Finance for SMEs

Small and medium-sized entities (SMEs) tend to be unquoted with ownership of the business usually being restricted to a small number of individuals. Often the financing needs are beyond the levels of initial seed capital invested by the owner when the business is formed. Capital will be required to invest in non-current assets as well as financing the working capital requirements of the business.

SMEs can often face difficulties when raising finance since investing in an SME is inherently more risky than investing in a larger company due to:

• lack of proper financial control systems
• have inexperienced management teams
• may not have an established track record
• lack sufficient good quality assets to offer as security (it is common for the owners of the business to be asked for personal guarantees).

Despite accounting for a significant proportion of economic activity around the world, many SMEs will fail within their first two years of trading, often due to an inability to secure sufficient finance.

The funding gap

As smaller companies tend to be unquoted, it is more difficult for equity investors to liquidate their investment. Typically therefore small firms rely on finance from retentions, rights issues and bank borrowings.

However, Initial ('seed') capital is often from family and friends, seriously limiting the scope for further rights issues.

Bank borrowing doesn't always provide a solution either. To control their exposure, banks will often use credit scoring systems, effectively creating competition amongst SMEs for the available funds. Additional information in the form of business plans will have to be submitted and lenders will very often require additional security to be provided (which the owners may be unwilling or unable to give). Lenders will also want to monitor their investment more closely.

As a result, a funding gap often arises when they want to expand beyond these means of finance but are not yet ready for a listing on the Stock Exchange or Alternative Investment Market (AIM).

This gap may be bridged with in a number of ways:

• Financial investors including:
  • Business angels
  • Venture capitalists
• Various government solutions including:
  • increasing the marketability of shares
  • provision of tax incentives
  • other specific forms of assistance

Financing solutions

Banks

Traditionally, small businesses have borrowed by means of loans and overdrafts from clearing banks. The main problems have always been the security required by the bank for granting the loan, and the risk averse attitude of banks when faced with a decision relating to a new and untested project. In the UK, the requirement for a personal guarantee from the proprietor to cover the loan or overdraft advance has inhibited the expansion of many small businesses and contributed towards the problem of British ideas being developed abroad.

Whilst the UK government has attempted to make debt investment in small businesses more attractive by the introduction of its Loan Guarantee Scheme, this has not proved very successful due to its relatively high interest rate.

Venture capital funds

The combination of increasing the prospective marketability of SME shares and tax relief schemes has led to the proliferation of venture capital funds, which provide equity capital for small and growing businesses.

One of the original, and still one of the best known, venture capital institutions in the UK is that forming part of the 3i Group. It takes a continuing interest in its client enterprises and does not require to withdraw the capital after, say, a five-year period.

However, in recent years, most major providers of business finance have in some way become involved in the provision of venture capital,usually by setting up or participating in specialist 'venture capital funds'. The main spur to their growth has come from the incentives described above.

The result is that there is now no real shortage of venture capital for viable projects. The range of possible funds includes those run by merchant and other banks, pension funds, individuals and local authorities.

Business angels

Although venture capital companies are the main providers of equity finance to small businesses, they are highly selective and normally do not invest in amounts under £100,000 in the UK. An alternative source of smaller amounts of equity capital are private individuals, sometimes known as business angels, who normally have a business background.

Business angels are willing to make investments in small businesses in return for an equity stake. They can also offer the businesses the benefits of their own management expertise. A number of business angel networks operate in the UK to match businesses seeking equity finance with potential investors.

Government solutions

Governments have adopted a two-pronged response to increasing the attractiveness of SMEs:

• increasing marketability of shares
• tax incentives for investors.

In addition they have provided specific assistance in a range of areas (see below).

Making shares marketable

A number of SMEs that have good business ideas and growth potential do not fulfil the profitability/track record requirements to obtain a full stock exchange listing.

The development of small firm markets, such as the AIM in the UK and the Growth Enterprise Market (GEM) in Hong Kong SAR, is designed to bridge this gap and provide both an exit ground and a venue for further fund-raising for investments.

In addition companies in the UK are now able to purchase their own shares, so a small investor can be bought out as needed.

