Small Business Funding Gap

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“The Funding Gap” Due Date: Wednesday November 1st, 2000 The question “The funding gap” is always quoted as a major issue for dstart up and developingh small businesses. What evidence is there to support this view and what measures have relevant organisations taken to overcome the problem? Executive Summary This report critically examine concerned with how young small businesses and start up business fund themselves externally. Firstly we look at the funding ga,p what it is and evidence of its existence. Secondly, how organisations that fund new and small usinesses have done to help this problem and finally a reivew of their usefulness. This is done in a report style Abbreviation list BOE; Bank of England SME; Meaning small - medium enterprise. For the sake of this report it is taken here to mean both business that are new or business that are still in the developing stage. DTI: Department of Trade and Industry Part 1 SME’s are an important contributro to the economy, defined by the Bank of England as 49 employees or fewer1. In 1997 SME’s accounted for over 40% of the economy’s turnover and 45% of total employment in the United Kingdom 2 The chart below reveals a b akdown of industry where sme are located including area as well. Source; bvca.co.uk Starting your own busines rasises many difficulties and raising the capital is just one of them, listed below are the main problems encountered. Throughout history, seeking external funds has remained one of the most difficult. Indeed this is not a ne problem The Macmillian Committee first regcognised the funding issue dubbing it the macmillian Gap in 1931. Today the funding gap can be defined by P Burns & J Dewhurst3 as: “where the funding requirements of a company are greater than those that can be met by the small scale providers of finance, but not substantail enough to be considered by the large equity providers”. Source; Small Business Finance Report BOE Oct 2000 Evidence of the Funding Gap The funding gap is prevelant with start ups and new firms. Indeed it is often known that is harder to raise £50,000 for a new firm with no history or collertaal than it is to raise £5,000,000 for a established firm. Information asymmetrics is often blamed for creating the funidng gap. This is when the entreprenurer generally holds better information regarding the firms performace than the bank for making decisions. Information asymetrics can lead to two developments. Firstly, adverse selection, The banks cannot distinguish which new firm has the highest returns relative to the degree of risk, they have trouble adopting the price mechanism to help distingusih be een firms . Secondly, moral harzard, where (in the absence of collertal) use of higher interest rates by banks to offset risk would give firms receiving loans an incentive to alter their behaviour to adopt risker projects. These two reason reveal why it is harder to obtain smaller rather than larger funds. Banks requuire collertal in responce to these problems. However this often excludes new firms who lack funds despite viable plans. Therefore many fall into the fundi gap. The central hypothesis is that the market is not cleared through the price adjustments because of the asymetry of information between banks and SME’s. So banks have an incentive to respond to an increased demand for loans by rationing credit fur er rather than by raising intereset rates. Also with new start ups having a 50% failure rate4 with the first three years funders can be generally reluctant to fiance such a propsotion. The funding gap questioned. The BOE report5 however states that there has been a decline in recent years of the funding gap. 1999 saw a trend away from debt reliance as new source of funding appeared. Below is a chart from6 showing the change of funding sources. Source: Bank of England see footnote 6. Empirically their is little evidence for the existence of such market imperfections. However this is only based on partial facts because it is difficult to obtain information on failed start ups . Therefore with information from only surviving firms is not easy to determine the full picture. What evidence their is suggests that the most finance constrained businesses are relatively small young located in the manufacturing sector and of below average profitability. This does sound risky and hence it is unclear whether the terms attached to s h lending are unreaosinable in relation to the extra risk. On the other hand, technology driven firms such as dot coms have seen a dramatic increase in available funding only to has this fall again. Therefore it could be that the funding gap is often related to fickle resaons like fashion and optisism rather than jsut moral hazards, information asymmetrics, history or collertral. However regardless of why the gap has appeared it is apparent that the gap has declined in recent years. More recent trends in small firms financing suggest that there has been a steady improvement in how finance providers service the market. However, against a background of sustained economic growth, it is difficult to distinguish improvements resulting om structural changes in the financing of these firms from those resulting from better trading conditions. The recent slowdown in the growth of economic activity will test the robustness of the improvements. Source: DTI Website Oct 2000 Part 2 Organisations that fund SME’s are now reviewed here. In particular what steps they have taken to helkp close the funding gap? Bank of England The B.O.E. has not played a direct hand in helping SME’s but instead taken its usual role in sterring the econmony accordingly. Also it has published reports on the sector from varying angles hence helping both borrower and borrowee. Government Support The government’s own Department of Trade and Industry is an umbrella for a whole range of support mechanisms.Some are listed below Small Business Services The Small Business Services group or SBS set to start in November 2000 working with regional development agencies. Here government policy has focused on the needs of the sme sector. Special attention has been given to funding technology based and oth high growth industries with a strong emphasis on businesss culture. These firms in the past have liitle collertol reling on knowledge as their main asset and hence diffcult to quantifly. Small Firms Loan Guarantee Scheme (SFLGS) This scheme extablished in 1981 by the DTI has aimed to improve access to debt finance for viable firms unable to able for conventional finance due to lack of history or collateral or both. During 1998/99 4,482 loans were guaranteed under the scheme t aling £189 million. Here the maximun loan is up to 250 ,000 for established business and for