Enterprise and Small Business Principles

Finance and the small business

Robin Jarvis

18.1 Introduction

The information available on how small firms are financed is limited because little is in the public domain. However, through a careful search of the literature a picture emerges indicating that small firms use different types of finance compared with large firms. Large firms benefit from established markets where they can raise funds. There are no similar markets for the vast majority of small firms. Therefore, the proportion of equity invested in small firms is much less than that of large companies. In general, small firms tend to rely on bank lending and other types of financial products.

The question of whether a finance gap exists for small firms has been examined and debated over many years and much has been written on the subject. Through govern­ment initiatives and the introduction of new products by the financial institutions much has been done to bridge this gap. However, many argue that the gap still exists, particu­larly for firms starting up or wishing to grow. The influential variables in the capital structure decision of large firms are not as critical in small firm decisions. The markets in which the small firm operates, the firm’s life-cycle and the preferences and desires of the owner(s) are influential. The research also shows that there is an important link between small firms’ annual report and accounts and the providers of finance. A num­ber of studies have identified that this information is used by providers in their decisions to grant credit and to monitor the firm’s progress.

18.2 Learning objectives

This chapter has five learning objectives:

1 To understand the arguments as to whether or not a finance gap exists for small firms.

2 To appreciate the types of finance used by small firms.

3 To recognise that capital structure theory is not influential when small firms make capital structure decisions.

4 To appreciate the importance of small firms’ annual report and accounts to the

providers of finance.

5 To understand the reasons why small firms and large firms are financed differently. Key concepts

■ finance gap ■ capital structure decision ■ the separation of ownership and management ■ the importance of annual reports to finance providers

18.3 Finance and the small firm

It is important, when examining the financing of small firms, to recognise that there are distinct differences between the financing of large quoted companies and small firms. Most of the literature, however, relating to finance focuses on large quoted firms and to a great extent implies that it is relevant to small firms. This reflects the commonly held notion that small firms are only smaller versions of large firms.

From a financial-economic perspective, the main difference lies in the lack of avail­ability of capital markets where small firms can raise funds compared with their larger counterparts who have established markets such as the London Stock Exchange. The differences from a socio-economic perspective are primarily associated with the rela­tionship between the finance provider and the enterprise. In the case of small firms the owner normally represents the enterprise in the capacity of both the owner and man­ager. In large firms, which are invariably quoted companies, the relationship is between the providers of finance (the shareholders who are the owners of the company) and the directors (the managers) who are invariably separate from the owners (shareholders). The significance of these differences will be a theme running throughout this chapter.

Although much has been written about the different types of finance employed by small businesses, only limited information is available on the extent to which each type is actually used. This is because not all the information relating to the financing of small businesses is in the public domain. By contrast, information relating to the different types of finance used by large companies is publicly available from a variety of sources including these companies’ own annual reports and accounts. The annual reports ‘Fin­ance for Small Firms’ published annually by the Bank of England has, however, over the last 11 years made an important contribution to giving helpful insights into the types of finance used by small firms. This Report brought together academic research and surveys from trade and professional bodies to formulate an authoritative picture of small firm finance. Unfortunately, the Bank of England’s eleventh report published in April 2004 (Bank of England, 2004) was its last.

The research and the surveys examining the financing of small firms should be inter­preted with caution for two reasons. First, there is no universal definition of a ‘small’ business; the second is connected to the aggregation of the data. This is particularly important when examining how small businesses are financed because it is likely that the extent and source of funds will depend upon the size of business. For example, small firms with a turnover of £50,000 are likely to have very different capital struc­tures from small firms with a turnover of £1m. Another important factor that tends to affect the type of finance employed by a small enterprise is the industrial sector in which it operates. For example, a firm which has tangible assets such as land and buildings that can be offered as security, such as a firm in the property sector, is likely to find it easier to obtain funds than a firm in a sector whose assets are intangible in nature, such as a firm in the advertising industry whose main assets tend to be creative, reflecting the skills of the personnel they employ. These problems will result in reducing the valid­ity of a comparative analysis between research and surveys.

This chapter begins by examining what is referred to as the ‘finance gap’. The importance of this gap is reflected in the significant proportion of small business liter­ature devoted to the subject, as well as the number of government committees that have been set up to investigate it. This is followed by a review of the main sources of finance employed by small enterprises and an examination of the relative risk from the perspective of the providers of the finance and the owner-managers of the firms receiving the funds. Next, the capital structure of small enterprises is examined and this focuses on the critical issue of the choice of financing the firm with equity only or with both equity and debt. This section looks at some theoretical models, followed by some evidence of practice. Finally, the role of financial information is considered, with specific reference to financial reporting, and comparisons are made between the users of large company financial reports and how these are used.

18.4 The finance gap

The finance gap refers to a situation where a firm has profitable opportunities but there are no, or insufficient, funds (either from internal or external sources) to exploit the opportunity. In finance theory this situation is known as hard capital rationing, as opposed to soft capital rationing which, to a great extent, is a self-imposed restriction. Hard capital rationing occurs when there is a mismatch between the supply and demand for finance from equity and debt sources. The term ‘equity gap’ is also commonly used and specifically refers to the gap between funds that can be profitably employed by the firm and its inability to raise equity as opposed to debt. Similarly, the inability to raise debt finance is commonly referred to as the debt gap. Clearly, if a gap in the funding of small businesses exists, it may seriously curtail the growth of such enterprises, which could adversely affect the economy. Not surprisingly, therefore, the subject has attracted much attention from government, policy makers and academia.