Tax incentives

The following are the responses of the UK government which illustrate the types of incentives available:

The Enterprise Investment Scheme (EIS)

The Wilson Committee's recommendations led to the development of the current EIS which offers tax relief on investments in new ordinary shares in qualifying unlisted trading companies, including those traded on the AIM. There is a limit on the amount an individual may invest(currently up to £400,000 each tax year) and the investment qualifies for 20% income tax relief.

Any gain on disposing of EIS shares after 3 years is exempt from capital gains tax (CGT). Income tax or CGT relief is available on losses.

The scheme applies to any company carrying out a qualifying trade or business activity wholly or mainly in the UK, provided that the company's gross assets do not exceed £7 million immediately before the shares are issued. It enables companies to raise up to £1m a year. Participating investors may become paid directors of the company and in certain circumstances still qualify for the relief.

Venture Capital Trusts (VCTs)

VCTs are companies listed on the London Stock Exchange and are similar to investment trusts.

At least 70% of the underlying investments must be held in a spread of small unquoted trading companies within three years of the date of launch.

The aim is to encourage individuals to invest indirectly in a range of small higher-risk trading companies whose shares and securities are not listed on a recognised stock exchange. By investing through aVCT, the investment risk is spread over a number of companies.

Income tax relief is available at 30% on new subscriptions by individuals for ordinary shares in VCTs, to a maximum of £200,000 pa. In addition, subject to certain conditions, CGT relief is available on disposal of the shares.

Share incentive schemes

In the UK, there are schemes designed to encourage employees to hold shares in companies by which they are employed. All such schemes require HM Revenue and Customs (HMRC) approval.

Specific forms of assistance

This may take the form of:

• business links - a largely government-funded service that provides information, advice and support to those wishing to start, maintain and grow a business
• financial assistance:
  • loan guarantees
  • grants
  • loans.

Small Firms Loan Guarantee Scheme (SFLGS)

This provides a government guarantee for loans by approved lenders. Loans are made to firms or individuals unable to obtain conventional finance because of a lack of track record or security. The guarantee generally covers 70% of the outstanding loan. This rises to 85% for established businesses trading for two years or more. Loans can be for amounts between £5,000 and £100,000 (£250,000 for established businesses) and over a period of two to ten years.

NB. Not all businesses are eligible for a loan and there are some restrictions on their use.

Regional Selective Assistance (RSA)

This is a discretionary scheme available in those parts of the UK designated as Assisted Areas. It takes the form of grants to encourage firms to locate or expand in these areas. Projects must either create new employment or safeguard existing jobs.

In England, for example, RSA is available for projects involving capital expenditure of at least £500,000.

Enterprise grants

This is a selective scheme for firms employing fewer than 250 people. It is available for high quality projects in designated areas. Businesses may only receive one such grant.

Regional innovation grants

This is available in certain areas of the UK to encourage the development of new products and processes. It is available to individuals or businesses employing no more than 50 people. The scheme provides a fixed grant of up to 50% of eligible costs up to a maximum of £25,000.

Small firms training loans

These are available through the Department for Education and Employment and eight major banks in the UK. The scheme helps businesses with up to 50 employees to pay for vocational education or training, by offering loans on deferred repayment terms:

• firms can borrow between £500 and £125,000 for between 1 and 7 years to cover education and training costs and, with restrictions, costs of consultancy advice on training matters
• the interest on the loan can be fixed or variable, and is paid by the Department for the first 6 to 12 months
• any education or training is eligible provided the firm can show that it will help them achieve their business objectives.

European Investment Bank (EIB) and European Investment Fund (EIF) schemes

The EIB provides loans to banks and leasing companies to help provide finance to small and medium-sized companies. The operators of EIB-supported schemes include finance organisations such as Barclays Mercantile, Lombard Business Finance and Forward Trust.

The EIF provides loan guarantees in conjunction with some finance organisations' own environmental loan facilities. These facilities are designed to assist business to finance investments that produce a quantifiable environmental benefit (energy usage, raw material usage,etc.).

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