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/

 

 

Creative Methods for Innovative Leaders

The June 2017 Leadership Training programme involved a workshop from Professor Mihaela Kelemen of Keele Management School. Professor Kelemen is the founding director of the Community Animation and Social Innovation Centre: a research centre which crosses traditional academic disciplines and works with local communities.

Professor Kelemen delivered an astonishingly creative session for our Mercia Centre for Innovation Leadership participants: 22 owners of innovative, growth-oriented firms from the Staffordshire area. Sue Moffat, the Director of the New Vic Borderlines, co-delivered the workshop with the professionalism expected of an experienced theatre director.

The theme of the workshop was Leadership in a Liquid Modern World: specifically, how SME owners could work with their teams to create an imaginative vision for their organisation.

The CASIC method, entitles Cultural Animation, uses playful, experiential exercises to create connections between participants, allowing them to step outside their day job as SME leaders.

MCIL participants creating an illustration of leadership
MCIL participants creating an illustration of leadership

In the image above, a group of SME owners created a beehive to illustrate the nature of a busy firm, where all the staff had an important role in creating value. The collaborative and hard-working nature of the firm could easily be understood through the analogy of the beehive.

Participants quickly learned that, despite the seriousness of the leadership themes, the creative nature of the exercises helped them see problems in a new way.

In other exercises, participants were asked to dramatise their leadership style: the image is the prelude to a group “high five” from one of the SME leaders, who has a participative and supportive leadership style:

2017-06-16 10.53.55
Group “high five” shows a supportive leadership style

The CASIC method was a powerful learning methodology: participants felt invigorated, challenged, but also much closer to each other as a result. Leadership programmes such as MCIL often show that improved networks are one of the most long-lasting outcomes. CASIC has certainly played an important role in helping participants learn to trust and work with each other, through creative play.

Leadership in a Liquid Modern World

We are now in the the second of our six month leadership development programme. This month we covered the theme of leadership. Our guest speaker, Professor Monika Kostera Professor Monika Kostera, delivered a fascinating lecture on the challenges of leadership in a changing world.

Monika holds a number of visiting professorships and is an accomplished writer and speaker. Her research  themes include imagination and organizing, disalienation of work, organizational ethnography and organizational archetypes.

Monika opened her lecture by describing the transformation of society from the “solid modernity” of the 1960s to 1980s. In those optimistic years, we believed that technology would improve lives to the point where we didn’t have to work, that science would answer all the questions that religion could not, and that equality for all was on the horizon. Remember the malleable, friendly “maintenance drones” in the 1972 film, Silent Running?  They did all the hard work, so that humans could spend their time doing useful work.

Huey Dewey Louie Silent Running
Huey, Dewey, and Louis as examples of helpful robots that would make our lives easier

 

However, the last twenty years have been characterised by “liquid modernity”, namely the growing realisation that technology created as many problems as it solved, a loss of religious faith, and an increase in inequalities. Zygmunt Bauman (1925-2017)  is the brilliant sociologist and philosopher who introduced the concept of liquid modernity . Monika explained that liquid modernity has caused our current state of psychological instability. Whereas before we thought that we were walking to a future utopia, we are now increasingly unable to predict the future. Just look at Brexit, Trump, and the recent UK general election for examples of how difficult it is to predict what will happen next.

Furthermore, the refusal to use history as a template for learning from our mistakes leaders to discontinuity. Monika discussed constantly changing fashions in the field of business studies. For example, the  balanced scorecard  is still an excellent tool for strategic leadership, yet it has fallen out of fashion.

Finally, the loss of religious faith in many societies has created a hyper-rationality, whereby linear thinking and logic are prioritised over mystery and uncertainty.

So what does this mean for leadership in a liquid modern world?

Monika argued that leadership requires storytelling and imagination. Telling a compelling, uplifting story about their organisation helps to reassure insecure staff. Given the high failure rate of many businesses, staff may not otherwise believe their organisation has a concrete future. Leaders can exercise their imagination collaboratively, to build and strengthen teams. Creating a shared story for an organisation can be done together with staff. The ability to think creatively also helps leaders to avoid simple solutions to complex problems.