Historically, the existence of a ‘finance gap’ was formally recognised nearly 70 years ago. In 1931 the government-sponsored Macmillan Committee reported that the financ­ing needs of small business were not well served by the then existing financial services institutions. The committee consisting of such eminent academics as John Maynard Keynes and politicians such as Ernest Bevin illustrates the importance given to the sub­ject of financing small firms by government in the 1930s. Since then this criticism of financial institutions has been echoed by other important inquiries (Bolton, 1971; Wilson 1979). In response to this criticism successive governments have introduced a num­ber of initiatives with varying success. For example, the Small Firms’ Loan Guarantee Scheme is a guarantee scheme for firms that have limited security to act as collateral for bank loans (this scheme is examined in more detail later in the chapter). In recent years financial services institutions have broadened their scope and for commercial reasons have introduced new products that have made access to funds easier for smaller firms. It has been argued that, if a finance gap still exists, it has been substantially nar­rowed because of these initiatives and subsequent responses by the market since the 1930s (Deakins, 1996). However, others dispute this claim on both empirical and the­oretical grounds (e. g. Harrison and Mason, 1995). The following examines the nature of the gap and some of the evidence of whether it exists and whether it is a constraint on the financing of small enterprises.

In terms of equity capital, most small firms depend on the capital the owner or own­ers put into the business at the start-up stage, together with a proportion of the profit retained to develop the business. There is a very limited opportunity for small firms to raise funds in the equity markets. The main market for small businesses in which to raise funds is the Alternative Investment Market (AIM), but only a very small propor­tion of small businesses in the UK are eligible for listing. In addition, there is some evid­ence to suggest that a large proportion of owner-managers of small firms are reluctant to seek equity finance from external sources (Cowling et al., 1991; Binks et al., 1990b). This reluctance is primarily due to the owner-manager’s desire to maintain his independ­ence and control of the business (Keasey and Watson, 1993). AIM will be discussed later in this chapter.

In terms of debt finance (e. g. bank loans) financial institutions should assess the application for funds from small firms applying the principle of risk-return trade-off. Figure 18.1 illustrates the relationship between risk and return. Simply, the economic rationale of the principle dictates that the higher the risk, the higher return that can be expected. With reference to Figure 18.1, point ‘a’ on the graph is the base rate and the gradient from points ‘a’ to ‘b’ represents the increase in interest rates as the risk increases. The point X on the horizontal risk axis represents the risk associated with Firm X; X1 indicates the interest rate (the return) relating to that level of risk. In con­trast, point ‘Y’ on the horizontal axis indicates the risk associated with the much riskier Firm Y and point ‘Y1’ on the vertical axis the interest rate relating to this higher level of risk. Risk is conventionally measured by the variability in returns of a firm; the higher the variability of returns, the higher the risk and vice versa. The variability in a firm’s returns and thus risk is a function of the type of business, the structure of the industry and other similar businesses characteristics.

Whilst this explanation of the relationship between risk and return is blessed with sound economic logic and is widely used for assessing large firms, it suffers from one major problem when applied to small firms since it is impossible to measure risk with any reasonable accuracy. At first sight, this is not necessarily apparent because the word ‘risk’ in this context is very much a part of institutional financiers’ rhetoric, whether referring to large or small firms; for example, the phrase ‘well it all depends upon the risk’ is commonly heard from clearing bankers when considering business loans. The inability of financial institutions to measure risk and make some assessment of the debt interest that should be charged has resulted in the use of secured lending and crude credit scoring systems to control exposure to risk. Security is normally based on the assets of the borrower or a personal guarantee. The amount of security available is clearly a constraint on borrowing by small business owners. Credit scoring is a system of analysing information for making lending decisions. Points are allocated based on

the characteristics of the applicant. The sum of the points is the credit score, which indi­cates the degree of risk (Berry et al., 1993a: 202). Security and credit scoring both limit the extent to which small firms can borrow and therefore contribute to the finance gap.

Since 1997 deposits have exceeded total lending to small and medium-sized enter­prises (SMEs) which suggests that small firms, in general, are not finding it difficult to access debt finance (Bank of England, 2004). This conclusion can also be extended to all sources of finance from the evidence of recent surveys where the small firm respond­ents have not raised access to finance as a concern (Wilson, 2004; CBI, 2004; Small Business Research Trust, 2003). This suggests that, in general, a so-called ‘finance gap’ does exist for small firms. However, there is evidence that a number of groups and sec­tors, categorised within most definitions of a small firm, face distinct challenges when accessing finance. Some of the firms who are subject to these challenges will be discussed below.

It would appear that a subset of small businesses who wish to grow have more acute financing problems because of their need for development finance (Buckland and Davis, 1995). The Wilson Committee some 28 years ago, for example, recognised that the finance gap was a particular problem for such firms. Research shows that only
around 10% of firms want to grow (Hakim, 1989a) and of these only approximately 10% will actually do so. However, this subset of small firms has attracted much atten­tion (e. g. Buckland and Davis, 1995) because of their significant actual or perceived contribution to the economy. A particular problem for growth firms is their lack of access to equity capital. The problem is that businesses can only increase loan capital in proportion to assets held and the equity interest prevailing. Therefore, the only way the firm can increase capital is through injections of equity capital. In recognition of the difficulties faced by small enterprises the capital markets have introduced AIM and financial institutions have developed products known as venture capital. Venture cap­ital normally takes the form of equity in high-risk small firms. These firms are charac­terised by high growth and are often in the high-tech industries.

