Financing SMEs: removing the anguish

Citizen John would love to invest in that small company just across town that manufactures fuel-saving boilers. It has just bought new land to expand. His cleaning lady’s son, a driver at the plant, is enthusiastic about how the products are being shipped to more parts of the world. And the newly qualified daughter of his squash partner has just started there as a thermal engineer.

But John is worried. It is a family firm. And accountancy and company regulation anywhere in the EU is not strong. If he were across the Atlantic, John would quite likely invest in the SME. But in Europe, even with his inside knowledge, John is afraid of getting his fingers burned. All sorts of things could go wrong.

Who knows what the family that owns the largest block of share might do. It could set up a trading partner, which could purchase the boilers at low prices. This would siphon off profits from the firm that John might invest in. It could manage its affairs to save tax, rather than to give benefits to shareholders. Overall, SMEs lack ‘solid process control’.

Generally, in the EU, difficulties over getting finance, such as from citizen John, are blamed for the vastly inferior dynamics of the sector in the EU compared with that in the US. Early stage venture capital availability in the EU 25 represented 2.9% of GDP, against 4.5% in the US (1). Currently, seed capital in Europe is estimated to be less than a tenth of that in the US. According to a recent Eurobarometer survey, 40% of small and medium-sized firms indicated that their development would be enhanced by easier access to finance. (Other obstacles to their growth are simpler social and fiscal regulations and better availability of qualified people).

This is a shame for the EU economy. In the EU, nine out of 10 companies are SMEs; they provide almost two out of three jobs. European Commissioner Günter Verheugen describes them as ‘the driving force of European growth and job creation’. According to the Union of Industrial and Employers’ Confederations of Europe, SMEs do give sorely needed jobs in the EU, but at nothing like potential. As a result, in the Eurozone unemployment remains 8.1%, which is nearly twice as high as in the US and Japan, each at 4.7%. The UK rate is 3%.

Initiative

Certainly, the European Commission is worried. It recently launched an initiative to triple early-stage capital investment. This seeks to generate more risk capital investments, to develop bank finance for innovation, and to make existing financing systems more SME friendly. It wants to step up early-stage investment from 2bn euros per year to 6bn euros (£1.3bn–£4bn) by 2013.

Another approach to reduce risk in investing in the sector is legislation to tighten up on company reporting rules. This is aimed ‘to get the cost of capital down, to create jobs’, as stated by David Wright, director of financial services at the European Commission. Important upgrades recently approved and now awaiting implementation by the EU national governments sometime during 2007 are those to the Fourth and Seventh Company Law Directives. The first applies to the financial statements from individual companies and the Seventh Directive applies to consolidated accounts for groups. In the case of listed companies, the upgrades are, to some extent, being trumped by IFRS. All listed companies have to apply this code in their consolidated accounts.

The revisions to company law, which are being processed as legislative amendments, introduce two main principles. One covers ‘companies’ transactions with their managers, the latter’s family members, or other so-called ‘related parties’. The new code will demand ‘disclosure’, ‘but only where such transactions are material and not carried out at arm’s length’.

Another factor addresses problems of off balance sheet arrangements, concerning the use of special purchase vehicles (SPVs, known to be used by companies to distance themselves from liabilities), which can make it difficult for investors to assess the real risk of investing in a company. It specifies that ‘appropriate disclosure of the material risks and benefits of such arrangements that are not included in the balance sheet should be set out in the notes to the accounts or the consolidated accounts’. Other elements in the revised legislation include confirmation that all board members should have collective responsibility for company financial statements.

A member of the European Parliament who nursed through the upgrade, Klaus-Heiner Lehne, has emphasised the need to avoid overkill in accounting requirements for small firms. ‘We are providing benefits to investors without too much regulatory burden on the companies themselves,’ he told accounting & business.

Strict

Whatever, any new policies may not have much effect on investments from the likes of John. In Europe, most non-family finance for SMEs is not from equity. It comes mainly from banks. Saskia Slomp, technical director at the European accountants’ representative body FEE, says the banks can be strict with their cash, demanding full collateral backing, especially in southern Europe.

Another source of finance is venture capital for start-ups, but in Europe that plays only a small role. According to a Commission spokesperson, in the EU overall, early stage venture capital availability in the EU 25 was 2.1bn euros (£1.4bn 2005, that is, about 0.02% of GDP). This compares feebly with comparable figures from the US for venture capital investments in technology (for 2004). The figure was 3.6bn euros (£2.4bn) in Europe, compared with 14bn euros (£9.4bn) for the US.

Incidentally, a ‘small’ company, under the relevant EU definition, has a balance sheet total of under 4.4m euros (£3m), annual revenue under 8.8m euros (£6m), and has fewer than 50 employees. The limit for ‘medium-sized’ firms is: a balance sheet total of 17.5m euros (£11.8m), annual revenue under 35m euros (£23.5m), and has fewer than 250 employees. Thought is being given to what a ‘micro’ firm might be.

In parallel with the modifications to the Fourth and Seventh Directives is the statutory Audit Directive, which tackles the same goal of improving shareholder confidence, but by dealing with the auditing end. It applies to auditors, including auditors of SMEs.

Another important step could be an exposure draft for accounting rules for SMEs from the IASB. Some had hoped for simplification of recognition measurements applied to assets and liabilities and, perhaps, more on disclosure. Others wished that smaller companies would be freed from practically all obligations, apart from rules for accounting for tax purposes. The draft was expected for the end of 2005. Until then, the IASB was going to keep its lips closed.

However, to soften what looks like a behind-the-scenes head-on clash between contrasting positions, the board has, unusually, already put on public record its staff draft. This by no means eliminates accountancy regulation, but it does slash back to approximately one-tenth from the full IFRS provisions for listed companies. It appears that the IASB would resist going further down this road. Wayne Upton, research director, addresses those who may be disappointed with words that stress the board’s fundamental objective to ‘meet the needs of people who use SME financial statements. These tend to be lenders,’ he noted.

The IASB may not be alone in its thinking about the interests of investors. The Commission is considering further possible moves in the pipeline. These have not yet been announced, but they could include more attention to the Fourth and Seventh Company Law Directives.

Reference
1. Figures from Eurostat, 2002

Jeremy Woolfe is a Brussels-based independent journalist, specialising in financial legislation.