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Small business finance differs in a number of ways from corporate funding, as do the external products available to both types of firm. In this chapter, two different but linked definitions are addressed:
The dual role of finance in business activity; finance provides a day-to-day input to production in addition to funding new capacity.
How the requirements of small and entrepreneurial firms differ from larger enterprises and corporate finance.
Both of these issues are key to the review of products to provide external finance for small and entrepreneurial firms that follows in subsequent chapters.
The role of finance in business activity
Finance has a dual role in business life. First, it can be regarded as an element of the means of production as it enables the business to purchase raw materials and labour as well as service and maintain equipment and premises. In this context, any shortfall in the availability of funding can disrupt day-to-day business activity. A shortfall typically occurs when a mismatch is evident between the flow of income from sales against the required pattern of bill settlement or payment of wages. The day-to-day management of cash-flow is a balancing act undertaken by all business owners. For some firms, this is more difficult than others leading to the popular – and probably correct – assertion that more firms cease to trade because they run out of cash rather than become truly unprofitable.
Second, finance in business is needed to purchase capital plant to provide the core of the productive capacity of a firm. This capital plant can be in the form of property, equipment or vehicles. For many people, this core funding is regarded as the permanent capital of a firm. (It can be contrasted with all types of debt held by a firm that eventually need to be repaid in full.) However, in reality, this is only part of the story. Some of the core capital of the business may be needed to fund operations day-to-day until orders are won and production starts. It is not permanent in the sense of being fixed and unusable. The capital is used until the venture is successful enough to fund itself. This is pre-revenue funding to rent premises, pay staff and start marketing. The amount of pre-revenue funding needed and its duration will vary from business to business. Some of this variation is determined by industry sector. However, in part, pre-revenue can reflect the choices made by the business founders, particularly the commitment and effort they are willing to put into the launch of the venture to get it going. In addition, the funding need is also influenced by the ability of the start-up team, notably in such things as networking skills and the contacts they have to get a venture up and running.
Initially when the business is first set up the capital outlay should be comparatively high as the productive capacity is built up and pre-revenue activities are commonplace. A similar peak in use of finance for this purpose should be evident in any subsequent period of expansion. Moreover, finance of this type is more closely associated with the risk involved in any new venture or project. Typically, this finance should be regarded as more entrepreneurial than the day-to-day purchase of labour and materials to complete agreed orders. In most businesses using entrepreneurial finance this way the owners and investors of the business are likely to have much more at risk than from day-to-day trading. If the venture fails, assets may be sold and in many cases the founder investors will have to use core capital to fund a loss (perhaps a 100% loss and the closure of the business). However, if the venture succeeds, the investors will be the beneficiaries from its future profits.
The dual role of finance is summarised in Figure 1.1. Finance is needed in the day-to-day activity of a business to ensure a smooth production process. Cash-flow management is essentially a balancing act between incoming revenue from sales and payments out for the variable components of production. This is the basic financing need for all small firms (and the only one for many of them once a business has been established).
However, at various points in a business lifespan, firms have an additional funding requirement to create, replace and expand the productive capacity of the venture and fund pre-revenue activities; this is entrepreneurial finance. All new firms need this type of funding to a degree at start-up. After a business has been established, this additional and ongoing funding requirement is particularly evident in the minority of firms that survive, expand and create employment.
The distinction between cash-flow and productive capacity may appear at first glance to be too stylised to be used in business analysis. However, the contrary is actually the case. Many business owners ignore or confuse the distinction, often to the peril of the success of a venture. Simply categorising a business between its needs for cash-flow as opposed to capacity finance is itself a useful tool. Table 1.1 provides an illustration on how the definitions for cash-flow and entrepreneurial finance can be applied across a range of business types.