The shortage of start-up and early-stage equity capital in general, not necessarily in growth firms only, has also been cited as a particular problem for small enterprises (e. g. Robson Rhodes, 1984; ACOST, 1990). The problem often relates to insufficient start-up capital (the amount owner-managers initially invest in the enterprise) and sub­sequently this affects the ability to raise loan capital.

Women setting up in business have been identified as a particular group who face challenges in raising finance to start up businesses. Women achieve one-third of the fund­ing compared with men when starting up in business (Carter et al., 2001). The reasons for this are not fully understood. Female entrepreneurship is a key issue on the UK gov­ernment’s small business agenda. It is claimed by the UK government that if women set up businesses at the same rate as men in the UK, there would be another 150,000 businesses created every year and if women set up businesses at the same rate as they do in the US there would be another extra 750,000 businesses. Under-capitalisation at the start of the business may lead to long-term under-capitalisation problems and put women at a disadvantage in terms of being able to grow their businesses.

Another group facing challenges in raising finance to set up businesses are univer­sity graduates. Graduates are one of the most entrepreneurial groups of people (Global Entrepreneurship Monitor, 2001) and research shows that nearly half of undergradu­ates would consider setting up their own businesses after university. However, average levels of student debt currently stand at £12,000 (Ward, 2004). This is increasing year on year and is predicted to reach levels of £33,000 per student in 2010 (Ward, 2004). New graduates with significant levels of student debt may be more inclined to enter paid employment. Lending institutions may not be able to provide funds to new graduates to start up in business, given the levels of debt. This could have a significant detrimental effect on the economy.

Much attention in recent times has been given to informal risk capital provided by investors, known as business angels, as a means of providing small amounts of equity capital to close the gap. A number of initiatives have been developed to make this form of finance more accessible. However, the main problem is one of matching potential investors with the firms that need the funds. Business angels are considered in more detail in the next section.

Research into the finance gap has also highlighted an ‘information gap’. It is claimed that the reason why small enterprises have problems raising finance is because owner - managers are insufficiently informed of funding opportunities with regard to both equity and loan capital, the quality and cost of information which can drive and sustain bank lending decisions (Bovaird et al., 1995; Binks and Ennew, 1995). In recent years, how­ever, the information flows and the advice available have improved substantially with the setting up of government agencies, such as Business Links, and the growing amount of literature on the range of sources of finance available to small firms.

It would appear that the evidence from research on whether or not there is a finance gap is inconclusive. However, the attention of successive governments to the problems faced by small businesses with regard to raising finance has resulted in a number of ini­tiatives that have improved matters for some owner-managers. At the same time finan­cial institutions have developed a number of products to increase the range of options for financing small enterprises.

18.5 Sources of finance

In this section empirical evidence is drawn upon in order to provide an overview of the nature and usage of varying types of finance employed by small businesses. Usage, it is assumed, is a reasonable surrogate for importance. As already mentioned, the results of the surveys reviewed must be interpreted with care due to the problems associated with the lack of a standard definition for what constitutes a ‘small’ business and other limitations of survey methods. The main sources of finance are reviewed below.

18.5.1 Banks

The importance of bank lending as a primary source of small business finance is widely acknowledged (Berry et al., 1993a; Binks and Ennew, 1995; Cruickshank, 2000; Keasey and Watson, 1993). Indeed, the Bank of England (2001) quotes the work of Cosh and Hughes (2000), which showed that bank finance accounted for an estimated 61% of external finance in 1997-99 compared with 48% in 1995-97. This is perhaps not sur­prising as small firms do not have access to the capital markets to raise finance.

The pattern of bank lending to small firms has changed dramatically in recent years. Just over two-thirds of lending by the UK clearing banks is on a fixed-term basis; only less than a third is in the form of overdrafts. This can be contrasted with the situation in 1994 when there was an even split between overdrafts and fixed-term loans. An overdraft is a short-term loan that banks grant customers giving them the right to over­draw their bank account by an agreed amount and is normally repayable on demand.

The term of any loan should ideally be matched with the life of the investment for which the loan is required. For example, if finance is required to purchase a printing machine, the term of the loan ideally should match the commercial life of the printing machine. This ensures that monies generated from the use of the machine are available to repay the loan. The life of the assets used by business to generate funds should be for periods commensurate with long - or medium-term loans that are fixed term. However, if finance is required to fund working capital, a short-term loan, perhaps in the form of an overdraft, is likely to be more appropriate.

Although matching the term of the loan with the life of the investment makes com­mercial sense, this does not always take place in practice because time is associated with uncertainty and therefore risk. The longer the time period, the greater the uncertainty and the risk associated with predicting outcomes. This notion of uncertainty due to the passing of time is therefore extremely relevant in the lending decision. The length of the loan, in terms of the period of repayment, will be strongly influenced by the other perceived risks associated with the applicant for the loan and the purpose of the loan. Therefore, in the case of most (but still acceptable) applications the lending banker is likely to lend only for a short period, ignoring the matching principles relating to the life of the investment and the repayment of the loan.

Smaller businesses are generally perceived as being more risky than their larger counterparts and this has tended traditionally to lead to banks lending short-term rather than long-term. A survey of small firms by Binks et al. (1988) found that 25% of the fixed assets (i. e. long-term investments) were funded by overdraft rather than by fixed, longer-term forms of funding. This strategy, it is argued, was one of the major causes of the liquidity crisis when banks called in overdrafts during the credit squeeze in the early 1990s. The banks suffered considerable criticism for this policy. More recent moves towards increased fixed-term lending may be a reflection of the banks’ sensitiv­ity to these criticisms, since such a policy means that they are more exposed to risk.

