those businesses went bad, their net return would be 0%, say, but they would still pay tax on the 5%. They would end up paying tax even though they had made no money. To put it another way, if a bank were to sign up to Funding Circle and lend on exactly the same loan as an individual, the bank would, effectively, be able to pay no tax and offset all its losses, whereas the individual would have to. What this means is that for a vast selection of businesses that—for want of a better word—you would classify as “riskier”, those are the kinds of businesses that unfortunately we are unable to service at the moment, as individuals or the thousands of people in Funding Circle cannot really lend to those businesses profitably. We have the US business, as I said. In the US this is not an issue. The irony is that if a US individual now were to come and lend on the UK Funding Circle platform, again they could offset their losses against tax, whereas a UK individual cannot. The biggest issue we face is around applying an outdated tax system to what is effectively a very innovative activity.
Tony Askew
I agree with Samir’s comments. The British Government have given quite a lot of attention to alternative finance. We participate in the Business Finance Partnership whereby the Government are deploying some of their wholesale funds to the platform. That is welcome. That helps the industry in terms of building trust and pushing into the mainstream. I think a key thing is that, like it or not, the big banks have a very captive relationship with SMEs. Small businesses will do everything with one bank and the bank effectively locks them in. If they have given them an overdraft, they cannot then go and shop around for invoice finance, asset finance or crane finance. They first have to go to the bank, and the bank then has to give them permission to go elsewhere. Through the debenture system and the contracts that many businesses are signing up to with the banks, when they do not fully understand the terms that they are signing into, it means there is an oligopoly structure of the big banks controlling the SMEs and where they go. They cannot shop around. If they want to go elsewhere, they force them into their own product. I think there has to be a little bit of investigation into anti-competitive behaviour there by the banks as well.
Chair
I have been having conversations on and off with the venture capital industry for 30-odd years, in various capacities, and a conversation does not last very long when three or four venture capitalists gather together with somebody from Government before tax relief comes into view, and tax relief is now in view in this conversation. Mr Askew, you did say earlier that you wanted to level the tax playing field. Did you have a specific proposal there in mind? Where are you going to put the taxes up in order to shave off these edges where taxes are too high? You were nodding your head vigorously in agreement with what was said on either side of you—
Tony Askew
Yes, I was nodding my head at something that Samir said.
Chair
—both of which were tax reliefs being proposed in various forms.
Tony Askew
Yes. I think what we are asking for is just a level playing field. As Samir was mentioning, it is crazy that a corporation with massive balance sheets and the ability to hedge is essentially able to take a long-term view on how it manages its tax affairs, whereas an individual is on a point-by-point transaction. As I said in my response to Mr McFadden, it is very hard to go into each individual point, because there are so many in the UK tax code that it is not straightforward.
Chair
In other words, it is an extremely complicated tax system.
Tony Askew
Correct. If you talk to an American about this, their eyes start to glaze over, because you have to start hiring an accountant or a lawyer to figure this stuff out and once you start doing that, the barriers have gone up.
Chair
So you do in the United States. Do not think for a moment their system is straightforward.
Tony Askew
It is not; I invest there. It is also bad, but the tax code is somewhat simpler in this regard. In many ways for private financing, it is much simpler. My point is: although it is a nasty word in government to hear about tax incentives, they do matter. Incentives matter a hell of a lot. They matter a hell of a lot at the early stage because you are putting so much on the line. An entrepreneur is putting—
Chair
I am sorry to interrupt, but you are back to describing the proposal for tax relief or the justification for tax relief—which is a case that has often been made and is often well made—but the question I am asking you is: if we are going to level this playing field without having to find a shed load of cash, we have to find the taxes from somewhere else in this part of the industry.