Figure 1.1
Day-to-day cash-flow management
Table 1.1 Business Types and Funding Needs
Business Type Finance Type
Farmer Third generation family firm Cash-flow
Builder (1) Small jobbing builder Cash-flow
Builder (2) Speculative house builder Entrepreneurial
Retail (1) Corner shop Cash-flow
Retail (2) New online venture Entrepreneurial
Manufacturer Established firm, new overseas plant Both
IT Services (1) Laptop repair shop Cash-flow
IT Services (2) Games design and licensing Entrepreneurial
A shop retailer, for example, may not have to wait too long to get paid as these are normally daily takings over the counter. However, as these sales receipts accumulate in the firm’s bank account, a cash-flow requirement still exists to pay salaries and suppliers. The terms of trade agreed by the shop owner with a supplier could require bills to be settled 60 days after the goods were delivered. Hopefully, the stock will have been sold before the bill has to be paid; however, this may not be the case, creating a cash-flow management issue. The shop premises may well be rented from the freehold owner, so reducing the initial capital outlay needed to open a business to a lease premium and a month’s rent in advance; but, any monthly or quarterly rental payments would also need to be settled on time.
In contrast, a new manufacturing firm is much more likely to have to purchase or build from scratch specialist equipment and production facilities even before it is in a position to bid for orders. As a result, the initial funding requirement for capacity purposes will be significant as will pre-revenue funding. Once an order book has been filled, this business will also order materials and employ staff to commence production. However, the delivery time may still be several months or even years away; in such circumstances, the purchaser is likely to have agreed to stage payments when certain production milestones have been met but the vendor will still have to manage the cash-flow.
All business types can be reviewed and considered by reference to the likely need for different types of finance. In part, the balance of funding by type is influenced by sector. However, it is also linked to the current phase of the business lifespan (start-up, mature, growing and diversifying into new products). The categorisation can change for the same firm over time as the needs of the business develop. A successful start-up will move from an entrepreneurial funding stage to a cash-flow-based environment. An established larger firm may develop a new venture or expand. As a result, such a firm may need both types of funding at the same time with the two activities operating partly at least at an arm’s length from one another.
The distinction between two different types of funding in business activity holds true in most cases. In specific circumstances the distinction is less evident. In particular, care needs to be exercised around the categorisation of certain types of activity that involve a degree of speculation. Similar issues can be seen in the categorisation of funding needs for many project-based activities. In effect, funding itself is the dominant raw material that combines together the entrepreneurial and cash-flow aspects of business funding.
As an example, if a property developer acquires a block of run-down vacant retail units, the expectation is that, once refurbished, the capital value of the site will rise as will rental income. This funding arrangement is predominately entrepreneurial. It is not the same as, for example, an arable farmer planting seed in the autumn in the expectation of a crop being ready to sell in the spring next year; the farmer’s funding need is primarily cash-flow management-based.
Indeed, it can also be argued that nearly every start-up firm goes through a phase where the purpose of funding is less clear cut. This is in their pre-revenue business planning stage and is often associated with a scramble to get the venture off the ground. The term ‘bootstrap funding’ is used sometimes to describe this activity where an entrepreneur will look to any available source of cash to support development work, rather than look for external equity or a term loan. However, subsequent analysis in the chapters that follow will show that bootstrapping is more to do with a scramble to get any source of funding rather than confusion as to why the cash is needed in the first place. In all cases, pre-start firms are looking for entrepreneurial funding.
Small and entrepreneurial firms versus corporate finance
In very general terms, the distinction between cash-flow and entrepreneurial finance apply to all types of business. However, it is worth considering in more detail the distinction between small and entrepreneurial firms versus the wider topic of corporate finance.
Even a very brief survey of the literature on funding for business reveals an extremely wide range of definitions being used for microenterprise, small firms, small and medium-sized enterprises (SMEs), entrepreneurial funding, corporate finance and so on. In many cases, the definitions can be tied back to categorisation based primarily on the number of employees. In the UK, these size class definitions are drawn from the relevant European Union (EU) guidance (summarised in Table 1.2). In the case of SMEs, for example, this definition is normally used if a business has fewer than 250 employees.
However, the strict use of an employee-based size categorisation alone is not sufficient to decide if a business is an SME. Indeed, the limitation of this method is recognised by a number of national authorities – including the European Commission – and many have introduced a more complex two-stage test (although it is not commonly used in the UK). The second stage assessment normally involves looking at the shareholding structure as well as the number of staff. For example, a large independent firm with a tightly controlled family-based shareholder structure and management team may have a lot in common with the funding opportunities of a firm with 10 employees that is run by a partnership team. In contrast, a business with 20 staff run by professional managers could be a 49% owned but non-consolidated subsidiary of a Plc. As such, this small business may have access to sources of finance that most firms of a similar size would envy. For example, a potential funder may well transfer at least some of the lower credit risk status of the major shareholder to the small firm and make a finance offer (or a lower-priced deal) (Table 1.3).
