The themes of technological innovation, entrepreneurship, and organizing

Innovations and Financing of SMEs, Part II: Case Study of German SMEs in 2010

David S. Walker

The University of Birmingham, UK

Horst-Hendrik Scholz

The University of Birmingham, UK

ABSTRACT

Financing is one of the most critical boundaries for the establishment and growth of a Small and Medium-sized Enterprise: SME (Moore, 1993). This chapter describes traditional and non-traditional financing opportunities for SMEs in Germany by focusing on its applicability. The disclosure of financial business information and giving a say to an equity financier is a difficult topic for owners of Small and Medium-sized Enterprises (SMEs), because these companies are often run as a ‘one-man-show ’ (by a single manager) and this person identifies itself with the company. The request for external funds is in that perspective still regarded as a disability of a business to be self-financed. A comparison of the organisational structure of a SME and that of a Large Scale Enterprise (LSE) reveals the structural weaknesses in terms of research and development (R&D) activities. While LSE have an extra depart­ment, budget and procedures to develop product and process innovations similarly to a knowledge push, in SMEs, innovations are often originated from customers—similarly to a need pull process (Tidd & Bessant, 2009). Furthermore, CEOs and customer contribute to a great extend to innovations in SMEs (BDI, 2010). The results of an online-based survey presented in the BDI-Mittelstandspanel 2010, show that less than 13% of innovations are originated by external scientists, R&D organisations and consul­tants. This proofs that external R&D sources (to compensate missing internal resources and structures) are rarely employed; impeding or slowing down the development of innovations.

DOI: 10.4018/978-1-61350-165-8.ch031

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INTRODUCTION

There are various financing options available to Small and Medium-sized Enterprises (SMEs) that can be classified generally in traditional and non-traditional financing as introduced in the previous chapter. Due to a rather conservative attitude towards dependence on shareholders, non-traditional financing options (e. g. private equity) are not very common within SMEs (es­pecially in Europe); aggravating the amelioration ofthe company’s financial structure and therefore creditworthiness. In order to get a rather holistic view, a case study based on a survey presents the structural development and economic situation of SMEs - and its financiers in Germany.

German Banks offer SMEs rather medium or long-term bank loans than project related loans. Therefore, the control and monitoring of banks over the efficient use of borrowed money is low compared to project financing. Looking at finance as an ‘Organisation’s Creative Area’ (OCA), non-traditional financing can be more suitable to develop core competencies and promote product innovations. Sometimes they are even the only financial source available when it comes to high - risk project financing. In order to support SMEs and generate a high profit, Private Investors are more likely to take part in project related (e. g. for a product innovation) financing. The level of control and monitoring, in order to ensure that a product or service innovation is turned into money, is high. By the financial and managerial support, Private Investors especially promote the ‘knowledge push’ innovation model. Due to lack of resources, the ‘knowledge push’ innova­tion model is rarely used compared to the ‘need pull’ innovation model in which the innovation is originated from customers.

BACKGROUND

The financing sector in Germany is highly com­petitive with the three types of banks (private banks, banks governed by public law and coop­erative banks) trying to maintain and gain market share and the non-traditional financiers (private equity and debt financiers). Therefore, the credit conditions have been favourable in Germany during the last decades. CEOs of SMEs tend to have a conservative attitude concerning addi­tional shareholders and financial independence. Therefore, medium - and long-term bank financ­ing has been in Europe (especially in Germany and France) a major financing option for SMEs. However, with respect to the financial crisis of 2008/2009, the credit conditions (especially risk premium) changed, impeding the availability of loans. While financiers accuse SMEs for having a weak financial structure, SMEs representatives accuse the financiers (especially banks) for the so called ‘credit crunch’ with unacceptable credit conditions.

SME-FINANCING AND INNOVATIONS Financial Resources and Innovation Boundaries of SMEs

The BDI1 announced in its latest report (BDI, 2010), based on an online survey, the developments and weaknesses of German SMEs in 2009 and expectations for 2010. These weaknesses include innovative boundaries, based on fundamental problems of the organisational structures and re­sources. Therefore, finance can also be regarded as an ‘Organisation’s Creative Area’ (OCA) that helps develop core competencies especially with the support of Private Investors, controlling and monitoring the realisation of product and service innovations.