The provision of finance and other services offered by the clearing banks to small firms has been subject to much criticism since the early 1970s. In 1979 the Wilson Committee concluded that bank managers tend to be overly cautious in their lending decisions, finding evidence of banks demanding a high level of security as collateral for loans, which constrained the financing of small firms in the economy. More recent research (Binks et al., 1988, 1990b, 1993) provides evidence that banks have continued to demand high levels of security. However, some relief has come from the introduc­tion of behavioural scoring and the Small Firms Loan Guarantee (SFLG) Scheme, examined below. Behavioural scoring is a type of credit scoring which monitors cus­tomers’ credit risk in the light of the activity in their bank accounts. This type of scor­ing is concerned with helping banks to decide specific terms for individual accounts, based on their risk assessment. For example, if a customer goes into overdraft on his account without previous agreement with the bank then this is likely to go against the customer in terms of his future relationship with the bank. It is claimed that greater reliance on these schemes has tended to lead banks to move away from secured lend­ing, but it seems that collateral is still a major consideration in successfully accessing finance (Graham, 2004).

There has been a concern for many years regarding the lack of competition for bank lending to small firms in the UK. Cruickshank (2000) estimated that the big four UK clearers have 89% of this market. Some commentators have suggested that such con­centration levels are detrimental to competition. In the large corporate lending market, the effects of deregulation created an open and competitive environment for UK clear - ers owing to competition from overseas financial institutions based in London (Berry et al., 1987). With the advent of the European internal market as well as the number of overseas banks in the UK there was an expectation that at least the European banks based in the UK would compete in the UK small business lending market, which would enhance competition. However, to date only a very small proportion of these European banks have entered the small business market (Berry et al., 2003).

18.5.2 Loan Guarantee Scheme

The Small Firms Loan Guarantee (SFLG) Scheme was introduced in 1981 by the gov­ernment. It stemmed originally from a recommendation of the Wilson Committee 1979 to counter criticism of the high levels of security required by small enterprises to pro­vide as collateral for a loan. Initially, there was a lower than expected take-up and there have been many critics of the scheme. The main criticism is that it is costly (because of the premium). In addition, banks are reluctant to use the scheme because it is exces­sively bureaucratic and expensive to administer (Robson Rhodes, 1984). For these rea­sons it had been described as a scheme of last-resort lending for small business owners who have limited security.

The scheme is aimed at small firms that have a viable business proposal, but have tried and failed to obtain a conventional loan from a bank, because of lack of security or business track record, or both. The provision by government to guarantee against the potential default by borrowers enables banks to reduce their exposure to risk and addresses market failure. Currently the government guarantees 75% of the loan, the other 25% being taken on by the banks. The maximum amount of the loan is currently £250,000 for a maximum term of ten years.

The scheme is intended to be in addition to normal commercial finance and is not available if a conventional loan can be obtained. Under the scheme the applicant applies initially to a bank. Once the loan officer has decided that the applicant has a viable business proposal and is eligible for a loan under the scheme, the bank applies to the Department of Trade and Industry (DTI) for a guarantee. The intention is for the scheme to be self-financing and a premium is charged on top of the normal interest rate to recover bad debts. The premium currently stands at 1.5% variable rate and 0.5% fixed-rate lending. In 2003, however, the scheme had a deficit of £60m due to a 35% default rate.

Recently the scheme has been reviewed and recommendations were published in September 2004 (Graham, 2004). These recommendations have been accepted by the government and the scheme will now be focused on start-ups and young businesses, the two groups identified who suffer the most from their inability to raise finance due to lack of collateral and business track record. One of the main criticisms of the scheme is that it is excessively over-regulated. In future, lenders will be able to make decisions without reference and approval from the Small Business Service.

18.5.3 Leasing and hire purchase

Leasing and hire purchase (HP) are often considered together in surveys and, exclud­ing equity, studies show that after bank loans and overdrafts, leasing and HP represents the second most important source of finance to small firms. In this section, further evid­ence is considered with regard to the use of leasing and HP by small firms, the nature of leasing and HP and the main reasons why it is an attractive source of finance to small firms.

Leasing can be described as a form of renting. The ownership of the asset rests with the lessor who allows the lessee the use of the asset for an agreed period. There are two types of lease: an operating lease and a finance lease. Under an operating lease, the asset is leased for a period that is substantially shorter than its useful economic life.

The responsibility, in this case, for servicing and maintenance normally rests with the lessor. Typically, equipment such as photocopiers, computers and cars are acquired by firms under operating leases. Such leases are very attractive to small businesses not only because they are convenient, but because by leasing instead of buying, small firms can insure against the risk of future uncertainty as to the asset’s value (e. g. changes in technology) as the risk is transferred to the lessor.

A finance lease is a lease that transfers substantially all the risks and rewards of ownership to the lessee (Hussey, 1995). It is a contractual commitment to make a series of payments for the use of an asset over the majority of the asset’s life, which normally cannot be cancelled. The lessee therefore acquires most of the economic value of the ownership although the lessor retains the title. Finance leases are long-term and are very similar, apart from the question of ownership when purchasing an asset with a bank loan.

HP is 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 of the goods passes to the purchaser when all the agreed number of sub­sequent instalments, which include an interest charge, have been made. Purchasers have the use of the goods over the period that they are making the payments and, as with leasing, benefit from being able to use the asset without incurring a large capital out­lay. It is because of this similarity that HP and leasing are often grouped together when considering sources of finance of firms, as discussed next.