Table 1.2 EU Definition of SMEs – Test 1
Test 1 Employees (n.) Turnover (Euro) Balance Sheet (Euro)
Medium <250 <50m <43m Small <50 <10m <10m Micro <10 <2m <2m Source: https://ec.europa.eu/enterprise/policies/sme/files/sme_definition/sme_user_guide_en.pdf This study looks at the products used in external funding for small and entrepreneurial firms. It does not seek to be a review of corporate finance as a whole. As a simple guide, the following definitions are used in respect of small and entrepreneurial businesses: Small firms are established enterprises that have no access to financial instruments or securities for any form of debt and equity. Owners often have a high degree of overlap between business and personal assets; any savings or investments they hold are typically undiversified. The money tied up in the business venture represents most if not all of the owners’ wealth, or debts are secured against the bulk of any non-business assets they own. Even if the business has a corporate structure, limited liability is compromised and not absolute (so owners have substantial personal value at risk from business failure). Normally small firms will meet the revised EU definition of an SME and have less than 250 staff. The majority of firms will be well below this size threshold. Entrepreneurial firms are typically small firms in a period of change or transition. This can be a business start-up or a growth phase; in some cases it could also be a firm looking at funding a business turnaround. A large firm is a business that has either direct or indirect access to a range of capital markets to fund loans and equity. Moreover, the ultimate owners of the business do have effective limited liability and diversified investment portfolios. The firm will probably have a number of lines of commercial activity in operation concurrently. Some of these may exhibit entrepreneurial characteristics of growth or change but these will not compromise the funding environment for the whole entity. The analysis of the financing needs and characteristics of large firms is interchangeable with the study of corporate finance. Normally, large firms will fall outside the revised EU definition of an SME and have more than 250 staff. While collectively very important for overall economic activity and employment, these firms are few in number. Large firms and the external funding products they use are excluded from this review (unless they are used by both large and small firms). Table 1.3 EU Definition of SMEs – Test 2 Test 2 Shareholding Structure* Accounting Structure+ EU Definition Autonomous <25% Simple Small Partnership 25% to 50% Simple Medium Linked >50% Consolidated Large
Source: www.ec.europa.eu/enterprise/policies/sme/files/sme_definition/sme_user_guide_en.pdf
* Does not own more than this percentage of another business or this level of share is not owned by another firm
+ Is the accounting structure of the enterprise simple (unconsolidated) or consolidated as part of a larger group?
Overall approach and outline of chapters
The following chapters of this book, first, identify and, second, contain an analysis of the external funding products for small firms and entrepreneurial firms. The separate chapters on each product include a review of:
The product scope and its use either for day-to-day or entrepreneurial purposes.
The main suppliers.
This is followed by a discussion on funding choices over the duration of both a business lifespan and through changing economic circumstances (including a review of the role of public policy).
Lending money to anyone or buying any form of financial investment involves a degree of risk. Providing a loan facility to a sovereign government or a blue-chip company has some risk of default. Even so, billions are lent by banks to these borrowers every year. Also, thousands of retail investors buy shares in companies every day and an even greater number do so indirectly as well via unit trusts and pension funds.
However, without exception, direct commercial lending or investing in small businesses is commonly regarded as a specialised activity with some unique characteristics and risks. While later chapters review current attempts to introduce a new group of smaller lenders and investors into the small business funding market place, the perception that this is a specialised finance market persists.
A common misconception is that the difficulty in dealing with small business finance markets is the level of risk itself. Small businesses do have a much higher risk of default than blue-chip firms. For example, across the whole small business market place in the UK, even in a good year for trading, over 10% of all firms will cease to trade and around 2.5% of firms with a loan will default on payments. This default rate is at least five times greater than amongst listed companies. Although the likelihood of default for listed companies is very low, the value of every default can be exceptionally high but this still does not appear to be a major barrier to finding lenders.
