Paper F9

Sources of Finance for SMEs

Dinesh kumar

The characteristics of SMEs

Definition
While there is no universally-accepted definition of what constitutes a small or
medium sized enterprise, they are
private companies
owned by a few individuals, typically a family group
The precise definition of what constitutes a SME may differ according to the
industry in which the firm operates.
In the UK, the Department of Trade and Industry defines a small firm as being
less than 50 employees and a medium firm as having 50-249 employees. In the
EU, a small firm is defined as being an independent enterprise (i.e. not controlled
by a large company), having less than 50 employees and either having turnover
less than 7m or net assets (a balance sheet total) of less than 5m. A medium
firm is also defined as an independent enterprise with employees less than 250
and either turnover of less than 40m or a balance sheet total of less than
27m.
Relative importance
Of the total number of businesses in the UK and EU less than 0.5% are classified
as large businesses. In the UK, small and medium enterprises account for almost
55% of employment and more than 50% of turnover. In the EU comparative
figures are 66% and 54%. The majority of employment growth has come from
small firms in the EU and the US.
This means that small and medium-sized enterprises make up a very large part
of a national economy. For a company to grow its economy, it is therefore
important that SMEs should be able to grow their businesses. To do this, they
need long-term capital.
The problem of raising sufficient long-term capital to grow their business is much
greater for SMEs than for larger companies.
The financing problem
Equity finance and SMEs
SMEs are normally owned by a few individuals. These existing owners are often
reluctant to issue new equity to new investors as this will dilute their control of
the business. External investors might also be reluctant to buy shares in a SME,
because of the high investment risk.
One possible source of new equity capital for a SME would be a new issue of
shares to the existing owners, who would then put more of their personal wealth
into their company. However the existing owners might not be willing to put more
of their own money into their company. Even if they were willing to put more
money into their company, they might not have enough personal wealth to meet
the companys capital requirements.
If SMEs cannot raise extra equity capital by issuing new shares, retained earnings
are their only source of new equity. Even in profitable small companies, it takes a
long time to build up capital through retained earnings, and it might be too late
to take advantage of the required investment opportunities. Opportunities for
growing the business even faster might be lost.

Short-term sources of capital can be used to some extent to help a small

company to grow its business, but SMEs cannot rely extensively on short-term
finance. SMEs might even face difficulties in negotiating trade credit if they have
not been in business long enough to build up a track record for creditworthiness.
Banks are also reluctant to offer a large overdraft, unless the owner of a
company is willing to provide a personal guarantee for the facility (perhaps in the
form of a bank mortgage over the family home). Too much reliance on short-term
finance also increases the risk of overtrading, which was explained in an earlier
chapter.
Without additional external capital, many SMEs are unable to grow as quickly as
their owners would wish. Many SMEs try to obtain finance in the form of mediumterm or longer-term debt, or to acquire assets through leasing.
Debt finance and SMEs
The main source of external finance available to SMEs is bank finance. There are
many problems for a SME in negotiating bank finance:
SMEs are often limited companies or partnerships for which financial
information does not have to be published to a wide audience. There may be
only limited requirements for external audit, or no legal requirement for an
annual audit. The SME will have to provide the bank with sufficient financial
information and also convince the bank that it has a credible business plan
that should ensure its ability to repay the money it borrows.
The SME may lack experienced management and a bank may be unwilling to
trust them with its money. For example a bank might suspect that the profit
forecasts provided by the management of an SME might be far too optimistic
and inaccurate.
The SME might have few assets to offer the bank as security for a loan. It is
often the case that long-term loans are easier to obtain as these can be
secured with mortgages against property (land and buildings) owned by the
SME. The main problem arises with short and medium-term loans, for which
adequate security does not exist, and this is known as the maturity gap.
The high-risk nature of investment projects by SMEs might mean that even if
a bank is willing to lend money, it will require a high risk premium to be
incorporated into the interest rate.
Leasing and SMEs
SMEs make extensive use of leasing as a method of obtaining long-term assets.
Both operating leases and finance leases might be used. A feature of a lease is
that the leasing company remains the owner of the asset. In the event that a
company cannot make the scheduled lease payment, the lessor is able to take
back the asset. This provides some form of security. A lessor might therefore be
more willing to agree a leasing deal with an SME than a bank is willing to make a
loan or offer a large bank overdraft facility.
Venture capital
The nature of venture capital
SMEs will usually try to raise the finance they need from retained earnings and
bank finance, and by leasing assets. Working capital requirements can be
reduced by negotiating credit terms with suppliers, and possibly by factoring
trade receivables and obtaining some factor finance.
For SMEs with an ambitious strategy for growth, these sources of finance are
unlikely to be sufficient. In some cases it might be possible to raise new finance
in the form of venture capital.

Venture capital is capital provided to a SME by one or more external investors, in

the form of equity capital, preference shares or debt finance perhaps a mixture
of all three. Some investment institutions specialise in providing venture capital
finance to private companies to support their growing businesses.
Venture capital investors require large returns on their investment, because of
the high risks involved. They want the profits on their successful investments to
cover the losses they inevitably suffer on business ventures that fail.

