It’s no longer the automatic first option for SMEs to call upon their bank or traditional lenders for financing. The dawn of the internet age and sharing economy has opened up a number of new avenues for finance, often via the medium of crowdfunding platforms. The concept of the mini-bond very much fits this mould.

So what exactly are mini-bonds and how do they work? Perhaps more importantly, are they a suitable financing option for you    and your company? Essentially, a mini-bond is a way for businesses to borrow money directly from private investors. You could call it an advanced IOU where a company promises to repay an agreed interest rate in exchange for a loan. You can find out more by checking out this infographic from alternative finance experts Choice Loans.

In the same way that a conventional bond operates, mini-bonds are small, long term loans of between three to five years. They offer the owner of the bond a coupon interest payment with a bullet repayment of the principal at the end of the loan term.

If you’re already familiar with the concept of the retail bond, then this won’t be too hard to understand. They are similarly non-convertible and are not protected under the Financial Services Compensation Scheme.

However, there are several key differences between mini-bonds and retail bonds. Firstly, they are not listed on the LSE and being non-transferable, lack the liquidity of retail bonds. The fact they are not listed also means there is a lot less regulation and that investors are more interested by the concept and vision of the project than the cold, hard economic data. The risk is increased but then so are the potential rewards. Mini-bonds are becoming a preferred option of less established but ambitious companies who need quick investment to achieve growth.

In a traditional financial sense, this kind of investment seems risky and yet the sector continues to grow. This is partially because mini-bonds are marketed in a way that strikes a chord with a public that is not necessarily au fait with markets, regulations, rates and investing. Plus, in a time of low interest yields, the prospect of a large return is tantalising.

Mini-bonds also offer a return based on the product being offered. To give you an example or two, London burrito chain Chilangos offered an 8% interest rate plus free burritos, with John Lewis offering 4.5% plus a 2% store discount. This kind of real world return is attractive to people in a fast moving society.

Other mini-bonds have offered life membership (River Cottage) and free wine (Hambledon Vineyard). It’s this kind of product-based repayment that mean mini-bonds are a great way of financing for SMEs, particularly in industries where there is direct contact with the consumers, such as food and drink.

With estimates putting the value of the mini-bond industry at around £90m in 2012 but suggesting this could increase to £8bn by 2017, it’s clearly proving to be a hit with both SMEs and potential investors. The absence of regulation and protection, plus less financial disclosure, is clearly being outweighed by increased interest repayments and the prospect of being involved at a ground floor level in a project that makes it big.

The main concern with mini-bonds appealing to a new type of investor is that they may not necessarily understand the associated risks. The FCA has tried to highlight the fact that mini-bonds are not protected by the FSCS and that investors should not be misled into confusing mini-bonds and retail bonds.

Some high profile cases of failure have also increased caution, such as the collapse of Australian firm CBD Energy only 15 months after issuing £7.5 million of ‘Secured Energy Bonds’. Investors lost the lot, and with minimum investments of £2,000, it was a significant loss too.

However, with some investors, it is precisely the high risk, high reward that appeals. The added human dimension of being able to engage with products directly, and share with friends as something you have had a personal involvement in, is apparently strong.

For the SMEs, it’s a great way of raising money and there are significant branding and advertising benefits too. Having someone pay you to then spread the word about your company is a marketing strategy even the Mad Men could not have conceived of.

As long as this mutually beneficial relationship continues in the absence of too many high profile failures, it seems both parties are happy for the sector to grow.

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