A survey of 90 small businesses (Berry et al., 1990) found that 70% had some assets financed by leasing or HP with 12% of the total value of assets leased and 65% acquired via HP. Of 238 different assets acquired by the sample businesses in a year, 45% were financed by leasing or HP. The sample comprised firms in printing, computer services and professional services, and some significant variation was found in the relative importance of leasing compared with HP. In the printing industry only 9% of the total value of the assets were leased, while 77% were acquired using HP. The main reason for this difference was because the assets acquired (in this case printing machines) tend to appreciate in value and there is a very active second-hand market for them. There­fore, printers preferred to use HP as a source of finance since the ownership of the asset eventually transferred to them. If firms in the printing industry are excluded from the analysis because of this particular preference for HP, the percentage of the value of the assets leased by the remaining sample would be just above 20%.

The study demonstrated that the use made of leasing and HP was related to certain characteristics of both the business and the asset. The larger the size of the firm, the more likely it was to use both leasing and HP. The firm’s past experience of various sources of finance in negative or positive terms was also found to affect the firm’s future pref­erence for a particular source of finance. Of the sample firms, 21% expressed negative attitudes towards leasing while only 4% of the sample responded negatively to HP. The type of asset was found to influence the type of finance used; for example, assets such as photocopiers and cars have traditionally been marketed via leasing. Finally, the study found that the number of firms using leasing appears to increase with the upward growth rate of the firm, although the number using HP does not.

Previous research, which was mainly focused on large firms, indicates that the influ­ence of tax is the most significant factor influencing the decision to lease. This relates to tax benefits via capital allowances that are obtainable when using finance leases as opposed to operating leases (e. g. Drury and Braund, 1990). A study by Jarvis et al.

(1994) gathered the views of owner-managers of small firms on the perceived advant­ages of leasing. The findings showed that tax was not important in the leasing decision and suggested that few owner-managers could undertake the complex tax computa­tions necessary to establish the cost of leasing compared with other forms of finance. The main advantages to owner-managers in leasing is that it avoids a large capital out­lay; it is cheaper; it helps cash flow; and it is easier to arrange.

18.5.4 Equity

The term equity is used here to mean the finance contributed by the owner(s) of the enterprise. This definition ignores whether the enterprise is a company, a partnership or a sole trader. Although funds from business angels and venture capital could be included within this definition, these forms of finance are considered in detail separ­ately. Individuals starting a business normally need to invest a certain amount of their own money in the business whether they are a sole trader, partnership or a company. After the start-up, owners can choose whether to withdraw profits from the business or to re-invest these funds. Funds retained in the business are another form of equity finance, which together with start-up funds are often referred to as internal equity. Fin­ally, during the life of the business, owners may make further investments from their own personal funds to finance the business.

The amount of equity invested by the owners in the business depends on a number of factors, the most influential of which are the owners’ wealth and the profitability of the business’s activities. From a survey of small firms, Keasey and Watson (1992) estimated that internal equity contributed approximately 30% of the capital structure. This suggests that the amount of equity contributed to the business after start-up from owners, and funds derived from the retention of profits, is relatively low compared with other sources of finance. A more recent survey (Cosh and Hughes, 1996) estimated that only 6% comes from this source. The Keasey and Watson study also found that approximately 70% of operating income is withdrawn by the owners of small firms leaving a relatively small residue to re-invest. This evidence has alerted policy makers to the need to develop strategies to encourage owner-managers, through tax incentives, to retain a greater proportion of profits in the business.

Access to sources of equity other than that contributed by the original owners (external equity) is limited to formal venture capital and informal venture capital (busi­ness angels) and raising finance from the Alternative Investment Market (AIM). All of these sources will be discussed separately. However, it should be borne in mind that, as already mentioned, the overriding evidence is that many owner-managers resist any form of external involvement and therefore do not seek external equity sources.

The extent of a small firm’s overall funding generally depends on the owner-manager’s wealth and the equity in the business. Other forms of finance, such as bank lending, normally depend on the security provided by the business. Such collateral usually takes the form of a charge on the firm’s assets or on the personal assets of the owner-manager, or a combination of the two. The limitations of equity sources of small firms therefore constrain the assets acquired by the business and the wealth of the owner-manager further limits their ability to raise finance elsewhere. Binks (1990b) argues that this reliance on collateral effectively creates a ‘debt gap’.

18.5.6 The Alternative Investment Market (AIM)

When AIM was established in 1995, Michael Heseltine (then President of the Board of Trade in the UK) said: ‘Smaller and growing firms are critical to Britain’s long-term economic prosperity and that a market which will enable them to raise capital for investment and have their shares more widely traded can only help to strengthen this sector of the economy.’ The support of the government was an important factor in the initial success of the market, but perhaps more important was the timing of its launch in the middle of a bull market when investors had been lured by easy profits made from the sensational share price gains. For example, the shares of ViewInn were placed at 100p and in June 1996 were traded at 650p.

In the first 12 months of its existence, 162 companies obtained a listing on AIM and by 1998 the number had grown to more than 260. This high volume of companies joining AIM in its short lifetime provides strong evidence of the need for an alterna­tive market for small companies. However, during 1998 a series of companies crashed shortly after they were listed on AIM and this has made companies wishing to join the market a little cautious. Generally, prospective companies considering joining, in par­ticular computer and high-tech companies, are looking for a higher profile and a wider source of funds. A survey by Kidson Impey, a firm of accountants, found that poten­tial users of AIM felt that the market is less accessible than a year ago and argue that this is attributable to the increase in due diligence required by nominated advisors as a result of well-publicised failures.

