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/