Even so, lending or investing requires acceptance of a degree of risk in order to obtain a financial return. Adjusting the price charged to accommodate for the degree of risk allows any financial service provider or external investor to accept a level of risk. In the case of a debt provider, the price will be reflected via the interest rate; for an equity investor, it will be reflected in the price paid to acquire the shares in the business and the anticipated share of any future profit. Of course, extreme cases of high risk can be seen as too difficult to support ‘at any price’. However, these cases are rare. Many high street banks will already provide unsecured loan products to smaller firms with an assumed default rate of over 20%, although the interest rate could be close to 20% a year. Venture capital investors will probably achieve a portfolio return based on the profits from two investments in every five; the other three (i.e. 60%) would be a total loss. Consequently, a hierachy of products exist with different risk-reward (see Figure 2.1).
Rather than the degree of risk itself in dealing with smaller-business finance markets, many investors are put off by the uncertainty around the likely return. In effect, investors find it difficult to strike the correct price commensurate with the risk. Also, unlike other forms of financial investment, market liquidity is low, especially for equity investors, suggesting even if a mistake is made over an investment choice you may still be tied into a firm for some time. As a result, it is uncertainty of return rather than the level of risk itself that ensures small business external funding remains a specialist field of activity.
What are the particular issues in small business finance markets that lead to this heightened uncertainty? Three issues are cited by most commentators. Small business data is of mixed quality; it is often called an opaque market. As a result, the related issues of adverse selection and moral hazard are often cited as being very prevalent in this market. These are three core issues that attract a lot of academic research, which is not repeated here. Rather, a short outline of all three issues and what potential lenders and investors can do to address them provides a good starting point to look at individual financing products in more detail.
Figure 2.1
Risk, Reward and Funding Selection
Opacity in small business information
The market information generally available about small firms is normally very limited in both scale and accuracy. Small businesses are normally privately owned. Most firms are owned by one person. For the minority that have multiple shareholders, these are often members of the same family.
The business owners may ultimately need to file tax-related information with the public authorities and in some cases a business register (such as Companies House in the UK). However, the depth and scale of the financial information is often very limited and only filed in arrears. This is in direct contrast with larger firms with publicly traded equity that have more detailed filing requirements and a specialised industry (brokers) looking at emerging business events, as well as professional investors and the financial press.
Of course, business owners should know everything about the underlying position of the business. However, because external providers are often much less well informed the balance of knowledge is one-sided. This asymmetric information is a market failure. In publicly traded equities and debt instruments, a legal sanction is in place to stop insider trading by the officials who hold this knowledge. However, these rules do not exist in unquoted company transactions for debt or equity (apart from general protection against fraud).
To overcome this problem, the credit reference industry has tried to collect and analyse what information is available. In some cases, firms being scrutinised volunteer information as well. However, this does not solve the problem. While credit information is valuable it is still essentially backward-looking. Also, while volunteered data is also useful, the control of its release is still in the hands of the business owner.
The existence of opaque or ‘fuzzy’ business information on smaller firms is not just a market failure in the provision of business information. Rather, as a knock-on effect, it is also a market failure in the small and entrepreneurial business finance market. The opacity, or lack of clarity, created by less than perfect information accessible to all generates the opportunity for incorrect decisions around lending and investment decisions. This is illustrated by the two related additional problems arising from information asymmetry that all external finance providers need to address in one form or another.
Adverse selection
The underlying poor quality of information makes it difficult for a lender or an investor to select who to fund rather than reject. Of course, the same problem does exist for the very largest firms as well but the level of uncertainty is much lower because the quality of information is much higher. The possibility of adverse selection refers to such an outcome. Either a ‘good’ applicant is denied funds or a ‘bad’ one is wrongly accepted. These two possible outcomes are often referred to as Type 1 or Type 2 errors, mirroring the outcomes of statistical hypothesis testing.
In a start-up situation, it can be argued that the roles are reversed. A funder may have more realistic and wider market knowledge than an entrepreneur. This could be used to leverage a deal on too favourable terms to them. In practical terms, reverse information asymmetry such as this is more likely to assist the funder in more correctly assessing who to decline and could indicate the market failure is less evident in some circumstances.
