Economic subjects | Finance » Finance and Small Business, Note

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