Financing SME Growth: Banks vs Equity Capital

Financing SME Growth

Our leadership development session included an inspiring workshop from Professor of Practice, Gary Crowe, of Keele Management School. Gary used his extensive experience in the banking industry to deliver a challenge to SME owners. How are they going to finance their growth ambitions? This post will look at why growth matters for SMEs, how credit finance can be used to increase growth, and why SMEs been reluctant to resist growth to date.

Finance to solve growth problems

Governments want businesses to grow so that more jobs are created and more taxes are paid. Firm owners want their businesses to grow so they can make more profit, keep up with their competitors, and expand into new markets. For a start-up, firm growth means a sole trader moving her office out of the spare bedroom and into a business park and hiring staff to help her run the business.

maslow growth quote

However growth can be expensive to achieve. Firms need to buy expensive equipment, hire skilled people, and build bigger offices to house their new assets. Small firms may not have the reserves to pay for these costs, so the expectation is that they will borrow to finance their growth.

However, the vast majority of SMEs are not borrowing at all, let alone for growth. The 2015 Small Business Survey showed that only 17% of SME employers had sought external finance in previous 12 months . This was a 2% decrease on the 2014 figure and a 9% decrease on the 2010 SBS figure. The 3-year decline in SME borrowing is surprising given that bank lending to SMEs has increased since 2014. The British Business Bank reports that the net flows of bank loans for small business turned positive in 2015  with four consecutive quarters of growth in bank lending totalling £1.6bn through to Q3 2015. The SME Finance Monitor reported that 70% of all loans in 2015 were successful. This shows that when SMEs do apply for finance, the majority of firms are successful.

Finance requirements change through the firm lifecycle

Given that only a minority of SMEs are seeking financing, at what point do growth-oriented SMEs seek investment for growth? The 2015 Small Business Survey showed that demand for bank finance increased with the size of the business. There is clearly a connection between the size of the company and their appetite for risk: 27% of mediums sought finance in the last 12 months, compared to 16% of micros.

Whatever their size, most SMEs will go to their bank for credit. However, for firms with growth ambitions, equity finance is a more attractive provider. Equity finance requires the firm owner to sell part of their ownership interest in the firm in exchange for their money. Equity investors therefore buy part of the firm and are looking for firm growth, so that their investment will deliver strong returns. As a result, equity investors are more likely to support growth-oriented plans. As small firms start to grow, their equity financing needs start to change.

We can see how the appetite for equity finance changes throughout the business lifecycle.  Gary provided a slide showing how sources of finance evolve from more informal sources of equity finance, such as friends and family in pre-start stage, to more formal, demanding types of private equity, such as the stockmarkets and mezzanine finance during the more mature stage.

Equity Funding Ladder

Source CBI – Slice of the Pie, Tackling the under-utilisation of Equity Finance

http://www.cbi.org.uk/cbi-prod/assets/File/pdf/cbi_equity_finance_report_3_feb.pdf 

Why firms don’t want to access credit

However, both equity finance and bank lending remain under-utilised. The reality is that, despite the availability of finance, most SMEs do not want to grow. The 2015 Small Business Survey showed that the top three reasons for accessing finance were to fund cashflow (62%), to buy property or equipment (39%) or to buy land (14%). Only 9% were looking to fund expansion (growth) and only 3% to invest in growth-enhancing R&D.

The majority of SMEs remain “happy non-seekers” of finance, content to remain small and unencumbered by debt. Another, less complimentary term, for this type of SME is “muppets”, or marginal, under-sized, poor-performing enterprises. These low-growth firms are described in Alex Coad and Paul Nightingale’s influential paper, Muppets and Gazelles: Political and Methodological Biases in entrepreneurship research. Coad and Nightingale argue that biased policy-makers and poor research practices have led to an over-estimation of the extent to which SMEs contribute to the economy. Coad and  Nightingale find that the majority of SMEs do not want to borrow money because the average SME owner is not capable, nor interested, in growing their business. “Muppets” are marginal because they lack the ambition or ability to grow or innovate, have high business failure rates and are poorly understood by government statistics or academic research. They are undersized because they remain too small for the efficiencies of scale needed to compete with the dominant players in their industries. The inevitable result is poor performance: “muppets” have poor productivity and low levels of innovation. These firms are simply incapable of accessing the credit market.

