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Source: http://www.doksinet Entrepreneurship & Management of SMEs, Summary Chapter 20, A.PL Kadiri F I N A N C E A N D T H E S M A L L B U S I N E S S FINANCE AND THE SMALL FIRM • Distinct differences between large companies and small firms o Financial-‐economic perspective: lack of capital markets o Socio-‐economic perspective: relationship between finance provider and the firm § Small firms: finance provider and owner/manager § Large firms: shareholders and directors o There is only limited information available for small firms § Large firms have publicly available annual reports o Research should be
analyzed with caution: 1. There is no universal definition of a ‘small’ business 2. Aggregation of data a. Extent and source of funds will depend upon size of the business/industrial sector/tangible assets THE FINANCE GAP • Finance gap / hard capital rationing – a situation where a firm has profitable opportunities but there are no, or insufficient, funds (either from internal or external sources) to exploit those opportunities o Soft capital rationing – the opposite of hard capital rationing; self-‐imposed restriction o Whether the finance gap exists has been the topic of many discussions
• Equity gap – the gap between funds that can be profitably employed by the firm and the funds they are able to raise from equity markets or investors o Most small firms depend on friends and family (‘love money’) o Limited opportunities in equity markets o A small proportion uses the Alternative Investment Market (AIM) o There is also the owner/manager’s reluctance à independence and control • Debt gap – inability to raise debt finance o In recent years, financial service institutions have also broadened their scope and introduced new products o Banks
apply the risk-‐return trade-‐off à the higher the risk (variability of returns), the higher the return that can be expected § Problem: it is impossible to measure risk in a small firm à results in the use of secured lending and crude-‐credit scoring systems § Credit scoring – a system of analyzing information when making lending decisions o BUT: small business sector is not as dependent on bank loans as is commonly thought Source: http://www.doksinet Entrepreneurship & Management of SMEs, Summary Chapter 20, A.PL Kadiri • Evidence suggests that the finance gap does
not suggest for small firms o BUT: for the small subset of the SME population that has the potential to grow substantially (high-‐impact firms) it is a particular problem à constrained in accessing debt finance and can only increase capital through injections of equity § As a result, AIM, mezzanine finance, and venture capitalists emerged § Mezzanine products – debt/equity hybrids aimed at established but growing firms, senior to common shares but junior to debt obligations • Higher rate of return than pure debt but less than equity, higher risk than debt but less than
equity • There is a shortage of start-‐up and early stage equity capital • There is also evidence that women are active in less capital-‐intensive sectors and are less willing to take on debt • University graduates are also facing challenges: o They are one of the most entrepreneurial groups of people o BUT: levels of student debt are often burdensome • Governments have introduced a number of initiatives with varying success • Business angels – informal risk capital provided by investors o Main problem is to match potential investors with the firms that need
the funds • Information gap – owner/managers are insufficiently informed about funding opportunities SOURCES OF FINANCE • Results must be interpreted with care à limitations of survey methods SUPPLIERS • Most important providers of short-‐term finance to SMEs à many sales are made on credit • Commercial relationship gives greater amount of information on and control over recipient o BUT: suppliers are very sensitive to economic and liquidity conditions (2008 crisis) • Late payments are unauthorized overdrafts o Despite being controversial and damaging, they are widespread Source:
http://www.doksinet Entrepreneurship & Management of SMEs, Summary Chapter 20, A.PL Kadiri BANKS • SMEs rely on bank loans because they are rarely able to access capital markets for funding o Reliance on banking tends to fall after a recession and rebounds when economy the recovers • Pattern of bank lending has changed dramatically in recent years à trend away from overdraft lending o Overdraft – a short-‐term loan that banks grant customers, giving them the right to overdraw their bank account by an agreed amount, is repayable on demand • The term of any loan should be
matched to the life of the investment for which the loan is required o Assets: long-‐ or medium-‐term loans o Working capital: short-‐term loans o Notion of uncertainty due to the passing of time is extremely relevant to the lending decision à in the case of riskier applications banks ignore the matching principle à banks tend to be overly cautious in their lending decisions à offer shorter-‐term loans to younger and smaller firms • There has been an effort to reduce the sector’s reliance on security: behavioral scoring + loan guarantees o Behavioral
scoring – a type of credit scoring that monitors customers’ credit risk in the light of the activity in their bank accounts; specific terms for individual accounts o BUT: collateral has actually risen dramatically in importance o There is also a lack of competition for bank lending to small firms in the UK LOAN GUARANTEE SCHEMES • Small Firms Loan Guarantee scheme (SFLG) introduced in 1979 o For small firms that have a viable business proposal but filed to obtain a conventional loan à guarantee not available if a conventional loan cannot be obtained o Gov’t
guarantees against a potential default; loan has a maximum amount o Had high levels of default, however, number reduced • Enterprise Finance Guarantee (EFG) introduced in late 2008 (financial crisis) o Aimed at more established and larger firms o Although the scheme was well conceived and designed, the gov’t failed to communicate its precise purpose and features LEASING AND HIRE PURCHASES • Second most important source of finance to small firms • Leasing – form of renting; ownership of the asset rests with the lessor, who allows the lessee the use of the asset for