Samir Desai
I do not know, just to jump in. Using the specific example I spoke about, ordinarily you would think that if you just let people offset their losses, there will be less income tax paid, but start to consider all the secondary effects of it. Every business that borrows through Funding Circle employs, on average, two new people within six months, and 33% to 40% of those businesses would not have been able to access the finance if it was not for us. This is all independent research by Nesta. What you are seeing is that a number of businesses that could not get access to finance are able to access it and employ more people. On top of that, those businesses—on average, again—increase turnover by 25%. Those businesses are making more money and are paying more VAT, and they are probably making higher profits, so they are paying more tax. On top of that, you get a number of additional people who probably would not participate in this type of activity ordinarily. By that, I mean that for the highest rate taxpayers in the UK, it is less advantageous to do peer-to-peer lending. They are likely to shift into this type of activity and there is likely to be more tax paid. One of the things that we do not promote as much, but that will be an unseen side benefit of the rise of peer-to-peer lending, is that it will be a huge tax boon for the Government because what you will get is a number of individuals who will be paying tax on the gross interest, not the interest that has been paid after banks have taken all their costs and losses out of it. I think, perversely, that when you look at the secondary effects, this will increase the tax take.
Chair
The dynamic effect will come through once the—
Samir Desai
Exactly. In reference to our change, for instance, Labour’s small business taskforce started recommending these changes a year ago, and I think this is the case with the venture capital stuff as well. On the surface of it, it always appears that there may be tax leakage, but I think, by encouraging this type of activity and by giving more businesses access to finance, it is unclear whether the tax take will go down, and it could go up.
Chair
Pat McFadden made another point, which was that there are quite a lot of schemes out there that many people might not fully understand and I think, Mr Askew, you said that SEIS and EIS were two of the better ones. We have several others on the go in the equity sector: the Venture Capital Trust Scheme, the Business Angel Co-Investment Fund, the Enterprise Capital Fund Programme and the UK Innovation Investment Fund. They are less worthy are they, Mr Askew?
Tony Askew
I would not say they are less worthy. I think the response was very specific around early-stage financing, which is where EIS and SEIS play in very strongly, because that opens up—
Chair
What I thought I heard you say earlier was that what we really need is less complexity and a level playing field. What I am trying to point out is that if we do that, these schemes are going to go, aren’t they, and we are going to be replacing them with lower, simpler taxes, but that means higher taxes for some people operating in some of these areas?
Tony Askew
I think what is happening at the moment is you have a series of fragmented Government support schemes, because what has happened is that the venture capital market is not mature enough yet. When it is mature enough and it becomes self-sustaining, a lot of those schemes tend to fall away. If you look at the history of the US and Israeli markets, these things were prevalent for 20 years or longer in the US.
Chair
These should have sunset clauses on them, albeit long sunset clauses?
Tony Askew
These will naturally sunset as the industry grows and matures. The reason why I think it is important is because if you do not have a vibrant entrepreneur base in an economy, you start to atrophy over time. I think that is precisely what happened for a period of time in this country when there were disincentives—taxation through to cultural—to take a risk and go for something with your life, when in other countries in the world that was not the case. They are now reaping the rewards of that, and what we are trying to do is to go, “Yes, of course, as you look at it point by point there are lots of different fragments,” and so on, so we want—
Chair
These are always set up with the best of intentions by successive Governments.
Tony Askew
Absolutely.
Chair
I have a list of seven here for straightforward lending.
Mr McFadden
There would be more than that.
Chair
There are more than that, yes. I just have the list of the seven main ones, and so it goes on. They may sound good when announced on Budget day, and they may benefit certain specific groups, but one has to ask whether this is really the way forward for trying to assist either lending or equity. What we are interested in hearing is not so much more specific schemes, whether it is for pension funds or targeted changes on personal tax relief, but something that at the cost of removal of some of these schemes or reduction and eventual removal can replace them with something that is simpler, better understood and can be of benefit right across the industry without the pluses and the minuses that come with targeting. Am I describing something that is of interest to the venture capital industry?
Tony Askew
I think what you said is true and where we are in the cycle at the moment is there need to have been Government incentives to move us through that period of the last 10 years.