Moral hazard
In discussions between a finance provider and a business owner, questions will be asked in order to help assess risk. It is possible that the owner will control the flow of this information in order to help a favourable outcome. In order to obtain funding, an owner may accept an offer of a very high interest charge or projected dividend schedule that they know is unrealistic to fulfil. In many countries such activity may be illegal but even if not it raises a question about honesty.
However, the concept of moral hazard is much wider than a concern about honesty before a deal is arranged. Rather, the hazard extends to the behaviour of the business owner post the funding deal being arranged. Will the owner spend the funding in line with the business plan, or work as hard as promised to achieve the goal? Such issues form the core of many disputes between business owners and both debt and equity funders. Again, the heart of the problem is lack of information so moral hazard can also be called asymmetric information ‘after the event’ (while adverse selection is ‘before the event’).
Addressing information asymmetry
All commercially based debt or equity investors will seek to reduce the incidence of adverse selection and moral hazard through a number of techniques. These activities fall into the following four main groups.
Assessing applicant quality
In debt markets, applications are normally appraised by a lender against a list of criteria; this may be a formal scorecard or, for larger loans, a series of tests applied against the business plan and other data supplied by the applicant. In the case of equity investors, going through a due diligence process before investment takes place is the norm. To varying degrees, a quality assessment will be included with all types of commercial finance products, as well as cash-flow-based activities.
Terms and conditions
Commercial funding is determined through assessment and negotiation. As a result, it is normal practice for an offer to supply finance to come with a range of terms and conditions as part of the deal offered back to the applicant. This may include regular access to private management information. A debt provider for both entrepreneurial and cash-flow purposes may include terms such as the receipt of regular loan repayments by a fixed date each month or the operation of banking facilities (not going over an overdraft limit). For an equity investor in an entrepreneurial venture, they may ask for a seat on the board of a company.
Asking for security and a personal stake
Debt and equity providers will often be reassured if the business owners have personal financial exposure to the risk of the newly funded activity. Security can also include charges over personal assets attached to the business debt obligation by way of a personal guarantee outside of any limited liability. Although most equity investors cannot have security as such, many of them will often structure a deal to include both debt and equity. (Some more complex equity arrangements do offer limited security options as well.) Providers of entrepreneurial funding will often ensure the owner has a personal stake (‘skin in the game’).
The price charged
Debt funding on commercial terms for entrepreneurial and most cash-flow activities has to be priced above the cost of funding to the financial institution (where the cost includes the administrative charge to assess the loan as well). How much over this cost will reflect the view of the funder of the risk involved in each case. As debt investors can only get the return of the original funds lent plus interest, they have to charge all borrowers an insurance premium to cover the likelihood that some of them will default.
How far debt interest can be used to exert influence over both adverse selection and moral hazard is a matter for some debate. If good borrowers are charged too much they may decide to use alternative funding, especially when a wide range of providers are active in the market offering a lower price. Only higher-risk applicants will pay the higher price as they have more limited choice. Hence, in an effort to control moral hazard, a debt investor can end up with more risky customers only.
An equity investor on the other hand can structure the price of an offer in a number of ways. The price they are prepared to pay for the shares is important. This can be in terms of a price per share or what percentage of the voting rights in a business they acquire for a fixed investment sum. However, investors can also make additional arrangements linked to the price such as an understanding with the Board on dividend policy or direct board membership. Consequently, equity investors will typically look to fund higher-risk ventures than debt providers. The greater insight and control over the business they have allows equity investors to accept a higher risk in exchange for the prospect of a higher financial return (as they have a right to a defined share of any future profits, unlike a debt investor whose receipt of interest is not linked to the success of the business). A key part in taking the higher risk is the enhanced assurances on the likelihood of a return through access to information from inside the management team.
Uncertainty of return rather than the absolute level of risk is the main reason why lending and investing in the small business market is seen as a specialised financial activity. This is particularly the case amongst entrepreneurial rather than established small firms. All funding – debt, equity or asset-based – seeks to reduce uncertainty through the appraisal of finance applications. This may be done simply via a standard scorecard or through a much less transparent interview and discussion process.
Moreover, a constant theme in this study is also to consider the techniques deployed by funders to try to control and reduce uncertainty. More examples of the activities commonly used are discussed in later chapters covering each of the product areas. Through looking at what funders want to achieve to control or at least better understand these risks on a case-by-case basis, applicants should find access to appropriate finance is easier to achieve.
