Learning how to walk: SME Finance
Andrew Chappell 11th August 2011
Seemingly governments all over the world who are strapped for cash are pinning their hopes on the entrepreneurs in the SMEs of their nations to drag them out of their respective holes. Indeed they are entirely correct in implying that SMEs could provide sources of economic growth in abundance; SMEs are responsible for between 60-70% net job creation in OECD countries and they constitute around 95-99% of business organisations. Not only that but SMEs and start-ups provide a means for the poorest to escape poverty and drive social change. However the ever present problem facing SMEs remains; financing. Numerous feasible business ideas are thrown to the waste-paper basket due to insufficient business knowledge and skills, primarily in the day-to-day running of a business and strategic thinking, but a key ingredient to realising their entrepreneurial dreams is being able to access the finance they require. After all the most successful multinationals of today’s world all began somewhere. Think of Microsoft and Apple, both started out in a garage and now look what they have grown into! This shows us it is possible, however to force the new wave of entrepreneurial legends into the multinational hall of fame, governments and finance providers need to smooth the entry of SME’s in their infancy in order for them to grow into what they have the potential to be.
Where are the sources for SME finance and why is acquiring it such a problem for SMEs, in particular for start-ups?
Let’s begin right from the start. Suppose you have an idea which you would like to bring to market; having done your market research to assess the potential for your idea you decide to go ahead with it. You need finance to begin operations, where can you go to?
The Banks
This is probably the first source that comes to most people’s minds. For the banks to lend corporate loans they need proof, or ‘collateral’ as the technical term, in some form that the business idea will be capable of paying the loan back. As you might expect it is rather difficult for an entrepreneur to provide ‘collateral’ based just on an idea that they think will be successful. This represents a high risk investment for the bank and correspondingly they can either offer the loan at very unfavourable rates or not at all if they deem it too risky an investment. Echoing the sentiments of China Onyemelukwe, in Renee Horne’s article last month, “You can’t compel people to invest”. Governments cannot force the banks to lend to businesses which do not make financial sense. This overall effectiveness and success of the Merlin Project in the UK will perennially be thwarted by this logic.
If the first stop by the banks doesn’t work, where next?
Venture Capitalists and Private Equity
These forms of financing have been hugely successful in recent decades in mobilising and directing institutional investor funds into projects which represent high growth potential. However there are two downsides to this form of financing. Firstly, in return for the injection of funds the venture capitalists receive a negotiated share of the company. This is often on less than favourable terms for the entrepreneur; would you really want to give up much of the control of your firm before you have even begun? Secondly these types of funds are more often than not aimed at SMEs that have already exhausted their personal debt and available financing options in order to expand. There is a definite distinction between SMEs who are looking to expand and those who are looking to begin. As the saying goes you have to walk before you can run.
So for a completely new-born start-up venture capital isn’t looking the best option. Where to next?
Government
There is a range of government support available to SMEs ranging from R&D grants, actual business funding, knowledge transfer partnerships and various business support functions. Further to this there are often several government funded institutions similar to the Regional Development Agencies in the UK. Although very welcome many forms of government funding and support do not necessarily fit the bill. Direct funding from government is limited to £250,000 and it will only cover up to two thirds of the investment cost (UK figures), where the final third has to come from private investment. Furthermore the interest rates charged by government funding are often above commercial rates, reflecting those investments the private sector does not wish to undertake.
Government research and development grants are also a useful source of developing products for industrial use however eligibility rules limit those who can access these funds. However again these grants rarely cover the full cost of the investment leaving a shortfall still needed to be filled.
In addition to these points government funding and grants are not used widespread. Only around 2% of SMEs in the UK use grants as a source of external funding.
Microfinance
According to Investopedia microfinance is defined as “A type of banking service that is provided to unemployed or low-income individuals or groups who would otherwise have no other means of gaining financial services. Ultimately, the goal of microfinance is to give low income people and opportunity to become self-sufficient by providing a means of saving money, borrowing money and insurance”. The concept of microfinance has been around for a while and has been particularly successful in the developing world. Lending small sums of money, at relatively low interest rates, to the poor, enabling them to create a self-sufficient lifestyle for themselves and their families has been somewhat of a success, indeed the World Bank estimates that there are more than 500 million people who have directly or indirectly benefited from such operations. A common view of microfinance is that many of the individuals who receive the credit are unable to pay it back. However on the contrary to date around 90% of the loans granted are repaid. Until recently a reserve for the developing world, now it is springing up in the developed too. Late in 2010 Grameen America, a branch of the Grameen Bank, was established aiming to assist those under the poverty line within New York. It now has over 6,000 borrowers all making a living having been given the opportunity too.
However microfinance has its own pitfalls too. High interest rates continue to dog a large number of borrowers from microfinance institutions. Only a very select, reputable few institutions offer rates which are manageable if the individual is unable to fulfil their obligations. Secondly many of these microfinance institutions are unsustainable themselves, hence the need to raise the interest rates on borrowers to reflect the risk of the small investment. Only 10% of microfinance lending institutions are self-sufficient, the rest rely on subsidies to stay in business. Thirdly many microfinance institutions offer no formal business training for the loan recipients. This is often a false assumption made by the institutions, believing that the recipients are experienced entrepreneurs and know how best to use the credit.
There is a definite distinction between different types of SME. Those who are just starting up and those which are looking to expand. Their needs are vastly different in terms of financing and they need assistance in helping to choose the correct source. Backing up this statement the SME Finance Monitor report says that 18% of SME’s with 1-9 employees are using bank loans currently in comparison to 34% of SME’s with 50-249 employees. There are many more sources of finance in addition to those which I have mentioned above, such as the smaller microfinance institutions and Community Development Finance Institutions. However the government should endeavour more to inform the SME’s of the available options so that they are able to choose the best one for their SME at that moment in time. Once they have found their suitable financial shoes the entrepreneur can then begin taking his or her first baby steps in the world of business.