Chair
All right.
Mr Love
While we are on this subject and being fruitful, perhaps you would put on record your organisation’s attitude towards the equity gap. You talked about early-stage finance. There is a gap there. We never seem to be able to construct schemes to be able to fill that gap. What would you and your organisation suggest?
Tony Askew
Sure. I think there are pockets of capital that can still be tapped. That is the trick if you want the Government to be removed long term through the incentives programmes. I think you have to stimulate that, whether it is through structural, regulatory, accounting or whatever practice we have in play. There are two big funding pools that I think we can tap more. One I have spoken about, and the other is corporate venture capital. My organisation, Reed Elsevier Ventures, is a corporately backed fund. We are one of certainly fewer than 10 on the FTSE, when you compare that with more than 50, I believe, on the Fortune 100 in the US. That is partly to do with cultural activity. It is partly to do with close proximity to the venture capital industry in the US. It is also partly that over the many years of various incentives and so on, organisations have just cut adrift the notion of very early support and venture capitalists. Deloitte estimated there is over half a trillion pounds sitting on corporate balance sheets, and there is certainly a hell of a lot of US money that is “trapped” through their tax regime in Europe and in the UK. That is another large pool of capital that would seem to be available if we can figure out the right way to unlock it. I think the answer to your question is to try to find these larger pools of capital in the same way that Samir and Anil are doing in trying to unlock the huge pools of capital that sit in people’s balance accounts in their personal lives, and have that flow into the early stage market.
Mr Love
You opened up a whole Pandora’s box there. I have to come on to the regulation of crowd-funding to get some of your attitudes. I would ask you the very obvious question—whether you welcome regulation. For whatever reason, the Financial Conduct Authority has introduced regulation in two specific areas, which I am sure you are only too well aware of. Those rules were obviously for consumer protection, but have they remained flexible enough to allow innovation to continue, Mr Desai?
Samir Desai
Funding Circle was one of the three founding members of the Peer-to-Peer Finance Association. We formed that with Zopa and RateSetter three years ago, and the entire purpose of that association was to lobby for regulation. What we felt was that the industry would be regulated eventually, so we did not want the tanks to turn up on the lawn at some point. We also felt that it was important that protections were put in place—especially if a platform were to fail—to make sure that investors could still get their money back. We have welcomed the regulation and we have been working very closely with the FCA to put it in place. I would say we have had a very positive experience. We feel that the regulation that has been put in place has been very proportionate. They have been willing to listen to our concerns. Certainly, on the peer-to-peer lending side of the regulatory regime, we have been very happy with it. Now it is early days, and people have always said to us—
Mr Love
Okay, that is fine. Mr Stocker, MarketInvoice is not regulated. The FCA has decided against that. Are you in agreement, or would you like to join the other association and become regulated?
Anil Stocker
You are absolutely right: MarketInvoice is not regulated at this point in time. We joined the Peer-to-Peer Finance Association, alongside Funding Circle and other platforms, because we wanted to run ourselves as if we were regulated. The reason why we are not regulated is basically very simply because we are dealing with businesses and sophisticated investors at this point in time. We do not have any consumers putting money into the business and we are not lending to consumers, so we do not touch any regulated activity. As I said, we are running ourselves as if we were under the same regulation that Funding Circle and other platforms have right now, and we would embrace an element of regulation over what we do. With regulation, you always have to tread carefully because one of the reasons why you see companies such as ours and Funding Circle here in the UK is that it was relatively light-touch regulation that let us get into the market and become a presence here. What usually happens when regulation is heavy-handed is that it serves just to benefit the incumbents, and that is probably why—
Mr Love
That is my very next question because there is obviously concern that regulation it will be a barrier to entry for new platforms.
Anil Stocker
Exactly.
Mr Love
Mr Desai, did your association come into being in order to stop others coming into being—new platforms; competition?