Conditions for listing on AIM are that companies must have a nominated advisor, broker and reporting accountant in order to give investors some degree of reassurance about the quality of the company. Once listed, the company must appoint, and retain at all times, a nominated advisor and nominated broker. The nominated advisor is selected by the corporation from a register of firms approved by the Stock Exchange. The advisor and broker are required to ensure that the company has complied with the listing rules for AIM. The reporting accountant is required to ensure that the company complies with the rules regarding the publication of price-sensitive information and the quality of the interim and annual reports. A prospectus must be produced, but not necessarily a trading record.

A listing currently costs between £200,000 and £400,000, plus around 3% funds raised. The annual cost of listing is at least £25,000. It is generally claimed that AIM is suitable for companies wishing to raise between £1m and £50m. Therefore, only the larger small companies tend to be listed. At this stage in its life, it would appear that AIM makes very little contribution to the overall funding of small enterprises in the UK.

18.5.7 Venture capital

Venture capital is finance provided to companies by specialist financial institutions. Venture capitalists tend to be very selective, concentrating on fairly risky investments typically in the form of backing for entrepreneurs, financing a start-up, developing busi­ness, or assisting a management buy-out (MBO) or management buy-in (MBI). Usually the venture capital is represented by a mixture of equity, loans and mezzanine finance. Mezzanine finance is usually provided by specialist institutions and is neither pure equity nor pure debt. It can take many different forms and can be secured or unsecured. It usually earns a higher rate of return than pure debt but less than equity, yet carries a higher risk than debt although less than equity. It is often used in the financing of MBOs (Hussey, 1995) and for medium - to long-term investments where the venture capitalist is looking eventually for an exit route.

Although much is written about venture capital as a major source of funds for small enterprises, the evidence is that the majority of firms that receive funds from this source are relatively large enterprises. The average investment of a venture capitalist is £1m to £2m and the smallest investment £100,000. A large and an increasing proportion of capital has been invested in MBOs. Although Murray (1995) contends that venture capital ‘represents a small but important part of the finance for new firm formation and industrial restructuring in both the UK and continental Europe’, earlier in the same paper he graphically shows start-ups and other early stage finance as representing 6% of UK venture capital investments as opposed to MBO/MBI investments of over 50% in 1991. Arnold (1998) claims that 75% of venture capital in 1995 went into MBO/ MBI investments, with only 4% being placed in early stage companies. The Cosh and Hughes (1997) survey shows that between 1% and 2% of small firms used venture capital to finance their business.

Other more recent research has suggested (HM Treasury/SBS, 2003) that the reason why venture capital plays a very little part in the financing of small enterprises is largely because of the high fixed transaction costs associated with the provision of small amounts of capital, a shortage of available exit routes and historically lower returns from early stage finance. In addition, there is also evidence that small business owner - managers do not want equity for fear of dilution of ownership and control (Bank of England, 2002).

In recent years a number of schemes have been introduced by the public sector to inject venture capital funds into the small business economy in an attempt to bridge the equity gap. It is too early to come to any reasonable conclusion relating to the per­formance of these funds (Bank of England, 2004).

18.5.8 Informal venture capital (business angels)

Business angels are a source of informal venture capital. They are wealthy individuals, rather than financial institutions, who tend to have considerable business experience and are willing to invest in start-ups, early-stage or expanding enterprises. Another description of business angels or, more precisely, informal venture capitalists, that focuses on the nature of the capital is: ‘equity or near equity risk finance invested by private individuals directly into businesses which are not listed on a stock exchange’ (Gaston, 1989). The term ‘informal’ venture capital derives from the fact that it is indi­viduals rather than financial institutions who invest venture capital in a more con­trolled environment. Although informal venture capital is well developed in the US and could also be a significant source of finance in the UK, it has only been in the past ten years that this type of finance has attracted much attention from academics and policy makers (Mason and Harrison, 1992).

It has been argued (Harrison and Mason, 1995) that the use of informal venture capital provides an appropriate resolution for the new small business equity gap because it lowers the information and monitoring costs that are incurred in borrowing from external sources and there is less likelihood of owner-equity value dilution. Loans and other forms of finance from external sources normally involve the preparation of detailed credit reviews and the collection of information for formal reviews and monitoring of the progress of the enterprise. However, informal venture capitalists normally have prior knowledge of the industry, which is a crucial factor in their invest­ment decision. Information is also disclosed to private informal investors on a more informal and informative basis.

Harrison and Mason claim informal venture capitalists are more patient than ven­ture capitalists and are willing to invest smaller amounts of capital in line with the needs of the owner-managers of small firms. Business angels tend not to look for quick exit routes and typically invest sums up to £10,000. Only a small proportion of angels invest more than £50,000. Very few business angels have high incomes or are millionaires. They tend to have an average income of less than £50,000 p. a. and their worth, exclud­ing their own residence, rarely exceeds £100,000. Business angels sometimes join together to become investment syndicates and, in such cases, the sums invested can be relatively large.

The major problem associated with informal venture capital is that of matching investors with smaller firms seeking finance. The main way in which firms and busi­ness angels find one another is through friends, family and business connections. In recognition of the importance of this source of income, formal networks have been set up to aid this matching; for example, most Business Links maintain databases of inter­ested parties. However, it would appear that only a small proportion of proposals are attractive to business angels since between 90% and 97% of proposals are rejected.

The extent to which business angels contribute to the pool of finance available to small enterprises is extremely difficult to determine. There does appear to be an acknow­ledgement, however, that informal venture capital contributes considerably more funds to financing small enterprises than venture capital does. A survey estimated that in 1997 some 4% of funds for a sample of small firms was derived from business angels (Cosh and Hughes, 1996). Therefore, business angels play an important role in the financing of small enterprises, but not so significantly to claim that this source of funds will address market failure and resolve the finance gap.