Business angel finance

Business angels are wealthy individuals who invest directly in small businesses,
usually by purchasing new equity shares. The business angel does not get
involved personally in the management of the company, but hopes to make a
large return on his investment from dividends and eventually from the sale of the
shares when the company has grown.
The main problems with business angel finance are as follows.
There are not many business angels, and it is usually very difficult for a small
company to identify an individual who might be willing to consider making an
equity investment in the company.
Since there are not many business angels, there is far too little business angel
finance available to meet the potential demand for equity capital from small
companies.
Obtaining venture capital
The term venture capital is normally used to mean capital provided to a private
company by specialist investment institutions, sometimes with support from
banks.
Venture capitalists might be willing to provide finance to new businesses in
return for an equity stake in the business. In addition to equity capital they might
also agree to provide extra finance in the form of preference shares. With some
venture capital arrangements, a bank might also be willing to provide loan
capital as part of an overall financing package for the company.
The company will have to demonstrate to the venture capitalist organisation that
it has a clear strategy and a convincing business plan. It must demonstrate that
its management are experienced, have sufficient skills to make a success of the
business and are committed to achieving success. Sometimes the venture capital
organisation will require a representative to be on the board or will appoint an
independent director.
Exit route for the venture capital investor
A venture capital organisation will not invest money in a company unless it is
satisfied that there is a strategy for the company that will enable them to
withdraw their investment at a profit, of the company is successful. This is known
as an exit route for their investment, and a venture capitalist might expect an
exit route to be available after about five years or so from the time of making the
investment in the company.
The exit route might be:
A stock market listing, if the company grows quickly and is successful. When
the companys shares are brought to the stock market, the venture capitalist
can sell its shares.
A trade sale of the company to a larger company. A venture capitalist
investor might insist that the company should be sold to a larger rival, so that
they can take their profits and disinvest.
Refinancing by another venture capital organisation. A venture capitalist might
be able to transfer its investment in a company to another venture capitalist.

Problems with obtaining venture capital finance

The main problem with obtaining venture capital finance is finding a venture
capital organisation that is prepared to look at the possibility of investing in the
company.

The problem is particularly severe for companies that want to raise seed corn
finance to build up their business from a very small beginning. Venture capitalists
are often reluctant to spend time and resources in looking at small ventures
where the potential returns are likely to be small. They are much more likely to
be interested in financing well-established medium-sized private companies,
such as private companies that gain independence in a management buyout.
Medium-sized businesses often need new equity to enable them to build their
business to a point where a stock market flotation is possible, and the risk of
business failure is lower than with smaller start-up ventures.
In the UK, for example, most of the larger venture capital organisations are not
prepared to consider providing finance for start-up companies or newlyestablished small companies, and focus instead on more well-established
companies such as management buyout companies.
On the other hand there are some very large financial institutions that provide
venture capital to companies on a global scale, including the provision of capital
to companies in China and India. For example in April 2008 US-based private
equity group Warburg Pincus announced the creation of a $15 billion global fund
for investing mainly in venture capital investments and growth capital for
private companies. The company announced at the time that it was looking at a
five-year to seven-year time frame for its investments.

Government aid
Many governments are aware of the importance for the national economy of
SMEs and want to encourage SMEs to develop and grow. Some governments
offer specific schemes to assist SMEs and give them access to finance either
through direct financial assistance or by means of tax incentives to investors.
The following are some of the schemes offered by the UK government.
Loan guarantee scheme
This was introduced in 1981 to help SMEs get bank loans even if they have
insufficient security for a loan in normal commercial circumstances. The
government encourages banks to lend to SMEs by guaranteeing 75% of each
loan up to 100,000 for new companies and 250,000 for existing companies
with the loan being guaranteed for two to ten years. In return the company pays
an additional rate of interest to the government. The loan guarantee has assisted
some small companies but has not been used extensively.
Enterprise Investment Scheme (EIS)
This was introduced in 1994 to encourage equity investment in small unquoted
companies. It offers income tax relief at 20% on annual investments of up to
150,000 made by individuals who are not connected to the company. Capital
gains made on the sale are exempt provided the shares have been held for a
minimum qualifying period. The scheme therefore gives wealthy individuals a tax
incentive to invest directly in unquoted companies.
Venture capital trusts
Venture capital trusts are investment trusts, approved by the tax authorities,
which are established to invest in small companies. Investors put their money
into a venture capital trust rather than directly into small companies, and the
venture capital trust makes investments in a number of small companies. In this
way investors in venture capital trusts obtain an indirect investment in a portfolio
of small companies, and receive tax relief on their investment. They are exempt
from income tax on their dividends and are also exempt from capital gains tax on
disposal of the shares, provided they have been held for a minimum qualifying
period.

Enterprise grants
The government or government agencies might award cash grants to small
companies. For example in the UK an enterprise grant scheme allows SMEs to
apply for a grant of 15% of their fixed costs up to a maximum of 75,000 when
they are investing up to 500,000.
Finance for SMEs: summary
The success of government initiatives to assist SMEs to obtain capital to grow
their business is limited. Most SMEs face serious problems with raising long-term
capital, and the supply of long-term funding for small companies falls well short
of the demand from SMEs for capital.