Samir Desai
No, I would say the reverse. The capital requirements have been set at low levels to encourage innovation. What we used to do is that Zopa, RateSetter and Funding Circle used to sit in a room and we would all have our different legal opinions and we would say to each other, “You are doing this wrong,” and someone else would say, “You are doing that wrong.” No one could agree because the lawyers could never agree, whereas what is now in place is a standard framework for companies that want to enter the space. I would expect more new entrants now because there is not this grey area. Companies like Google—large companies—I would expect to enter the peer-to-peer lending space, which we think is a good thing. It will expand the market. We do not think we are necessarily competing against each other yet. We are really competing against the banks and the vast financial system. I would say the opposite: I expect it to encourage competition, as opposed to the other way round.
Mr Love
One of the rules that have been introduced is to restrict the amount that retail investors can put into schemes to a maximum of 10%. What is your attitude towards that and what impact has it had on the volume of funding that is coming through to peer-to-peer lenders?
Samir Desai
That particular piece of regulation you are speaking about is on the equity crowd-funding side. What the regulator did was to divide crowd-funding up into what it calls loan-based crowd-funding—what we call peer-to-peer lending, or is generally called peer-to-peer lending—and equity-based crowd-funding. What it says, which reflects the reality, is that equity crowd-funding tends to be more risky than, say, loan-based crowd-funding, so there is more regulation and more restrictions around that area. In terms of that particular policy, we have not seen any effect because it does not really apply to us.
Mr Love
How do you ensure that your investors are not investing more than 10% of their assets?
Samir Desai
We do not, and if it is someone like me, I probably have more than that in Funding Circle lending.
Mr Love
They self-certify themselves. Are there real dangers in that?
Samir Desai
No. Those particular restrictions do not apply to us. The loss rate on Funding Circle loans is about 2% a year. On some of the consumer platforms, it can be as low as 0.5% a year. What we do do is we diversify investors across lots of different businesses. What we found is that every investor that has lent to at least 100 businesses equally has a positive net return after fees, losses, everything, and 70% of those investors are earning between 6% and 10% a year. If you want to lend on Funding Circle automatically—if you do not want to pick and choose the businesses you lend to—you have to lend to at least 100 businesses. There are a lot of protections in place in terms of diversification. We have all the risk warnings on the site—“Your capital is at risk”; things like that—and this is a much lower risk activity than investing in equity.
Mr Love
Mr Stocker, in an earlier answer you said that your organisation only has sophisticated investors, high net worth individuals and people who can look after themselves in the marketplace, if I can put it that way.
Anil Stocker
For the moment, yes.
Mr Love
Why did you decide to do that, and are you looking actively at extending your list of investors?
Anil Stocker
Yes. Again, you have to remember that we set up MarketInvoice against the backdrop of mis-selling products to various people. We wanted to be a little bit safe in the sense that we wanted to stick with professionals, at least until we had proven the model was sustainable. We have a loss rate of 0.1%. It is extremely low. We have been able to build up experience. We have done a statistically significant sample of transactions. We have learned a lot. We have refined our model and, yes, now that we can see that it is safe—it is scalable, it is working—we will look to extend and open up a way for retail investors to deploy funds on our platform. Yes, that is definitely in our plans.
Mr Love
Let me ask, finally, both of you to respond. There has been quite a lot of concern that the internet as a platform gives opportunities for fraud in all sorts of different ways. It must be clearly on both your radar screens. How are you responding to that both in terms of dealing with suspected fraud, and also in reassuring your investors that they will be treated fairly?
Anil Stocker
We do a lot of anti-fraud. The internet obviously invites fraudsters, but that was happening in the offline world as well. There were fraudsters in the offline world as well as the online world. What we have at our disposal is using the internet to uncover fraudsters in ways that they themselves do not even understand. You can trace, track, monitor and check a lot more things by looking at the digital footprint of someone than you can glean from having a relationship based on walking into an office or branch and having a conversation with someone. It is harder to hide yourself if you are a fraudster in the world that we live in with the digital insight that we have. Where we have uncovered—and we have—instances of fraud and genuine attempts to defraud us, we have done so through ways that were not face to face, looking at them in the eye. It has been through ways we have spotted it online. Of course the internet invites fraudsters, but it also gives you a better tool to combat it.