The funding of a SME is regarded as one ofthe most difficult process from the management point of view. Because the owner or manager identifies itself with the business, asking for external funds indicates helplessness and dependence on others. As discussed in the section “Financial interests and characteristics of SMEs” of the previous sec­tion, there are several trade-offs between financial figures. One example for a trade-off is the reduc­tion of tax payments and establishment of a good credit rating. Additionally, the financier requires an extensive disclosure of detailed business informa­tion, which is sometimes perceived as a potential risk ofplagiarism due to changing account manag­ers of banks and their wide range of customers and financial services. Furthermore, the development of interest rates and lending conditions as well as the term of loans are important factors to take into consideration when making a financial decision. As presented in the BDI-Mittelstandspanel (2010, p.19) 71.8% of SMEs have trouble with getting new credit lines granted, 48.35% complaint about strict documentation and safety requirements when applying for a loan, 55.85% gained a lower credit rating in 2009 and just 16.5% of SMEs have an own budget for R&D. Nevertheless, most SMEs do R&D activities within the framework of cus­tomer orders (BDI, 2010, p.25). The insufficient innovation performance of some SMEs is not only caused by a lack of external funds, but also by detrimental organisational structures. Just 16.5% of SMEs have a special budget to execute R&D (BDI, 2010, p.25). The establishment of a R&D department, definition of its responsibilities, sys­tematic collection and evaluation of innovative ideas and the method budgeting are regarded as useful auxiliary activities for innovations.

Innovation Sources of SMEs

There are three main areas where innovations can take place: Product, Process and Business Model. According to the BDI (2010, p.25) four out of ten firms are working on - or released within the last 2 years - one product innovation. In order to assess the innovative capability of SMEs under existing structures, it is worth it to have a look at the different types of innovations. Concerning process innovations, a third of consulted SMEs apparently have been successful within the last 2 years (BDI, 2010, p.25). The business models of most SMEs have evolved within time, but are based on traditional management ideas and struc­tures (Figure 1); therefore, a strategic reorientation and the receptiveness towards non-traditional financing are rarer to find. In addition, every new reorientation is associated with a risk of failure. According to the report, just 1 out of 200 ideas are successful on the market.

Innovation ideas originate from a diverse range of sources. The main source of innovation in established SMEs (in contrast to entrepreneurial businesses) are customers and suppliers. The customer and supplier (BDI, 2010, p.25) initiate for instance in Germany on average 64.4% of innovations. In contrast to LSE, where resources enable ‘knowledge pushes,’ in SMEs, innovations are more likely originated from customers in a ‘need pull process ’ (Tidd & Bessant, 2009, pp.232- 236). In SMEs where the CEO is involved in the product - or service development process and customer relationship management, this person causes major innovative stimulation. Furthermore, on average 55% of innovations are originated from the CEO. Other external sources on the other hand are rarely used. Scientists and R&D organisations as well as external consultants ac­count for less than 10% each for innovations. Compared to LSE, employing R&D staff, this can be regarded as a competitive disadvantage or respectively potential.2

Historical Background of German SMEs

Due to socialistic influences, SMEs located in the east of Germany have been challenged to rebuild old company structures from the time before the

German Democratic Republic3; or create com­pletely new company structures. During the era of the DDR, small enterprises were nationalised and forced into central planning structures, which were rather ineffective; in terms of not only in­novations and expansion plans. Limited foreign trade caused a lack of spare parts for machines, which blocked growth and innovations down. Due to the fact that unemployment was higher and the minimum wage lower than in western parts, SMEs needed help from the federal- and Lander (states) government and banks to finance the development of companies in the post-war period. According to Mullineux (1994, p.7), the government provided SMEs in the east with investment and depreciation allowances. Additionally, local saving banks and community-type banks (like ‘Volks - and Raif - feisenbank’) supported SMEs by lending small loans. Larger loans mainly came from official banks of the Lander (OECD, 1982).