Even ambitious firms are reluctant to borrow due to bad experiences with banks. Many indebted SMEs found that their lenders became less supportive once the credit crunch began. Banks examined their loan agreements for covenants that the borrower might have breached and, if they found any, they called in the loan or altered its terms. In other words, bank debt was actually behaving like equity finance: the bank lender became a part-owner of the business, able to dictate terms and potentially even causing the business to fail. High-growth firms were more likely to access finance from highly leveraged and unstable banks; therefore, researchers argued, the effect of the credit crunch on business failure of high growth firms was amplified. A persistent memory of badly behaving banks has caused many SME owners to avoid seeking credit.

 

How can policy-makers support financing for growth?

Policy-makers have long been concerned about why SMEs are not interested in accessing finance for growth. There are calls for the government to help build an equity culture in the UK, including a pre-capital market equity investment house. Other policy advisors recommend a Business Academy Network, similar to our own MCIL project. Business Academies, backed by the government, could help business owners to be more confident their growth and financing plans. The British Business Bank was set up as a result of government concern about the lack of options for bank lending. The government-underwritten bank now funds start-ups and businesses wanting to grow.

In conclusion, SMEs now have a wider range of financing options for growth than ever before. However, SME owners remain, on average, uninterested in growth. Those who are accessing finance are going to bank lenders, rather than equity capital who may be more able to help them with long-term growth ambitions.

The “muppet” show isn’t over yet.

Further Reading

Coad and Nightingale (2011). Muppets and Gazelles, political and methodological biases in entrepreneurship research: https://academic.oup.com/icc/article/23/1/113/670219/Muppets-and-gazelles-political-and-methodological

Du, J., Gong, Y., & Temouri, Y. (2013). High Growth Firms and Productivity – Evidence from the United Kingdom. Retrieved from www.nesta.org.uk/wp13-04

Freeman (2013). Finance for Growth – Challenging the Myths about Funding for Small Businesses https://www.demos.co.uk/files/DF_-_Finance_for_Growth_-_web.pdf?1378216438

HM Treasury. (2011). The Plan for Growth. Retrieved from https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/31584/2011budget_growth.pdf

SME Finance Monitor website: http://bdrc-continental.com/products/sme-finance-monitor/

 

 

SME Growth and Public Policy

Entrepreneurship research is characterised by the close collaboration between business, policy, and research. My own research would have been impossible without the help from organisations that foster networking. Two of these organisations, the  Institute for Small Business and Entrepreneurship, and the Enterprise Research Centre, organised a policy round-table event  at Coventry University Techology Park last week to discuss SME growth.

The “Start-Up or Scale-Up” event was to ask whether policies in the UK currently support the development of growth-oriented plans by entrepreneurs. Participants came from a range of universities, and support organisations such as Growth Hubs, LEPs, and Chambers of Commerce. Debate amongst the participants was lively.

Research by the ERC on the impact of high-growth firms and job creation in 2015 showed that, over a three year period, high growth firms represent less than 1% of established businesses, but create over 20% of job growth in all established businesses which grow. High-growth firms make a disproportionately huge impact on job creation. Hence the government interest in supporting high-growth firms. An influential report from NESTA (Brown, Mason, & Mawson, 2014) explores the misalignment between public policy and high-growth firms, particularly given the complex and under-researched nature of what growth involves.

Definitional problems around “high-growth” firms

The policy round table was opened by Professor Stephen Roper with a definitional problem: most policy-makers are using a very specific, even restrictive definition of what a “high growth firm”, or scale-up, actually is.

Start Up Scale Up

The Department for Business Energy and Industrial Strategy is using the OECD definition of a high-growth firm:

“All enterprises with average annualized growth greater than twenty percent per annum, over a three-year period, and with ten or more employees at the beginning of the observation period. Growth is thus measured by the number of employees and by turnover.”  (OECD & Eurostat, 2007)

The problem is that this definition excludes the vast majority of SMEs. 82% of SMEs in the UK have fewer than 10 employees (Department for Business Innovation and Skills, 2016). Of these, 76% had no employees. Start-ups generally have no employees, but have huge growth potential, and often require credit finance, leadership development, and support with exporting to achieve that growth.

A further difficulty is spotting firms at the right time, so that they can be offered help when they most need it. Firms spotted “ex ante” have often come out of a growth cycle and no longer require help. Professor Roper has developed a process whereby high growth firms are spotted through HMRC quarterly tax returns. When HMRC notice an unusual increase in pre-growth indicators, perhaps a change in employee numbers or turnover, they would inform the Growth Hub advisors in the firm’s geographical area. The advisors would then visit the firm to offer support for their growth.