Mr Love
Mr Desai, in answering that question, perhaps you can just pick up—this is my final question—cyber-attack: what you are doing to prevent catastrophic attacks made upon you?
Samir Desai
It is obviously a constant worry and something that we take very seriously. We run penetration tests on our website every three months. What that means is that we basically pay a load of sophisticated hackers to try to break in and we make sure that there are clear delineations between the front-end site and any back-end data, in terms of financial data and things like that. It is constant vigilance and constant testing to see if others can break through our systems, because we know that it has been a common occurrence. What we have also done is to separate out any financial transactions from the front-end site as well. Whenever money leaves or enters the Funding Circle system, it is always manually reviewed. To be honest, that has been the safest way of ensuring that financial data does not get stolen.
Mr Love
Do you separate the investors’ funds from your own funds, and do you have a trail that someone could pick up if the organisation went—
Samir Desai
Yes. That is a regulatory requirement and, frankly, we were doing it before regulation even came in. On top of that, what Funding Circle has is a S&P-rated back-up servicer. What that means is that if, say, we were to go bust tomorrow, they would effectively step into our shoes and ensure that all the loan repayments still got collected from borrowers and distributed, and they would manage the client account. When you talk about systemic risk, there is no systemic risk with these platforms. We are not too big to fail; we can fail and there is an orderly workout.
Mark Garnier
Mr Askew, could we look at the relationship between venture capitalists and those entrepreneurs who seek their advice? Gil Dibner, who I think wrote some ethics and professionalism within venture capital for BVCA, quoted that venture capitalists need to ensure the right investment from the right investors at the right price at the right time. How do venture capitalists ensure that?
Tony Askew
That is everything. That is our job. Often, people get that wrong and that is the nature of the risk we take, which is why it is high risk, high return, because when it does pay off, it really does pay off very well. Typically, they do not work and that is the way. If you look at the statistics of the venture industry, a huge number of the guys with a PC fail quite early. It is a little bit akin to medicine and drug discovery, in that the venture industry is structured ideally so that you fail cheaply and fail early. In the recent 10 years, we have seen an enormous advance in the underlying infrastructure that has become now rentable. Rather than having to go and buy a server for a million bucks, you can essentially now rent a server farm at a fraction of the cost and burst into it through Amazon. Of course that has reduced the level of capital that has gone in, but also increased the cycle time of failure, because now entrepreneurs can fail cheaply and fail quickly at home before they have even raised more than $10,000 or $20,000. I use dollars because I invest in dollars, you understand.
Mark Garnier
Yes.
Tony Askew
What you find is there is an enormous failure rate within early-stage capital, which is why as venture capitalists we ponder this very point that Gil is raising here. It almost seems, if you look back, that stuff obviously looked that it was going to win, but in the mix it can be very disconcerting. You have things that are working and then they do not work—they fall out of bed, and then you get it right. Every successful company I have invested in has had this crisis moment at some point when things do not look like they are going that well. You have to push on through and everyone has to take a deep breath, typically.
Mark Garnier
It is very labour intensive assessing a venture capital prospect, isn’t it?
Tony Askew
Very much. Very much.
Mark Garnier
Your return has to be quite substantial in order to justify that labour, if nothing else?
