As bank lending to small businesses has dropped off in the years since the financial crisis, crowd funding is becoming an increasingly important alternative for many firms, finds Mark Latham.

When George Osborne stands up in the House of Commons on Wednesday to deliver his last Budget before the General Election, he is expected to present a bouquet of voter-friendly schemes.

There is one in particular that will not only improve the flow of investment to small and medium-sized companies but will also allow savers - saddled with record low interest rates since the crash - to make better returns.

The scheme is expected to allow savers to lend cash to an individual or business and pocket the interest payments tax-free, either through the creation of a third category of Individual Savings Account (Isa) to run alongside long-standing cash and equity Isas or by allowing peer-to-peer lending to be included in the current schemes.

According to Stuart Lunn, of Edinburgh-based crowd-funding platform LendingCrowd, giving tax breaks to peer-to-peer lenders would turbo-charge an already fast-growing industry. He said: "The sector in the UK has so far attracted about 200,000 investors, but this will increase dramatically if the budget leads to tax breaks in the form of Isa."

Most savers are nowadays lucky if they can make a two per cent return on savings but a peer-to-peer ISA would open the possibility of an eight per cent annual return, albeit with more risk.

Last year peer-to-peer lending in the UK was worth £1.7 billion, with nearly half of it business lending according to a recent study by Cambridge University and the innovation think-tank Nesta. However, despite rapid growth that will take it to £4.4bn by the end of 2015, peer-to-peer lending currently makes up just one per cent of business loans in the UK.

Any move to give tax breaks to investors would increase that proportion significantly, said Lunn.

He believes that the crowd-funding sector has provided much-needed competition to the banking sector and opened up new funding routes for businesses, particularly those small to medium-sized enterprises that have found it hard to obtain loans and raise equity in recent years since the financial crisis.

Lunn highlighted the flexibility for investors in peer-to-peer lending: people can invest as little as £100 and can chose to invest between six months and five years. Among the benefits for borrowers are the fact they get a quicker decision on a business loan than they would from a bank.

In addition, because of the industry's low-cost online platforms, peer-to-peer lenders are more efficient than banks as they have low overheads and no legacy issues and can therefore offer competitive rates.

Since launching in October last year LendingCrowd has invested about £1 million in 16 companies - nine in Scotland and the rest in England and Wales. "We have now reached a tipping point and hope to ramp this up to £10m by the end of this year," Lunn said.

"By matching investors and investees we believe we satisfy the needs of both. We think there is a huge amount of growth to come in this marketplace."

But one major risk in crowd funding comes from the fact investors aren't covered by the Financial Services Compensation Scheme, which guarantees up to £85,000 of bank deposits.

However, Paula Skinner, of Glasgow-based law firm Harper Macleod, said the regulation of the sector by the Financial Conduct Authority since April last year has had minimal impact on the sector itself, but ensures investors are now made fully aware of the risks.

Tim Wright, of Glasgow-based financial consultancy Twintangibles, said the crowd-funding industry in Scotland is still small compared with the sector in England.

A significant development in Scotland last year, said Wright, was the launch of a partnership between crowd-funding platform Funding Circle and Glasgow Chamber of Commerce and Glasgow City Council.

Under the scheme, peer-to-peer loans to companies identified by the Glasgow Economic Commission will include a direct contribution from the City Chambers. To be eligible, companies must have a minimum of turnover of £100,000 and have been trading for at least two years.

Wright added that the crowd-funding model lends itself particularly well to raising investment for companies with strong brand loyalty. For that reason, craft breweries in Scotland have done especially well in raising equity through established crowd funding platforms or, in the case of companies like Brewdog, through their own DIY platforms.

But Wright said: "Less sexy sectors, such as the manufacturers of nuts, bolts or widgets might do better with loan funding."

Professor Colin Mason of Glasgow University believes crowd funding and other forms of alternative finance will have an increasingly important role to play in the financing of Scottish businesses in the years to come.

Mason also pointed to the egalitarian and democratic nature of crowd funding, where small investors not just institutional investors are able to become involved in growing businesses.

What was regarded as a wacky idea just a few years back has now become mainstream.