Small and entrepreneurial businesses use a limited group of financial products in order to meet their external finance requirements. In this chapter, using data from the UK, the products for both the day-to-day and the capacity-building finance needs of small firms are identified. First, this is done by looking at the aggregate profile of financing of small firms in the UK. Second, the sources of external finance selected from the UK analysis are reviewed against similar data for key international markets.
External versus internal funding
Prior to looking at the external financial products used by small firms, it is also necessary to consider in more detail the circumstances in which they are needed. It could be argued that it would make sense if businesses never needed to use external finance at all either for cash-flow or expansion purposes; indeed, for many firms, this is their goal and operating practice and in such circumstances the use of any form of external finance reduces the immediate financial returns to the business owners to some degree. Many business owners look to achieve this position as well as it provides the firm with a degree of independence and security.
A large number of firms, as illustrated later in this chapter, report they do not use any external funding. These firms are fully funded from internal sources, mainly for cash-flow purposes without any plans for expansion or growth. While external commentators may well argue that the desire for financial independence may only be achieved at the expense of a firm reaching its full potential, it is very understandable, given the wide range of motivations people have for going into business in the first place, why the objective of self-sufficiency in cash-flow funding is attractive to many. However, this, in turn, creates differing views on the desirability of external finance when needed. For example, if a business owner needs to seek external finance products to address a cash-flow management problem, this is often seen by them as a necessary evil; they would rather not have the product but need it and have to accept the immediate associated reduction in business income. However, because the product has to be used grudgingly to offset a business problem, this often forms the origin of tension between the user and supplier of the product or service (perhaps about the quality of service or, in particular, the rate of interest on an overdraft facility).
In contrast, firms that are unable to fund in full an entrepreneurial phase in business development from internal sources more eagerly seek external suppliers to fill this gap. Indeed, given that entrepreneurial activity by definition is more risky than work to fulfil agreed orders on a day-to-day basis, it makes more sense for business owners to share the risk where they can. The ‘pecking order’ theory of funding is the term used to illustrate this phenomenon where business owners in such circumstances will seek other sources of funding to help share risk. However, the ‘pecking order’ process also means that external entrepreneurial funding is more welcome with owners willing to allocate a share of any expected increase in business revenues with someone else.
In practical terms, this means that firms using external finance for equipment and property purchase or business expansion are much more comfortable with using the associated products and paying the related costs than is the case for cash-flow products. Selling a part of the business through an equity stake is still a big step for any owner but generally most that do also report this to be a positive step towards a business goal. This provides a stark contrast with a discussion between a business owner and the bank manager about the cost of an overdraft facility the business needs to keep on a monthly basis to ensure security of cash-flow management, even though it is rarely used.
Which products?
While the issues discussed in both Chapters 1 and 2 apply to businesses in any geographical market, the UK has been selected as the basis for the identification of a range of financial products that will be reviewed in depth in subsequent chapters. Selecting a specific market is important for a later discussion of many aspects of the wider business environment and its impact on funding decisions. Using the SME Finance Monitor, a comprehensive review of market conditions in the UK is available. Based on the full results for 2013, Table 3.1 contains data on the external products that were used by SMEs.
In 2013, about 41% of SMEs in the UK were using some form of external finance in order to operate the business. The remainder – and the majority of them – were self-sufficient, being able to operate through cash-flow management and using the financial reserves of the business (or the personal savings of the owners). Indeed, regardless of using external funding or not, in one in three firms the owners decided to put in additional funds from personal resources in order to top up financial reserves. The motives for doing this were mixed; some owners decided they had to do it as they may have believed external funding would be difficult to arrange (or whoever was supplying the external funding made the cash injection a condition of agreement). Otherwise, some owners may well have wanted to retain full control of the business (and any future profits).