Tony Askew
Yes. If you look at the gold-standard venture capital structure, it would be west-coast style—west coast US; I do not mean Cornwall—in that it is very much a hits-driven business where you will have one or two big return companies, like a Google, a Facebook or a Twitter, that essentially, to use the parlance of the industry, return the fund. In other words, if they have raised $1 billion from limited partners, that one exit, as we call it, will pay for that $1 billion and then all the other little ones that come through is where everyone in the fund makes their money. You get a few like Google and Facebook that blow through that and you get multiple returns on that, but typically that is the west-coast mindset. If you invest on the west coast of the United States, that is what everyone is in it for. There is a lot of weeding out early on, which is why you find this notion, which particularly started on the west coast, of the acqui-hire, which you get less of in this country. The large technology companies in the US will buy young companies with 10 or 15 people that are struggling, but have really smart talent in them—they just have the smart talent working on the wrong stuff—and they will pay $1 million or $2 million per employee to acquire that company. That is the nature of the value of a strong talent pool on the west coast because it is the difference between having a big win and an okay win. With the venture capital mindset, the big win is what pays for everything.
Mark Garnier
We are talking about equity or equity debt splits?
Tony Askew
Equity.
Mark Garnier
Only equity?
Tony Askew
Yes.
Mark Garnier
The problem for venture capitalists is that you have to identify it, you have to work out your deal in the first place, you have to run with it, you have to recover what assets you can when it fails—it sounds like they fail as often as they do not fail—and then, when you have a success story, you have to work out what your exit is going to be. Your exit can either be a trade sale or an IPO, such as Google or Facebook, at $100 million.
Tony Askew
Exactly.
Mark Garnier
Clearly, if you are an entrepreneur who comes up with an idea and it is just a bad idea, you probably won on that. You had a free chance to try out your idea, or a relatively low-cost chance. Do you find on the other side that people feel that they are being slightly rolled over by the venture capitalists? If you do have a very successful business—I completely accept that some businesses just would not be successful were it not for the venture capitalists—do you get many complaints that people feel they have had a deal written that, with the benefit of hindsight, they would not have done? This is partly due to the fact that some of these venture capitalists may have identified something that the entrepreneur did not, but it also might be due to the fact that an entrepreneur is good at writing code or is good at producing fruit juice—whatever it happens to be—but what he is not as good at doing is writing business deals with people who do this for a living. How do you square that circle?
Tony Askew
That is a very important point because when that manifests it puts people off. It is like that whole customer service pyramid that used to be drawn: with every complaint there are at least 10 or 15 underneath that and underneath that and so on. That is true of all kinds of behaviour. Again, this is why I go back to what I think is the gold standard, which is what developed on the west coast of the United States and, in a sense, has been exemplified in social media where everyone talks about everything. In the US, if you get a bad reputation for that kind of stuff, you will see less good deals going down the line. As you move into the other places to invest in the UK and elsewhere, which are less well developed, of course you end up with a bit of a patchwork between the understanding of an entrepreneur, how well educated they are at raising money and how aggressive individuals want to be as investors, and you cannot patrol that kind of thing on a point-by-point basis. But rather like in a marketplace, you can start to set the conditions as an industry of what good practice is. Good practice leads to spectacular results, and bad practice typically leads to trouble, lawyers getting involved and failure. People are smart. Even the very aggressive types will very quickly realise the quick route—the best route to victory for everybody—is the win/win and that the win/lose approach does not pay dividends. We absolutely pay attention to that, which is why we talk at the BVCA about the standard document. One way in which these can manifest, if you are not careful, is in a bubble, on a single-point basis. If the entrepreneur is not well skilled and clued up on this—the investor could be someone who is a bit more aggressive—and they are working to their own documents and they are working with their own lawyer, and no one is checking these documents have some sense to them—of course, you are going to get the potential for a bad deal to be done. But if you are working with industry standard documents that everybody has accepted and that have been invested on time and time again—the “vanilla-style” documents where you should not be discussing any of this stuff anyway, because it is just what everyone else does—you start to do two things. You skill up the industry with what to expect. That was why I made a point a little bit earlier about the education system. I think education plays a big role in that and, responding to Mr McFadden’s question about what it meant by systemic, the more returning entrepreneurs you have, the better clued up the next generation of entrepreneurs are, because the best thing an entrepreneur can partner themselves up with is someone who has already done it and the big adviser networks that you find. We are beginning to build that at scale also in the UK through programmes like Seedcamp and Techstars, and all these other great programmes. Coming back to the point I was making, what you can do as an industry, and what we heavily promote, is the notion of what best practice is. Talking about the BVCA, we have training courses and seminars, we get people together, and we encourage people to go to these early-stage programmes. The third thing I would say in that an indicator of the advancement of the venture market ecosystem is the number of people who do understand what venture capital is. That is still a question mark for me in the UK. Just wandering around the City there is a massive misunderstanding of what venture capital is versus other forms of private finance, which you just do not get in Israel, you do not get in China and you certainly do not get in the United States.
