Intermediation is represented by the banking sector that brings together savers and investors in a cost effective manner to allocate scarce funds.
Accessing scarce funds for SME investment
Thus we see that, even for the best firms, with the most effective management and the most original ideas there is a shortage of funds inasmuch that there will always be a limited supply. The market for available funds is competitive. Managers of SMEs who fail to recognise this do not understand an important part of their job which is to secure proper financing: this is the point at which accounting advisors are most useful.
Beyond saying that there is a limited supply of funds there is a deeper issue. It is well recognised in the academic literature on this issue that the problem of adequately financing SMEs is a problem of uncertainty. A defining characteristic of SMEs is the uncertainty surrounding their activities. However much managers inform their banks of what they are doing there is always an element of uncertainty remaining that is not a feature of larger businesses. Larger businesses have grown from smaller businesses and have a track record - especially in terms of a long term relationship with their bankers. Bankers can observe, over a period of time, that the business is well-run, that managers can manage its affairs and can therefore be trusted with handling bank loans in a proper way.
New businesses, typically SMEs, obviously don’t have this track record. The problem is even broader. Larger businesses conduct more of their activities in public, or subject to external scrutiny, than do SMEs. Thus, if information is public, there is less uncertainty. For example, a larger business might be quoted on an exchange and therefore subject to press scrutiny, exchange rules regarding the provision of certain of its activities, and has to publish accounts that have been audited. Many SMEs do not have to have audits, certainly don’t publish their accounts to a wide audience and the press are not really interested in them. The problem of SMEs is how do they get over this barrier of conveying that they are a good business, can make profits if only they were provided with appropriate finance, and can grow large if given half a chance.
Overcoming information barriers
This is the point at which financial intermediaries enter. There are basically two forms: banks, and accountants acting in their role as activators. Thus, we see a vital role played by professionals in getting SMEs to grow. Let’s deal with banks first.
If SMEs wish to access bank finance then banks will wish to address the information problem in three phases. First, by screening applicants to assess their product, the management team, the market they are to address and, importantly, any collateral or security that can be offered. This first phase is likely to involve properly prepared business plans, an audit of the firm’s assets, detailed explanation of any personal security offered by the directors and owner managers, and the experience and relevance of the skills of the management team.
The second phase involves setting an appropriate contract for a loan. You should not forget basic finance at this point. Thus, in the first phase, a bank would make an assessment of the risk of the business and any loan interest rate, set in the second phase, will reflect that risk. A key feature for accessing bank finance is therefore in the assessment of risk from the information gathered in the first phase.
Contract details will specify interest rate, term, the level and type of security offered, restrictive covenants, and repayment details. The third phase is the monitoring phase by which banks monitor the performance of any loan according to the contract details set-out in phase 2. Compliance comes to the fore at this point. It is also at this point that the key banking relationship can be established.
There is still an important issue remaining. What about businesses that fail one of the screening or contracting tests? What about businesses that have few tangible assets to offer as security, which is very typical of high technology or Internet start-ups? These businesses are thus characterised by great uncertainty but still need that start-up finance to develop. Accountants play a crucial role at this point. In order to understand how this might be resolved it is important to see how the needs of SME financing change with their stage of growth.
Types of financing and growth in SMEs
A broad list of SME financing can be usefully provided at this point:
- Initial owner financing
- Business angel financing
- Trade credit
- Venture capital
- Short-term bank loans
- Medium term bank loans
- Mezzanine finance
- Private placements
- Public equity
- Public debt.
This list is loosely structured along growth lines. Thus, very small organisations start at point 1 and work through to point 10. Not all of the financing is successive and a number will overlap. Further more, as businesses grow, more information becomes known as they develop a track record. Thus the list is ordered as much in terms of information availability as it is in terms of growth.
Diagrammatically, the relationship between type of finance and growth may be represented along a time line on the assumption that growth is related to age of business as shown in Diagram 2.