How Crowd Funding Works:

Although around since the 1990s, crowd funding has only taken off globally around the world since the financial crisis and is now being increasingly used as an alternative to bank lending, to fund personal and business loans, to raise equity and to support projects or campaigns through donations.
The UK Crowd Funding Association claims the world's first online crowd-funded project was in 1997, when British rock group Marillion asked fans to contribute towards the cost of a US tour it was struggling to afford.
Since then, the concept of raising finance online by persuading a large number of people to contribute a small amount of money in return for a small stake in a business or as an investment has mushroomed and is now estimated globally at $10 billion a year.
The crowd-funding concept has also been used by politicians to fund election campaigns. Barack Obama used online communities to raise cash for his 2008 presidential campaign. In the UK, both the Green Party and the SNP have turned to crowd-funding to bolster their election war chests.
The UK's first online crowd-funding company, Zopa, was founded in 2005 and has over the last 10 years lent nearly £750 million. Other popular platforms to be founded since then include Funding Circle and Ratesetter.
The first crowd-funding site to be launched in Scotland was Bloom VC, in 2010. Other crowd-funding Scottish companies are Edinburgh's ShareIn and LendingCrowd and Glasgow's Squareknot.
A wide range and growing number of companies in Scotland have now successfully used crowd funding to grow their business.
There are four main types of crowd funding, of which the first two are the most important for businesses:
l Equity: small parcels of shares are offered to the crowd in return for investment
l Peer-to-peer: this puts savers with money to lend in touch with individuals or small businesses that need to borrow
l Donations money is pledged with no expectation of a tangible financial return
l Reward: a product or service is offered in return for a pledge of money.
In the case of peer-to-peer and equity schemes, investors' money is "sliced and diced" so small chunks are lent to a number of borrowers. Equity investors become shareholders in businesses while peer-to-peer investors can expect to receive repayments each month, made up of interest and capital repayment.
Interest rates on loans charged by crowd-funding sites are often competitive with those of banks. The Edinburgh-based LendingCrowd company is currently charging between 5.95 and 13 per cent for business loans, depending on the level of risk. In addition the company charges an arrangement fee of between two and four per cent, depending on the loan's length. Unlike many banks, LendingCrowd imposes no early redemption fees.

The Investee:

STUART Dinnings, 39, who runs Growlerbeers, a specialist craft beer off-licence in Edinburgh, said he decided to apply to London-based Crowdcube to raise equity after being cold-shouldered by banks for a loan.
The £100,000 of investment he is seeking is needed to fund the opening of three new retail premises across the Central Belt, which would see the number of employees rise from three to 15. In return, investors will own 10 per cent of the company.
The equity offer launched on the Crowdcube website last week and within a few days investors had pledged a fifth of the amount Dinning was looking for.
"Our offer will stay on the website for 45 days and it now becomes a Dragon's Den-type situation as it must be fully subscribed or we will get nothing, but I am hopeful we will get there," he said.
"Once you get to 30 per cent of your target, other investors see there is interest and that the offer is successful and hopefully will pile in.
"The banks didn't want to lend: we were regarded as too high risk. I looked into raising finance from angel syndicates but I feel crowd-funding was the best option for a company of our size."
Dinnings founded Growlerbeers in 2013, the same year he graduated from Edinburgh University with a degree in archaeology. Last year he won an award from the Scottish Institute for Enterprise for his success in launching the company.

The Investor:

WHEN Bill Howie, 74, returned to the UK seven years ago to enjoy his retirement in Musselburgh after a career working overseas as an engineer in the mining sector he was looking for investment possibilities to supplement his income, particularly as his entitlement to the state pension was minimal because of the time he had spent in Australia when he was not paying into a UK pension scheme. A dramatic fall in value of the Australian dollar made his search for good investments more pressing still.
After being used to earning interest on his bank savings of 6.6 per cent in Australia, when Howie returned to the UK at the height of the financial crisis he found the high street banks were offering depositors interest of just one or two per cent.
Howie looked at other investment options, including investing in the stock market, and decided to sign up as an investor with Edinburgh-based LendingCrowd, where he calculates he can earn a return on his capital of about eight per cent once fees and the occasional default are factored in. Howie has so far invested £20,000 through the peer-to-peer lending platform but plans to raise this to £100,000 over the coming months.
"My experience with crowd-funding has so far been excellent," he said. "I am free to pick which companies to invest in and I personally assess each potential borrower according to my own criteria and can set the interest rate. As an investment, it is certainly the best route that I have found so far."