Prior to considering some of the finance sources available to small and medium-sized enterprises (SMEs) we should first consider what we mean by SMEs, why they are important, and why they often find raising finance difficult. In this article, we consider potential finance sources that an SME could use. There will be a particular focus on the more modern sources of crowdfunding and supply chain financing. Finally, we will consider how, and why, governments often try to assist the SME sector.
What is an SME?
It is generally accepted that an SME is something larger than those businesses that are fundamentally a vehicle for the self-employment of their owner. Equally an SME is unlikely to be listed on any stock exchange and is likely to be owned by a relatively small number of shareholders. Indeed, very often the majority of the shareholders come from one extended family. Hence the term SME covers a very wide range of businesses.
Why are SMEs important?
As we have just seen, the term SME covers a very wide range of businesses. As a result, the SME sector as a whole is very important to the economies of many countries. Estimates vary widely but within the UK, SMEs probably account for about half of employment and half of national income, and hence are of great importance.
As SMEs are relatively small they are often more flexible and quicker to innovate than larger companies. Indeed, SMEs are often thought to be better at embracing new trends and technologies. Obviously it is important to any economy that this occurs. One consequence for some successful SMEs is that they are acquired by a larger company with the financial resources to fully exploit the potential of what the SME has developed. When this happens the SME sector has provided a useful service as it has helped a larger company to innovate and continue its success into the future.
In economies, such as the UK, where manufacturing industry has declined as a proportion of total economic activity and the service sector has become increasingly important, the SME sector is likely to continue to grow. This is because, in the service sector, economies of scale are normally less important than they are in manufacturing. Hence, within the growing service sector it is easier for SMEs to survive and flourish.
Finally, it is important that SMEs can flourish as potentially a number of the SMEs of today could be the bigger companies of tomorrow.
Why do SMEs find raising finance difficult?
The directors of SMEs often complain that the lack of finance stops them growing and fully exploiting profitable investment opportunities. This gap between the finance available to SMEs and the finance that they could productively use is often known as the ‘funding or financing gap’. As advisers to SMEs it is important that we understand why this gap occurs.
The first thing to understand is that there is a limited supply of funds from investors. Once potential investors have satisfied their need and desire to spend and have paid their tax there is often little left over to be invested. An additional issue at the current time in the UK is that the returns available to investors on a typical deposit account are so low that investment does not seem attractive.
Equally there is a competitive market for the limited supply of investors’ funds. Governments and larger companies have a great appetite for the funds available and, hence, the SME sector can be squeezed out.
The SME sector tends to suffer because SMEs are viewed as a less attractive investment opportunity than many others due to the high levels of uncertainty and risk they are perceived to have. This perception of risk is due to a number of reasons including:
- SMEs often have a limited track record in raising investment and providing suitable returns to their investors
- SMEs often have non-existent or very limited internal controls
- SMEs often have few external controls. For instance they are unlikely to be abiding by the rules of any stock exchange and due to their size they are unlikely to attract much press scrutiny. Indeed, in the UK many SMEs are no longer required to have their annual accounts audited
- SMEs often have one dominant owner-manager whose decisions may face little questioning
- SMEs often have few tangible assets to offer as security.
As a result of the above, investors are nervous of investing in SMEs as they are concerned about how their funds might be used and the returns that they might get. Hence, the easiest thing for an investor is to decline any opportunity to invest in an SME, especially when there are so many other investment opportunities available to them.
Accountants can do little to alter the supply of funds or the competitive market for those funds, but can assist by showing how an SME could reduce the level of risk it is perceived to have, thereby improving its ability to raise finance. For instance, SMEs that can show that they have treated earlier investors well, have adopted some key internal controls, and have a rigorous and documented approach to decision making are more likely to be attractive to investors.
What are the potential sources of finance for SMEs?
In reality there are quite a few potential sources of finance for SMEs. However, many of them have practical problems that may limit their usefulness. Some key sources and their limitations are briefly described below. Crowdfunding and supply chain financing are then considered in more detail.
The SME owner, family and friends
This is potentially a very good source of finance because these investors may be willing to accept a lower return than many other investors as their motivation to invest is not purely financial. The key limitation is that, for most of us, the finance that we can raise personally, and from friends and family, is somewhat limited.
The business angel
A business angel is a wealthy individual willing to take the risk of investing in SMEs. One limitation is that these individuals are not common and are very often quite particular about what they are prepared to invest in. Once a business angel is interested they can become very useful to the SME, as they will often have great business acumen themselves and are likely to have many useful contacts.
SMEs, like any company, can take credit from their suppliers. However, this is only short-term and, indeed, if their suppliers are larger companies who have identified them as a potentially risky SME the ability to stretch the credit period may be limited.
Factoring and invoice discounting
Both of these sources of finance effectively let a company raise finance against the security of their outstanding receivables. Again, this finance is only short-term and is often more expensive than an overdraft. However, one of the features of these sources of finance is that, as an SME grows, their outstanding receivables will grow and so the amount they can borrow from their factor or from invoice discounting will also grow. Hence, factoring and invoice discounting are two of the very limited number of finance sources which grow automatically as the business grows.
Leasing assets rather than buying them is often very useful for an SME as it avoids the need to raise the capital cost. However, leasing is only really possible on tangible assets such as cars, machines, etc.
Banks may be willing to provide an overdraft of some sort and may be willing to lend in the long term where that lending can be secured on major assets such as land and buildings. However, raising medium-term finance to fund operations is often more difficult for SMEs as banks are traditionally rather conservative. This is understandable as the loss on one defaulted loan requires many good loans to recover that loss. Hence, many SMEs end up financing medium-term, and potentially longer-term assets, with short-term finance such as an overdraft. This is poor matching and very much less than ideal. This issue is often known as the ‘maturity gap’ as there is a mismatch of the maturity of the assets and liabilities within the business.
Furthermore, banks will often require personal guarantees from the owner-manager of the SME, which means the owner-manager has to risk his personal wealth in order to fund the company.
The venture capitalist
A venture capitalist company is very often a subsidiary of a company that has significant cash holdings that they need to invest. The venture capitalist subsidiary is a high-risk, potentially high-return part of their investment portfolio. Hence, many banks will have venture capitalist subsidiaries. In order to attract venture capital funding an SME has to have a business idea that may create the high returns the venture capitalist is seeking. Hence, for many SMEs, operating in regular business, venture capitalist financing may not be possible. Furthermore, a venture capitalist rarely wants to remain invested in the long term and, hence, any proposal to them must show how they will be able to ‘exit’ or release their value after a number of years. This is often done by selling the company to a bigger company operating in the same trade or by growing the company to such a size that a stock exchange listing is possible.
By achieving a listing on a stock exchange an SME would become a quoted company and, hence, raising finance would become less of an issue. However, before a listing can be considered the company must grow to such a size that a listing is feasible. Many SMEs can never hope to achieve this.
Supply chain financing
In supply chain financing (SCF) the finance follows the value as it moves through the supply chain. SCF is relatively new and is different to traditional working capital financing methods, such as factoring or offering settlement discounts, because it promotes collaboration between buyers and sellers in the supply chain. Traditionally there was competition as the buyer wanted to take extended credit, and the seller wanted quick payment. SCF works very well where the buyer has a better credit rating than the seller.