In the western parts, the Federal Ministry of Economics and Technology (‘Bundesministerium fur Wirtschaft und Technologie’) launched a Pri­mary Innovation Scheme from 1972 to 1979 by spending 114 million on 230 projects covering 50% of high risk new technology costs. These loans are repayable if the projects have been successful (OECD, 1982). Additionally, the government-backed risk capital bank (‘Wagnisfi - nanzierungsgesellschaft’) bought shares of firms with a minimum participation of DM4 400,000 per firm. Furthermore, Private and State supported participation banks (‘Beteiligungsgesellschaften’) provided risk capital to SMEs. Low interest rate
loans have been offered to SMEs through the Eu­ropean Recovery Programme (ERP) Funds. This budget was DM 500 million in 1978. In 1979, the federal Government aid programme raised capital with low interest rates in order to fund SMEs for 20 years. The so-called Lander (states) offered capi­tal guarantee schemes backed by official Lander banks supporting new companies. A programme by the Ministry of Economic Affairs announced in 1979 the law, that SMEs with a lower turnover than 150 million and less than 1000 employees can subsidise 40% of R&D cost (up to DM 300,000) and 25% of excess costs (up to DM 400,000) per year. In 1980, the budget was increased to DM 390 million. To sum up the development of SMEs in east and west it can be stated that profited from a diverse range of supporting programme in the post war period. The following paragraph will present the current situation of the ‘Mittelstand’5 in Germany mainly influenced by post-war sup­port programmes.

Regional Differences of SMEs in Germany

Analysing SMEs in Germany, two regions with similar SME-patterns can be distinguished: The new - and old federal states of Germany6.Addition- ally, Baden-Wurttemberg and Bavaria (as states of the west) should be mentioned as major locations for the engineering industry, mainly characterised by suppliers (SMEs) for the automobile industry. Furthermore, the Rhine-Ruhr metropolitan region with services in the financial, insurance, high tech and multimedia sectors has the third highest GRP in the EU (Eurostat, 2010). Furthermore, the city - state Hamburg has one of the biggest harbours in Europe and is an important place for the aviation industry As described in the previous paragraph, SMEs in the east have evolved their organisational structures differently due to socialistic influences and make still more use of governmental subsidies. According to Boerner (2008, p.8) 49% of firms in the east and just 21% of firms in the west use public funds. This phenomenon can be explained not just by the increased availability of subsidies in the east, but also by the fact that the need for subsidies is even 20 years after reunification higher. The government funded and supported Universities and Technical Universities in rural areas (especially in the East of Germany) to provide companies with highly trained staff and promote innovations (Broekel, 2009, p.7). Nevertheless, most eastern states suffer from movement of la­bour from east to west and demographic changes. According to a newspaper article by Astheimer (FAZ, 05.08.2010, no.179, p.10), the highest pre­dicted emigration rate of 25% until 2025 will take place in parts of Saxony-Anhalt and will cause a critical shortage of specialised employees in this area. According to Haselhoff (FAZ, 05.08.2010, no.179, p.10), 90% of59,000 firms have less than 20 employees and a low wage level compared to the western standard. Therefore, many specialised and trained workforces emigrate to western states.

Figure 2 shows the median7 equity ratios of different size classes ofthe non-financial industry in east and west of Germany. With an average value of 9.5% in the east and 6.6% in the west, SMEs in the east have shown higher equity ratios during the last years. Since 2007 the equity ratio increased minimal stronger in the east than in the west. When it comes to investment decisions, SMEs located in the so-called ‘neue Bundeslan - der’ (literally translated ‘New States’ which are located in the east) tend to regard the necessity of liquidity protection as more important than SMEs in the west (Boerner, 2008, p. 8). The equity ratio is a major part of quantitative factors influenc­ing a firm’s Credit Rating and therefore access to bank credits. A higher equity ratio indicates a better financial situation and a better ability to overcome a crisis. Presumably, the recession will have an impact on the more current upcoming equity ratios. Due to the fact that the recession can be regarded as an imported recession, businesses
which are more focused on the domestic market (like many businesses in the east) will be belated affected from the recession (DSGV, 2010, p. 55). In the western states, the automobile industry is a very important sector. LSE in this industry are very export oriented and therefore subject to economic fluctuation. This fluctuation has a strong impact on many SMEs which are supplier of LSEs.