There is more detailed discussion of informal and formal venture capital and its role in the development of entrepreneurship and small firms in Chapter 19.

18.5.9 Factoring

Factoring is the purchase by a factor of the trade debts of a business, usually for immedi­ate cash. The sales accounting functions are then provided by the factor who will man­age the sales ledger and collection accounts, under terms agreed by the seller. The factor may agree to take the credit risk within certain limits or this risk may be retained by the seller. This source of finance is, to a certain extent, dependent upon the nature of the business (i. e. where the business has a reasonably high debtors’ balance). In the right circumstances, factoring can provide a significant source of finance on a continu­ing basis to firms.

An interesting paper published by the Policy Unit of the Institute of Directors in 1993 examining the late payment of debt argued convincingly that the ‘majority of overdue debts could be reduced by better credit management’ (Institute of Directors, 1993). Good credit management itself is, of course, a source of finance. Research shows that small firms in particular suffer from late payment and tend to have weak credit management. Factors employ specialist credit controllers and tend to use state - of-the-art computer software, which enables them to manage efficiently the credit given to the customers of small firms. The effectiveness of factors in credit management is demonstrated by figures published by the Factors and Discounters Association (FDA) in 1995: the average waiting period for payment was 75 days as compared with the factoring industry’s own average of 58 days.

Over the past 20 years factoring has increased in popularity. For example, turnover in the factoring industry rose from £4.4m in 1984 to £47.2m in 1997. Ignoring cur­rency fluctuations this still represents a significant increase. However, it would appear that only 8% of small and medium-sized enterprises (SMEs) in the UK currently use factoring (Grant Thornton, 1998). A survey of the perceptions of accountants (Berry and Simpson, 1993) identified three main reasons why SMEs do not use factoring: the high cost, reduced customer relations and the issue of confidentiality. There is, however, very little independent evidence on the perceptions of owner-managers of small enter­prises since much of the literature in this area tends to be anecdotal and speculative.

Invoice discounting is normally classified as a form of factoring; however, it simply relates to the raising of finance from customers and excludes all the credit management functions normally associated with factoring. With invoice discounting, therefore, invoices are pledged to the finance house in return for an immediate payment of up to 90% of the face value. It will then be the responsibility of the finance house to collect the debt. Invoice discounting has grown significantly over the years and in 2003 invoice financing provided just under £1b of finance for firms with an annual turnover of less than £1m.

18.6 The capital structure decision

Finance theory assumes that the firm is a vehicle for shareholders to maximise their wealth and ignores other stakeholders. Much of the finance literature also assumes there is a separation of ownership and control by directors/managers. Therefore, it is not surprising that the main question when deciding how the firm should be financed is whether there is an optimal capital structure that will maximise the value of the firm and hence shareholders’ wealth.

Traditionally, the starting point for examining the capital structure decision is the seminal paper by Modigliani and Miller (1958). Modigliani and Miller demonstrated that assuming a perfect capital market with no information costs, the value of the firm is independent of its capital structure. Thus, there is no optimal capital structure, there­fore the financing decision is irrelevant and the value of the firm is solely dependent upon the firm’s ability to generate profits (cash flows) from operations. Their assump­tions importantly include a world with no taxes. Since this paper, a number of researchers have examined the effect on the capital structure decision by the relaxing of one or more of the market imperfections which Modigliani and Miller in their 1958 paper assumed did not exist (e. g. Ross, 1977; Myers, 1984). Perhaps the most influen­tial research that allowed for one of these market imperfections was in a paper by Modigliani and Miller themselves in 1963 which considered the effect of corporate and personal taxes on the capital structure decision. Modigliani and Miller in this later paper demonstrate that, when other things are held constant, firms with high tax rates should use more debt than firms with low rates, because the value of debt financing is tax deductibility vis-a-vis equity, and the value of this benefit increases with the tax rate. Therefore, financing the firm using debt rather than equity implies that firms should obtain as much debt finance as possible. Clearly this does not happen in prac­tice, primarily because of the countering effects of other market imperfections such as bankruptcy. However, this is not to say that this tax effect is not influential to some extent in the overall capital structure decision.

Despite these developments in finance theory it does not yet fully explain the differ­ent capital structures that firms adopt in practice nor do we know how firms choose the debt, equity or hybrid securities they issue (Myers, 1984). Nevertheless, from a careful inspection of real-world market imperfections we get a good idea of the factors that will affect the capital structure decision (Higson, 1993). However, large firms have been the main focus of the research on capital structure decision (Michaelas et al., 1996) and thus the literature relating to small firms’ capital structure is less well developed and restricted to a few papers (Keasey and Watson, 1993).

Small firms, of course, are subject to very different financial, economic and socio­economic structures compared with large firms. For example, as previously mentioned, there tends not to be a separation between ownership and control of firms and large firms are listed and quoted on markets. These are two significant characteristics of small firms that are likely to influence the capital structure decision. Therefore, capital struc­ture decision theory related to large firms has very limited applicability to small firms.

Norton (1990, 1991a and 1991b) is one of a few researchers who have examined the capital structure decision from the perspective of small firms. In examining a num­ber of market imperfections, which it is claimed are influential in the capital structure decision of large firms, Norton argues that bankruptcy costs, agency costs and informa­tion asymmetries seem to have very little effect on a small firm’s capital structure decision. He also highlights the importance of certain factors relating to the market in which the firm operates, and the preferences and desires of the owner(s). Small firms, Norton concludes, are less likely to have target debt ratios and there is a preference to use internal finance to external finance.