Table 3.1 SME Finance Products in use, 2013
Percentages of UK SMEs, 2013 Used in 2013 Applied in 2013 Success rate
Overdraft (incl. renewals) 18 6 88/90*
Credit card 18 4 88
Term Loan or Mortgage (incl. renewals) 8 3 56/65*
Leasing/HP 8 4 87
Loans/Equity from Directors 5 3 90
Loans/Equity from Family/Friends 5 3 84
Grants 2 1 59
Invoice Finance 1 1 75
Loans from other 3rd parties 1 1 72
Equity from other 3rd parties <1 Any External Source 41 Personal Funds Injection 33 • Out of choice 18 • Out of necessity 15 Source: BDRC, SME Finance Monitor: The Year in Review, Q4 2013, February 2014 * Two different success rates are quoted. The lower rate is a positive outcome which is the product applied for. The higher rate is a successful funding outcome (including being redirected to successfully apply for a more appropriate product). Using an external finance product in 2013 Looking at firms using an external finance product in 2013, cash-flow-oriented funding such as overdrafts and credit cards were by far the most common. This is not surprising as all firms need to trade day-to-day (which also ensures trade credit as a financial management practice is widely used as well). While similar numbers of firms use a credit card and an overdraft, about 10% of smaller firms use both at the same time. The credit card is normally regarded as the most commonly used external finance product, largely because the incidence of use is higher (a firm may have two or three credit cards held by directors rather than a single overdraft). The validity of this ranking is a matter of debate as most card purchases are low value and an overdraft or a structured loan may well provide a greater share of total external funding in monetary terms. In terms of incidence of use, it is often the low percentage of SMEs that have a term loan or commercial mortgage that surprises many commentators. Only 8% of small firms overall held this product in 2013. This again reinforces the point that most small firms are not seeking to grow or develop; rather, they just need to trade on a day-to-day basis. It is also the case that leasing and HP is just as commonly used by firms as structured debt finance and in many industry sectors the products are effective substitutes for each other. The common thread through most of the other sources of funding – including grant funding that is not a commercial activity as such – is the very low incidence of use in the small business population. This is even the case for invoice finance. Also, in a small business population of up to 250 employees, using any truly third-party equity (funded through a business angel or private equity) is exceptionally rare (well under 45,000 firms in operation in 2013 had ever raised funding this way). Applied in 2013 and average success rates The use of a product such as a 15-year commercial mortgage does not automatically provide too much information about recent availability of external finance as this product may well have been obtained by a business many years ago. Table 3.1 also provides data of the number of firms in the UK SME market applying for each product in 2013 alone and the corresponding application success rate. Looking just at 2013 applications still suggests that overdraft and credit cards are the most popular external sources of funding. Indeed, in 2013 at least, the overdraft was a more popular product than the credit card measured this way, although in reality these products have been on par with each other for a few years. Structured loan applications were less popular that those for leasing and HP. Also, other types of external funding were still much less common, although the less than strictly commercial funding sourced from existing directors or friends and family appear to have been more common than in previous years (a point discussed in Chapter 10). In terms of success rates, it is of some surprise to many people that the vast majority of applications for external funding overall are successful, even for overdraft and loans. For an overdraft, 90% of applicants overall ended up with funding (nearly all with an overdraft); the equivalent figures for credit cards (88%) and loans (65%) were also high. Leasing, which is a fully secured rental rather than debt activity, was higher than for structured loans though; indeed, it was close to those of non-commercial director and family funding. Success rates for invoice discounting were slightly lower, probably reflecting counter-party credit ratings, as discussed in Chapter 6. The range of small business experience All reviews of a single national market in one year will inevitably provide an ‘average’ view of overall activity. The variations around this average are often just as important as the overall picture. A number of possible characteristics can be reviewed to look at the scale of variation. In Table 3.2, the use of two different products groups – overdraft and loan – are illustrated with reference to industry group, along with the injection of personal funds to the business. This suggests, for example, the overdraft is more commonly used – as is debt funding overall – in agriculture. Structured funding, on the other hand, is more common in hotels due to freehold investment. Moreover, the higher incidence of debt funding also appears linked to the use of personal funds. In the product-specific chapters that follow, further analysis is provided about the different types of business that typically tend to use certain types of external funding sources, including industry where appropriate. However, additional attention is particularly given to the variation in use by size of business where the range of variation is considerably more marked than is evident for either industry or region of business