sources of finance for small and growing businesses
Introduction
In this revision note , we concentrate on how small and medium-sized businesses (“SME’s”) obtain finance.
SME’s can be defined as having three main characteristics:
• Companies are not quoted on a stock exchange – they are “unquoted”
• Ownership of the business is typically restricted to a few individuals. Often this is a family connection between the shareholders
• Many SME’s are the means by which individuals (or small groups) effectively achieve self-employment
The SME sector is a vital one in the UK economy. In 1999, the Department for Trade and Industry (DTI) estimated that there are 3.7 SME businesses in the UK. Sole traders account for the majority of the businesses in the UK (63 per cent) but a smaller proportion of the number of employees (23 per cent) and an even smaller proportion of turnover (9 per cent). As a proportion of all businesses in the UK, SME's account for some 55 per cent of employment and 45 per cent of turnover.
Why do SME’s find financing a problem?
The main problem faced by SME’s when trying to obtain funding is that of uncertainty:
• SME’s rarely have a long history or successful track record that potential investors can rely on in making an investment;
• Larger companies (particularly those quoted on a stock exchange) are required to prepare and publish much more detailed financial information – which can actually assist the finance-raising process;
• Banks are particularly nervous of smaller businesses due to a perception that they represent a greater credit risk.
Because the information is not available in other ways, SME’s will have to provide it when they seek finance. They will need to give a business plan, list of the company assets, details of the experience of directors and managers and demonstrate how they can give providers of finance some security for amounts provided.
Prospective lenders – usually banks – will then make a decision based on the information provided. The terms of the loan (interest rate, term, security, repayment details) will depend on the risk involved and the lender will also want to monitor their investment.
A common problem is often that the banks will be unwilling to increase loan funding without an increase in the security given (which the SME owners may be unable or unwilling to provide).
A particular problem of uncertainty relates to businesses with a low asset base. These are companies without substantial tangible assets which can be use to provide security for lenders.
When an SME is not growing significantly, financing may not be a major problem. However, the financing problem becomes very important when a company is growing rapidly, for example when contemplating investment in capital equipment or an acquisition.
Few growing companies are able to finance their expansion plans from cash flow alone. They will therefore need to consider raising finance from other external sources. In addition, managers who are looking to buy-in to a business ("management buy-in" or "MBI") or buy-out (management buy-out" or "MBO") a business from its owners, may not have the resources to acquire the company. They will need to raise finance to achieve their objectives.
Sources of finance for SME’s
There are a number of potential sources of finance to meet the needs of small and growing businesses:
• Existing shareholders and directors funds (“owner
financing”)
• Overdraft financing
• Trade credit
• Equity finance
• Business angel financing
• Venture capital
• Factoring and invoice discounting
• Hire purchase and leasing
• Merchant banks (medium to longer term loans
A key consideration in choosing the source of new business finance is to strike a balance between equity and debt to ensure the funding structure suits the business.
The main differences between borrowed money (debt) and equity are that bankers request interest payments and capital repayments, and the borrowed money is usually secured on business assets or the personal assets of shareholders and/or directors. A bank also has the power to place a business into administration or bankruptcy if it defaults on debt interest or repayments or its prospects decline.
In contrast, equity investors take the risk of failure like other shareholders, whilst they will benefit through participation in increasing levels of profits and on the eventual sale of their stake. However, in most circumstances venture capitalists will also require more complex investments (such as preference shares or loan stock) in additional to their equity stake.
The overall objective in raising finance for a company is to avoid exposing the business to excessive high borrowings, but without unnecessarily diluting the share capital. This will ensure that the financial risk of the company is kept at an optimal level.
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