Mark Garnier
Can you expand on that? It is interesting that you talk about the west coast of America being the model, but what you have there is a very innovative business environment—it is very different from our business environment. You also said that the UK venture capital is relatively new, but Ronald Cohen has been at this for 30 years and has obviously made quite a lot, having started it—
Chair
Very good at lobbying for tax breaks, too.
Mark Garnier
Very good. We cannot keep him out of the place.
Chair
He picked on Gordon Brown very well on the tax-break front.
Mark Garnier
It is interesting you talk about the City not quite understanding what venture capital is. Do you think it is because the City of London—in whatever form it takes—simply just has this ancient merchant banker-type mentality that has not caught up with the rest of the world, or do you think that it is because the types of businesses that you have in America generate that type of innovative thinking, and we are just not seeing that type of business here in the UK? Can you put your finger on it, aside from the obvious—tax?
Tony Askew
I think there is quite a lot in that. When I said that the UK industry was further behind, absolutely. Apax and Ronald Cohen have been around since the 1970s, but there has not been a scale platform in this country for venture capital for lots of reasons, which we could spend a whole afternoon going into. It is the fits and starts point that I made at the beginning when I first introduced myself. It is only in the past 10 years where we have seen a consistent push of entrepreneurialism. You have seen entrepreneurs written about across the press. We have TV programmes about it. We have early-stage funding programmes about it. We have people willing to put their own capital through forums like the two gentlemen next to me, and Seedcamp and so on, and more institutional money coming in. That is one thing. The second part of this is when I say that the City does not understand it, some individuals do, but when I talk about venture capital, I often get misunderstood with what venture capital is.
Mark Garnier
Can you give me an example of that? Having been in the City for 27 years myself, I wonder whether I know what you are talking about. Where does the City get it wrong? What do you see as venture capital and how does that differ between, say, angel financing or what 3i was doing, for example?
Tony Askew
Right. Well, 3i used to be venture capital and then it moved into private equity. Apax used to be venture capital and then it moved into private equity. Where there is confusion in this country—more so than there is in the US—is the split between private equity and venture capital.
Mark Garnier
Private equity is looking to maximise existing businesses where venture capital is looking to start?
Tony Askew
Correct, using leverage usually, and venture capital is all equity, very high risk, very early stage. I think the reason that it is misunderstood is just that there has not been enough of it. I come back to the education system. If you think about the people you graduated with, most did not join entrepreneurially backed companies; they joined big companies so they could have a CV. They joined lawyers. They became a medic. They became accountants and consultants and so on. The UK became the service hub for the world, which was a good thing, but in doing that I think we had a prejudice against people just standing on their own two feet and getting on with it, and finding other people of like mind to back them. That is what we are dealing with now and have been dealing with for the last 10 years quite well. What I have been expressing is that we continually need to push on that because of this lever effect that we have already spoken about—for every dollar and pound that goes into venture capital, you have all these other benefits: jobs; cycling of the cash in the market; an opening of people’s minds; and, hopefully, you have a return to some kind of value-added intellectual industrial base that would match the UK’s position on a field-weighted scientific basis as being the No. 1 place to do scientific research in the world. It has just overtaken the US on that, according to the Business, Innovation and Skills Department, which did a report on this. We still have four of the world’s top 10 universities in this country. Does that last? Why can’t we put this commercialisation energy much more prominently on that intellectual output that we clearly have pouring out of our institutions every year?