location. While the overall incidence of use may be modest at a national level across business of all sizes, in some of the larger employment categories, product use significantly increases. For example, while only 2% of SMEs overall used invoice finance in 2013, this increased to 19% of firms between 50 and 249 employees, making it a very important source of cash-flow funding for this group. Table 3.2 SME debt products and personal capital injection use: industry analysis, 2013 Applied in 2013 (new or renew) During 2013 Percentages of UK SMEs, 2013 Overdraft Structured Loan Used Personal Funds Agriculture 12 8 38 Manufacturing 7 3 31 Construction 6 3 38 Wholesale and Retail 8 4 36 Hotels and Restaurants 10 7 41 Transport 8 3 40 Property and Business Services 4 3 40 Health, Social and Community Firms 6 2 37 Other Services 3 2 37 Source: BDRC, SME Finance Monitor: 2013Q4, pages 53 and 71 Moreover, each small business is different and circumstances cannot be accurately described just from using these standard analyses based on industry sector, size or business age. To illustrate this point, contrasting case studies have been included in Appendix I to look at how different types of business use external finance. These provide a further introduction to the more detailed chapters on specific types of product that follow. International comparisons This study of external finance primarily uses data on the UK market. However, a short review of some other national markets suggests the broad types of product selected for more detailed analysis are just as relevant in an international context. Attempts at a country-by-country comparison of SME statistics are always difficult. National definitions can vary. For example, it is commonplace in North America for the category of SMEs to include firms with up to 499 employees rather than 249 in the UK and the European Union (EU) as a whole. Even within the EU, some national authorities have domestic definitions of an SME that differ from the European Commission. Banking data often looks at loans under a certain value threshold, rather than loans issued to businesses within an SME size-band. As any international survey moves beyond the EU, the availability of data collected in a consistent format declines. A decade-long project led by the World Bank did collect a unique firm-level dataset covering patterns of funding in SMEs across 48 countries (where SME was defined as under 500 employees). The survey period covered 1999–2000 and reported in 2004. The results have never been updated but they do provide a historical benchmark to confirm that the core external financial products serving UK smaller firms are also valid in a wider international context. Profiled against the average of all the country data reported in Table 3.3, the UK made more use of retained profits and savings and used fewer external finance products than many others. However, the World Bank results also illustrate again the need to take account of national circumstances when looking at the use of external products. For example, several countries, notably France, Germany, the USA and Canada, have substantial state-backed development banks and government funding schemes that the World Bank reported as being part of the other sources of finance, not commercial bank finance. This suggests that across national boundaries the type of supplier and the terms and conditions of funding will influence the external funding products used, an issue compounded further by tax and business legislation. Consequently, a UK-centric focus continues throughout the chapters that follow (some additional comments on international variations are provided in Appendix II). Table 3.3 External Finance for SMEs – World Bank Business Environment Data, 2003–2004 Conclusion – products for detailed review Looking at both finance in use and applications made in 2013 in the UK suggests five core product groups cover the external financing activities for small and entrepreneurial firms: Overdrafts and Credit Cards Structured Debt Products Leasing and Hire Purchase (HP) Invoice Finance Third-party Equity The inclusion of equity may appear at odds with its low level of use in the small business market as a whole. However, in order to address entrepreneurial business funding more directly, while non-commercial sources of external funding such as grant or family and friends are strictly out of scope, this review includes a discussion of third-party external equity. Further analysis of the variation in product use within different industry and size groupings of UK businesses illustrate the same five groups remain valid. A brief review of some major international economies also points to the same conclusion. The following five chapters of this book take one of these product groups in turn. Each chapter provides more detailed definitions on the products under review, which types of business tend to use them and why. In addition, the chapter looks at the suppliers of these different types of product and what factors they take into account when deciding if they can agree to funding requests. Subsequent chapters of the book then move from a detailed product-by-product analysis to a more integrated view of external finance for small firms over time looking at how businesses change the sources of external funding as they survive and grow. Bibliography BDRC SME Finance Monitor, Q4 2013 Report, London, BDRC, 2014. Note that all source data in tables and charts are referenced against the pages and tables in this Q4 2013 report. For further information see the data source information for this chapter. STEWART C. MYERS, The capital structure puzzle, The Journal of Finance, 39 (2), pp.574–592.

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