This is where archetypes come in: the leader as adventurer, for example: Odysseus who bravely led his men through various dangers in a long and epic journey

330px-Arnold_Böcklin_-_Odysseus_and_Polyphemus
Odysseus protects his men from Polyphemus

Further reading was suggested: Gareth Morgan’s Images of Organization“Images of Organization” as a way to understand how archetypes and metaphors can be used by leaders to describe their organisations.

Monika’s most recent book, Management in a Liquid Modern World, is a more detailed examination of the themes of how managers can survive in a society where alienation and confusion are rife.

Our participants were stimulated by Monika’s lecture, particularly by her wider perspective and sociological theory. One attendee said “This is the benefit of coming to a leadership course run by a University. Where else could we hear someone like this speak?”

Monika used one of Albert Einstein’s quotes to emphasise the importance of imagination in leadership: “Imagination is more important than knowledge. Knowledge is limited. Imagination encircles the world.”

Following Your Vision

This is the excerpt for your very first post.

This post describes the first workshop on vision and strategy: creating a vision is essential for developing a strategy.  The strategy then becomes a roadmap for enabling innovation and growth. The session was delivered by Professor Kurt Allman and Phil Johnson from Keele Management School.  Both academics are experienced in developing strategy with SMEs and drew on their personal experience to lend authenticity to  this inaugural workshop.

The workshop focussed on how to engage in innovation through a strategic lens. Despite importance of innovation for business growth, the majority of SMEs in the United Kingdom are not planning to innovate. This surprising result is evidenced by the Small Business Survey, 2015 which found that only 48% of SMEs were planning to introduce new products and services in the next 3 years.  While 48% is a small increase from 2014, where only 42% SMEs were planning to innovate, it is worrying that the majority of SMEs are not planning to innovate.  The use of structure and planning results in better innovation: failing to plan means planning to fail (Slater, Mohr, & Sengupta, 2014). Also worrying is that a recent research report from the ONS found that that smaller businesses in the UK are less likely to engage in structured planning (Office for National Statistics, 2017).

So, given that innovation has long been linked to firm growth (Schumpeter, 1934) and that structured planning helps innovation, what tools are available to help an SME owner to develop a structure for growth and innovation.

Kurt and Phil introduced a simple strategy model based on the influential work of Michael Porter (1980). This model aligns a business along the axes of competitive advantage (“cheap and cheerful” or “high quality”) and competitive scope (as broad a base of customers as possible or being highly selective about which customers to target).

Strategy Model

Adapted from Competitive Strategy: Techniques for Analysing Industries an Competitors The Free Press by Michael E. Porter, copyright 1980, 1998 by the Free Press.

A luxury brand, such as Porsche, would go for “Differentiation” by targeting their marketing to a relative few wealthy customers while also investing in a highly specialised product. A low-cost brand, such as Lidl, would market to as wide an audience as possible while investing in logistics and price control to produce a high number of low-cost goods.

The participants revealed that they, like many SMEs, are “stuck in the middle”. Many of our business owners have chosen a hybrid strategy which involves keeping  their options open. They do not want to deter potential customers by becoming too expensive. Our manufacturing business owners were also reluctant to invest heavily in expensive operational cost controls which would keep their prices down. Kurt and Phil warned that the danger is that an SME can be out-performed by companies who have decided on a single strategy.  And are pursuing it ruthlessly. The advice to SMEs for strategy selection was therefore: ensure you have  a strong understanding of the culture of your organisation, what your customers want, what your competitors are doing, and what legal and economic changes may be coming your way. In other words, choose to be “stuck in the middle” with your eyes wide open.

So how do you think SMEs should create a vision for growth? What tools could help SME owners map out their vision? Does it matter than an SME approaches innovation and growth without a clear strategic plan?

 

Further Reading

Office for National Statistics. (2017). Management practices and productivity among manufacturing businesses in Great Britain: Experimental estimates for 2015. Newport.

Porter, M. E. (1980). Competitive Strategy: Techniques for Analyzing Industries and Competitors. New York, NY: Simon and Schuster.

Schumpeter, J. A. (1934). The Theory of Economic Development: An Inquiry Into Profits, Capital, Credit, Interest, and the Business Cycle. Piscataway, New Jersey: Transaction Publishers.

Slater, S. F., Mohr, J. J., & Sengupta, S. (2014). Radical Product Innovation Capability: Literature Review, Synthesis, and Illustrative Research Propositions. Journal of Product Innovation Management, 31(3), 552–566.