Mark Garnier
Have you found that the bad press that private equity guys have been getting has spilled over into venture capital because of that misunderstanding, or do you think there is a clear distinction?
Tony Askew
Not with people who know about venture capital, absolutely not—no. Entrepreneurs who understand this and are dealing with venture capital understand what that is.
Chair
I am going to end by coming back to where I said I would begin—partly because Mr Stocker and Mr Desai have been very patient for the last 10 minutes, although it has been very interesting listening to some information about the venture capital industry—the single measure that can improve competition in your industry and help to get it going. Mr Stocker has been particularly patient this afternoon.
Samir Desai
I would just reiterate the change that I talked about, and I would call this less of a tax break but more of a tax common-sense simplification. Most of the investors who come to Funding Circle expect to pay tax on their net returns, just like every other investment product. I know you mentioned some points—
Chair
We have that one on board.
Samir Desai
You mentioned some points about tax breaks and I was waiting to come to the defence of Mr Askew. In terms of Funding Circle, we set it up five years ago. I and my two co-founders quit our jobs in the middle of the biggest recession there was—or that certainly we had experienced—and we raised £600,000 to build the initial IT and launch Funding Circle. I can tell you now that we would never have been able to do that if it was not for the EIS scheme. Investors were taking a chance, but they knew there were tax benefits to doing so. Funding Circle now employs 170 people globally; 120 of those are in the UK. We think we have had indirect job creation of 12,000 jobs through the Funding Circle platform from small business borrowing, and I have a number of letters that will testify to say there will be a number of small businesses that would not be trading if it was not for what we had come and done. While it is very difficult to extrapolate the effects of some of these tax changes, what I would hope this gives is a small example. They are very beneficial. Changes that may appear small, and may not appear as potentially headline grabbing can make a huge difference to the ecosystem. Coming back to the tax that I am talking about, there will be tens of thousands more people lending through the Funding Circle platform within a year if this tax change were to be made. We are not asking for people to pay no tax on their gains. We are just asking that, if they lose money by lending to a business, that can be taken into account and they can offset those losses.
Chair
That is helpful. Mr Stocker?
Anil Stocker
Yes. MarketInvoice is also an EIS-registered company and EIS did make a big difference for us when we got going—this is a similar story to what Samir has. I think the single biggest barrier is still awareness. Too many companies and businesses are either frustrated with how they are being dealt with, or with the choices that the bank is giving them, and they do not know where to turn. What that manifests itself in is a reluctance even to have a conversation with your bank manager, or even to go and request something from your bank, if you fear that you are going to be disappointed.
Chair
Or ripped off.
Anil Stocker
Or ripped off or turned away with nowhere else to go. It is quite a lonely place being an entrepreneur of a business. Let us say you are trying to get from £2 million to £10 million. You are juggling lots of different things. You might have contracts in different countries. You are travelling. There needs to be some way that we can either build awareness at the point of application, or build awareness alongside the banks and banking infrastructure. I think some things are already being debated and discussed around referrals and ways of signposting, just to build awareness, because I think that with awareness you are going to have a lot more businesses finding out about us, using us, and creating jobs. We have companies that had never exported to the US. They can only export to the US now because we helped them. It is the same with companies that are exporting to Africa, Asia, the Far East. British businesses want to export and take their talent across geographies. The banks should be doing this; they are not. We are filling that void and more people need to find out about us. We need to think about that in a structured way.
Chair
We have found it extremely interesting this afternoon. Thank you very much, all three of you, for coming to give evidence. As you put it, there must be some way of raising awareness, so if you have the inspirational thought—you cannot rely on politicians to have those inspirational thoughts—or any further points, please give them to us. We are very much in the market for them as we are thinking through this area of finance. Thank you very much indeed for coming to see us. Oral evidence: SME Lending, HC 204 3