an agreed period o Operating lease – asset is leased for a period that is substantially shorter than its useful economic life § Responsibility lies with the lessor; convenient insurance against the risk of future uncertainty o Finance lease – a lease that transfers substantially all the risks and rewards of ownership to the lessee § Long-‐term and very similar to purchasing an asset with a bank loan Source: http://www.doksinet Entrepreneurship & Management of SMEs, Summary Chapter 20, A.PL Kadiri • Hire purchase (HP) – a method of buying goods in which the purchaser takes
possession of them as soon as an initial instalment of the price (known as the deposit) has been paid; ownership passes to the purchaser when all subsequent installments have been made o Because of their similarity HP and leasing are often grouped together o The use made of leasing and HP was related to certain characteristics of both the business (size, past experience) and the asset § The larger the firm’s size, the more likely it is to use both leasing and HP • Previous research focused on large firms and indicated that taxes are the most significant factor
influencing the decision to lease à for small firms tax is not important in that decision à most do not make the complex tax computations • Main leasing advantages: o Avoids large capital outlay o Is cheaper o Helps cash flow o Is easier to arrange EQUITY • (The term equity in this context refers to the finance constituted by the enterprise’s owner(s)) • Internal equity – funds retained in the business as well as start-‐up funds o Amount depends on a number of factors (owner’s wealth and business’ profitability) o Compared to other forms of financing
relatively low à BUT: since the 2008 financial crisis there has been a high degree of debt-‐aversion • External equity – sources of equity other than that contributed by the original owners o Many owner-‐managers resist any form of external involvement § Depends on the owner-‐manager’s wealth and equity in the business THE ALTERNATIVE INVESTMENT MARKET (AIM) • Established in 1995 • Listing conditions: firms need to have a nominated advisor, broker etc. à give investors some degree of reassurance about the quality of the company • Initially it was successful
(according to the number of firms listed) o BUT: at this stage in its life it makes very little contribution to the overall funding § Specialist exchanges generally suffer from a lack of liquidity VENTURE CAPITAL • Venture capital – finance provided to companies by specialist financial institutions o Very selective, concentrating on fairly risky investments à backing for entrepreneurs, financing a start-‐up, developing business, assisting a mgmt. buy-‐out (MBO)/mgmt buy-‐in (MBI) • Usually a mixture of equity, loans, and mezzanine finance • Remain invested for around five
years • Venture capital has not yet recovered from the dotcom bubble (2000) • Majority of firms receiving funds are relatively large à less financing of small firms o A reason may be high fixed transaction costs, a shortage of available exit routes, and lower returns Source: http://www.doksinet Entrepreneurship & Management of SMEs, Summary Chapter 20, A.PL Kadiri • Public funds are increasingly involved in venture capital deals à may be due to the reason that conventional venture capitalists withdrew from early stage deals BUSINESS ANGELS • Characteristics: informal venture capital,
individuals (sometimes they also join together), no family connection to owner-‐manager, active involvement (greater degree of direct control) o Well developed in the US • Provides an appropriate resolution for the equity gap à lowers the information and monitoring costs o Private disclosures (between angels and owner-‐managers) are both informal and more informative • They tend not to look for quick exit routes • Major problem is the matching of angels with entrepreneurs à as a result, more formal networks started to form in the 1980s o Generally, over 97% of
business proposals are rejected by the angels FACTORING • Factoring – the purchase by a factor of the trade debts of a business, usually for immediate cash o To a certain extent dependent upon the nature of the the business o Good credit management itself is a source of finance à factors manage efficiently • Factoring was further boosted at the expense of overdraft lending o Despite this trend, only a small percentage in the UK currently uses factoring § Main reasons: high cost, reduced customer relations, confidentiality • Invoice discounting – a form
of factoring; relates to the raising of finance from customers and excludes all credit management functions that are normally associated with factoring o Has grown significantly OTHER SOURCES OF FINANCE • Credit card debt (business credit cards) o More expensive and risky route: owners’ or directors’ personal credit cards • Home equity • Bootstrapping: internal financing techniques (retained earnings, personal savings, trade credit, late payment, shared use of assets and resources) THE CAPITAL STRUCTURE DECISION • Does the way in which the firm is financed affect its value?
• Modigliani & Miller: in a perfect market with no information costs there is no optimal capital structure o However, in reality there are market imperfections like corporate and personal taxes § Modigliani & Miller: firms with high tax rates should use more debt than firms with low rates (tax shield) à in practice this is countered by effects of other market imperfections such as insolvency Source: http://www.doksinet Entrepreneurship & Management of SMEs, Summary Chapter 20, A.PL Kadiri • Small firms are subject to very different financial economic and socio-‐economic structures from
those of large firms à limited applicability • Norton: bankruptcy costs, agency costs, and information asymmetries seem to have very little affect on small firms’ capital structure decisions à small firms are less likely to have target debt ratios and there is a preference for using internal rather than external finance • When firms start up and as they grow they use debt finance, but as they mature the reliance on debt declines FINANCIAL REPORTING CONSIDERATIONS • An important link between the sources of finance for a business are the financial reports à assessing
lending and credit risk Recipients The bank and other lenders Tax authorities Directors or other employees who are not shareholders Major suppliers and trade creditors Major customers Credit rating agencies Industry regulators Percentage of companies 67 50 31 12 10 9 5 • In recent years: introduction of International Accounting Standards for SMEs