Michaelas et al. (1996) conducted a study of the financial and non-financial factors that determine the capital structure of small privately owned firms. Their findings show that the life-cycle of a small firm is influential in determining its capital structure. When firms start up, and as they grow, they use debt finance. However, as they mature the reliance on debt declines. A positive relationship was found between gearing and the collateral value of the assets and this emphasises the importance of security in the bank lending decision. The research also found that tax and bankruptcy costs were not influential in the decision and no relationship was found between gearing levels and profitability, growth, risk and the level of debtors. Firms in different industrial sectors seem to differ in their capital structure preferences and it was found that economic conditions also had a bearing on the capital structure decision.

Research to date from a small firm perspective does highlight that financial theory related to large firms, and particularly that related to the theory of the capital struc­ture decision, is not necessarily appropriate to smaller enterprises.

18.7 Financial reporting considerations

An important link between the sources of finance for a business, particularly for small firms, are the financial reports produced periodically by firms which primarily give an account of the performance for a stated period, normally a year (the profit and loss account), and the financial position of the business on a stated date (the balance sheet). The evidence is that this information is required by the providers (creditors) of finance when assessing the applicant firm requiring the finance (Berry et al., 1993a). Also there is evidence that some creditors, such as banks, require financial reports to monitor the progress of the business to which they provided finance (Berry et al., 1993b).

Sole traders and partnerships are not required by statute to disclose such informa­tion, but may do so in order to satisfy the needs of creditors. In contrast, companies are required by statute to file annual accounts (whether or not they are seeking exter­nal finance) with the Registrar of Companies and give copies to their shareholders. However, it is the legal requirements and accounting regulations that influence and drive the form and nature of the annual accounts produced by small enterprises who are outside the scope of these requirements. In the main, the legal and regulatory requirements have been designed for large quoted companies where there is a separa­tion of ownership and management. The primary concern of the regulations is one of stewardship; that is, the annual financial report forms an integral information liaison between the managers (directors) of the company, who run the operations of the busi­ness on the one hand, and the owners (shareholders) of the business on the other. Of the total companies in the UK, only 0.8% are quoted; the other 99.2% are unquoted, and 99.5% of these companies are small. Therefore, the way in which these small com­panies report has very little to do with their needs. Consequently, it may be the case that the financial reports for small businesses would look very different if standard set­ters considered what they are used for and who uses them.

In a review of the literature (Jarvis, 1996) on the users and uses of the financial state­ments of small businesses, banks were identified as a major user (e. g. Berry et al., 1987, 1993b; Deakins and Hussian, 1994b). Within the bank-lending process, it is recognised that financial reports play a significant role (Berry et al., 1993b). In fact, the ‘excessive’ use of financial reports and other financial information in this process has been heavily criticised by some; for example, Deakins and Hussian (1994a) argue: ‘we find that there is an excessive reliance on financial information such as forecast balance sheets and profit and loss accounts and standard financial ratios.’

The findings of research into bankers’ use of financial reports recognise that the use of financial information is dependent upon a number of contingent variables (Berry and Waring, 1995). An influential factor in the use of financial information is whether or not the applicant is currently a customer with the bank and whether the business in question is new or existing (Berry et al., 1993b). For example, if the application is from an owner-manager of a new business no financial reports would be available. There is also evidence that this user group can obtain additional information in support of figures in financial statements (e. g. management accounting information and valuation reports commissioned by the business). Banks are able to successfully demand this information because they are in a relatively powerful position within the relationship.

In the literature review identified earlier (Jarvis, 1996) a study by Mitchell et al.

(1995) examined venture capitalists’ use of financial reports in investment decisions. The financial statement was seen as an important source of information in the process of making decisions.

Recent research (Collis and Jarvis, 2000) provides evidence of owner-managers’ use of financial reports. It is clear that managers recognise the importance of financial state­ments to creditors of the enterprise. In that context it is likely that owner-managers will monitor the reports to ensure that everything looks correct in respect of creditors, otherwise this may cause concern (Jarvis, 1996).

Although there is no further evidence of other creditors’ (e. g. business angels) use of financial reports it is generally assumed that these investors in small companies are significant users of financial reports of SMEs, even though they may not necessarily reflect the needs, as previously mentioned, of users of the reports.

18.8 Chapter summary

This chapter examined the types and sources of finance used by small firms and three important related issues: the finance gap, the capital structure decision and financial reporting. Small firms use different types of finance compared with large firms. Large firms have established markets where they can publicly raise funds but there are no similar markets for the majority of small firms. The proportion of equity invested in small firms tends to be less and there is more reliance on bank lending. Over the years the question as to whether a finance gap exists has been debated. Although the finance gap is never likely to disappear completely, through the introduction of government initiatives and new products by financial institutions it has become much less of a con­straint for the majority of firms.

Finance theory relating to the capital structure decision was found not to be wholly applicable to small firms. A significant influential variable is the life-cycle of small firms. When firms start up, and as they grow, they tend to rely on debt, but when the firm matures this reliance on debt declines. The amount of security available, however, restricts the extent to which the firm can obtain debt financing. The concept of stewardship (reporting to the owners of the business on the performance of the firm’s management) is irrelevant in the reporting of the financial affairs of small businesses. However, financial reports are an important source of information for financial insti­tutions in making credit decisions and monitoring the client’s progress. Therefore, it is clear that from a number of perspectives the financing of small businesses differs significantly from the way in which large firms are financed.