Policy Suggestions for Growth

Professor Roper’s process addresses a key problem: only a small fraction of SMEs have heard of support organisations. Indeed, participants noted the fragmented nature of support for SME growth. In 2015, only 13% of SME employers in England had heard of Growth Hubs, the government-sponsored advisory and training service for SMEs. Growth Hubs are currently provided by the 39 LEPs in England. Wales, Scotland, and Northern Ireland have separate arrangements. Participants in the room noisily discussed the need for a joined-up policy on promoting business growth.

In addition to a lack of joined-up support for growth, a previous post argued that most SMEs are neither willing nor capable of growth. Participants then discussed whether government policy should stop subsidizing all SMEs and focus only on those with growth ambitions. This argument has been made by DEMOS , a non-partisan think-tank. A straw poll of the room showed that about 50% of us thought that government policy support should only go to firms with growth ambitions. The other 50% thought that all SMEs, irrespective of whether they have growth ambitions or not, should be supported.

I would also argue that we must support SMEs who appear to lack growth ambitions. We already know that the majority of entrepreneurs do not have higher education (Department for Business Innovation and Skills, 2016). Research shows that those with higher education can get better-paid jobs, and therefore don’t need to start a business. However, entrepreneurs that want to grow their business may be deterred by their lack of education, including knowledge about support organisations. A lack of growth ambition could therefore simply be a lack of confidence. All entrepreneurs should be given the confidence, skills, and knowledge to grow. Government and local policy should explain the benefits of growth to SMEs, and show them how to grow in a productive and sustainable way. Today’s event was a timely reminder of how much more needs to be done in this area.

 

Further Reading

Brown, R., Mason, C., & Mawson, S. (2014). Increasing “The Vital 6 Percent”: Designing Effective Public Policy to Support High Growth Firms. London. Retrieved from http://www.nesta.org.uk/wp14-01

Department for Business Innovation and Skills. (2016). Longitudinal Small Business Survey Year 1: SME employers. Longitudinal Small Business Survey Year. Retrieved from https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/522364/bis-16-227-sme-employer-report.pdf

OECD, & Eurostat. (2007). Eurostat-OECD Manual on Business Demography Statistics. Retrieved from http://www.sourceoecd.org/industrytrade/9789264041875

 

 

 

Stay private or go public? Firm funding strategies.

Innovative, growth-oriented firms, such as those on the Mercia Centre for Innovation Leadership project, often require additional funding. This could be to finance innovative new projects or to fund employee and capital equipment growth. This post looks at the advantages of going public versus staying private. (A longer version of this article was published in The Conversation)

Control over executive pay

First, founders and bosses get full control over senior executive pay. Because a small group of existing shareholders dictate who buys the shares, it makes it far less likely that activist shareholders will reject controversial pay awards.

Avoiding red tape

Staying private also avoids the onerous disclosure requirements from stock exchanges. Some companies fear that a small failing in due diligence could lead to troublesome interest from regulators, or even expulsion from a stock exchange.

High costs of firm listings

The costs can be significant too. A firm listing on London’s AIM stock exchange for small companies will have to pay in the region of £350,000-£400,000, with a further 6% of any funds raised being paid to brokers.

 

Public vs private.jpg

 

With these incentives to stay private, why go to the markets at all? The public markets are still the ultimate destination for a number of reasons.

Regulatory requirements

Prior to the Jumpstart Our Business Startups (JOBS) Act of 2012, firms in the US had to go public if they had more than 500 shareholders. This is the ruling that forced Facebook to go public in search of more capital. Now that firms can have up to 2000 shareholders, fewer firms need to go to the public markets. Yet growth-oriented companies will still, eventually, have to go public.

 

Promises made to staff and investors

Innovative, growth-oriented firms often extract long hours from staff and patience from investors by promising shares when the firm eventually goes to the markets. Staff and investors cannot be placated indefinitely if they are waiting to cash in their shares.

Recruitment of top talent

Going public can also be a stimulus to recruit top talent. A company preparing for IPO is advised to bring in the best CEO and chief financial officer one to two years before so they can build relationships and galvanise staff.

Companies can also derive a moral benefit from the transparency of public markets. This is particularly true of growing global stars, like Uber and AirBnB, that are changing employment and social practices. A broad base of public ownership is more democratic than ownership by wealthy and invisible individuals. In the increasingly fractured world described in the June training session, companies need to demonstrate they deserve the trust of the public.