start ups 1000,000 . Source: Federation of Small Business “ SME’s and the Economy 1998. Late Payment of Commerical Debts Act 1998. To be implemented in November 2000. This act will able firms to claim interest from other small business, rather than only larger firms and the public sector. Many firms now excersie their right to charge interest and many more are likley to do so from ovember 2000 onwards. The act plays a important role in the credit management process. The Alternative Investment market The Alternative Investment market raised £ 933 million with the goviernment keen to encourage entrereprenship in this area. This investment is usually only viable for hi tech firms that are faily established.However the rise and fall of dot coms has l t this market over valued currently. Forums In recent years there has been a increased interested in forums being held. Recently the Ethnic Miniority Business Forum7 was held in July 2000 and the Connecting Creativity with Capital 8held in November 1999. These forums spondered by various public nd some private sources allow information and funds to be shared. Equity finance 9 Accounting for just 3% of external finance for sme’s between 1995 -1997, venture capital is a small player. The formal venture sector invested nearly £5 billion in over 1300 firms during 1998. But only 288 went to start ups and early stage develeoment. e mainly to the level of available agggregate returns, high transactionss costs associated with making an investment and the subsequent monitoring costs. Despite issues of liquidity, depth of markets and vaulations theis type of funding is geared towar high tech firms such as dot coms. Business angels More prevalent in the USA than in the UK. These business angels are specific individuals who wish to become involved in the financing of higher risk projects. They are usually motivaed by a desire for some form of control and profit in return for fin cing the firm. It is bellieved their are 18,000 business angels in the uk offering 500 million annunally.10 Banks Debt finance is the traditional route for sme of external finance with overdrafts and loans as their main tools. Despite their decline in recent years the still play the largest role. The banks characteristics have changed considerably in the 1990’s. K changes include shift towards technology orientated banking delivery systems ie internet and phone banking. Trade credit, asset based and receivables finance play an big role. Factoring has doubled between 1991 -1999.11 The structure of bank lending has also shifted, away from short-term variable-rate lending and towards more term finance. The ratio of overdraft to term lending has fallen significantly, from 49:51 in 1992 to 31:69 in 1998, and fixed-rate lending has ri n from 28% to 33% of term lending since 1996. See chart below. This has addressed one of the problems highlighted by the early 1990s recession —small firms’ over-reliance on the overdraft facility to finance anything from working capital to long-term in stment projects—and has reduced the vulnerability of small firms to the economic cycle. Banking and Finance Issues Source: DTI Website Biliography Books Small Business Guide Lloyods Bank By Sara Williams. 1996 Edition, Penguin Books. Chapter 5 Financial Preparation And Control. pages 268 - 334. Innovation and Entrepreneurship by Peter Drucker Butterworth-Heinemann. 1995 Chapter 15 The New Venture, pages 172 - 191 & Chapter 16, Fustest with the Mostest pages 193 - 203. An Introduction to Strategic Financial Management by David Allen. Kogan Page Publishing. 1997 Chapter 2 Finanical management pages 27 -38. Paths of Enterprise - The future of Small Business By J Curran & R Blackman. Routledge Publishing. 1991 Chapter 8 - Small businesses and thier banks in the year 2000 pages 149 - 163. Small Business and Entrepreneurship, Second Edition by P Burns & J Dewhurst. Macmillian Press. 1996. Chapters 7 Venture Capital pages 131 -166. Chapter 8 Franishing pages 166 - 180. Handbook of Entrepreneurship Edited by D. Sexton & H. Landstrom. Blackwell Press. 2000. Part 111 Financing Growth, pages 195 - 283. Websites www.venturesite.co.uk www.bvca.co.uk www.govgrants.com www.otech.fi.incubator.html wwwfinanceforbuisiness www.venturesite.co.uk www.entreprenuers.about.com www.dti.gov.uk www.bankofengland.com Newspapers Sunday Times 22nd October. Financial Section - Article Small Business suffers from red tape. page 3 Guardian Thursday 12 October Money Section - Interest rates affect business page 21 Reports Bank of England Report on Financing for Small Firms year pages etc. Barriers to growth Section 3 This section looks at whether relevant organisations have been useful in reducning the funding gap? In general SME’s have become markedly become less dependent on external finance. Recently published research has shown that only 39% of small businesse sought external financing of any kind between 1995–97, compared with 65% between 1987–90. 12 Listed below are bullet points of the usefullness of the relevant organisations. Business start-ups rose rapidly in the 1980s, as a result of a combination of government schemes and deregulation of credit controls. Small businesses are now more appropriately financed than in the 1980s, using a wider range of financing sources. Th are no longer so dependent on overdraft financing, and rely more on committed funds, with fixed repayments. Individual small business banking codes of practice have lead to a open, two-way relationship between banks and small businesses. This has benefited small businesses—research by the Forum of Private Business13 shows that SMEs that had developed a more ticipative relationship with banks were obtaining lower charges and collateral requirements. Banks now have better warning systems in place to detect at an early stage whether businesses are encountering trading difficulties. Small firms are more prepared to share information with their banks. Better relations and a greater degree of co-operati should help to avoid some of the strains of the previous recession, which contributed to increased business failures and seriously affected the reputation of the banks. Small firms are now assisted by a wider network of training and support agencies, such as Business Links, TECs and Chambers of Commerce. The providers of bank finance to small businesses operate in a concentrated industry. The four main English clearing banks account for 84% of the market, with NatWest and Barclays together accounting for 48% of the total (see Chart below). However, tho h the overall market share of the Big Four has remained fairly stable, the market shares of the individual clearing banks have changed significantly over the 1990s: NatWest and Barclays have lost market

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