The Net Profit (NP) ratio8 is, unlike the eq­uity ratio, a figure direct linked to the economic situation of a business. As shown in Figure 3, the decrease of NP ratios since 2006 indicates the effect of the recession clearly for all size classes of the non-financial sector in east and west.

Notjust SMEs, but especially larger companies in East Germany have problems with their net profit ratios. This can be explained by a relative increase of material and labour costs during the last years (Plattner, 2008, p.11). However, today there are many successful and specialised firms in the east; closing the gap between the two areas continuously.

The German Banking System

Banking systems have different structures accord­ing to the history and needs ofnations. In Germany there is a system based on three pillars (Figure 4).

Private Banks as one pillar of the banking system aim at a profit maximisation; serving either private - or business customer. Their core busi­nesses are depositing - and lending. Banks gov­erned by public law, in contrast to private banks, do not aim at profit maximisation but are subject to governmental guarantee schemes to support businesses. Especially during the recovery after WW2 or in a financial crisis, these institutions play a vital role. Due to the fact that major Private Banks, small Private Banks, credit associations and state banks all target business customer, there is a high competitive pressure arising leading to relatively low prices for banking services in Ger­many. On the other hand, the system approved its cushioning effects in the financial crises and re­cession 2009 thanks to different functions and diverse product/service portfolio of each bank type (Starke, 2010). The small local banks gov­

erned by public law (Sparkassen and Volks - banken) are serving local companies and because oftheir independence from the international bank­ing business, they are less affected than other larger bank institutions. Some larger banks have to revise their risk assessment methodologies because ofthe credit crunch and low lending costs; in order to be able to target new customer. Serv­ing private-, business-, and corporate customer, large private banks (also called universal banks) helped to get through the financial crisis. Never­theless, some institutions needed governmental help.

The Credit Rating Process

The banks need to have an own rating system to judge investments. In this example, lending money to a SME can be seen as the investment. Therefore, the bank rates the lender’s ability to pay back the borrowed money including a provision. Every bank has its own rating system, criteria, and grades. Nevertheless there are institutions like the “Initiative Finanzstandort” that provide reference and comparability information. At the beginning of every relationship between the business customer and banks, the customer (bor­rower) needs to offer information to issue a file
generated by a rating programme. According to an executive of a leading German Private Bank, the rating programme can consist of the follow­ing modules: Loan behaviour, account behaviour, qualitative factors, external data, finance analysis and master data. The ‘Finance analysis’ is based on collected and automatic evaluated balance sheets. Due to changing financial ratios, a certain economic development can be interpreted. In order to execute such a financial analysis, at least two annual balance sheets are required. Key figures are equity ratio and ‘Earnings before Interest and Taxes’ (EBIT). The account behaviour is dealing with the customer’s overdraft history, capitalisa­tion of credit line and booked turnovers. Master data is set of information put together by a ‘key of professional categories’ (according to the industry of customer), evaluation of industrial sector, as well as the length of customer rela­tionship and the time that the company is on the market. When judging about short - and long-term loans, the behaviour of borrowers is particular of interest. Furthermore, qualitative factors are being judged by an expert’s evaluation of the market, competition, and management. The last module is presented by external data, which are information from other financial service provid­ers like ‘Kreditreform.’ All six modules are being evaluated according to its importance to generate a result that gives an approximate value. Even if the business itself generates attractive financial ratios, the Master data factor, which judges for instance the company’s industry, can influence the result towards a low credit rating. According to Starke (2010), previous rating systems used to evaluate financial ratios with qualitative factors each with a fixed weighting. For example, all fi­nancial ratios account for 85% and the qualitative factors for 15% of the overall score. However, in some cases it is possible to change the credit rat­ing manually (known as “overruling”) to either improve or adulterate it; which of course requires documented rationales. The next important step of current credit rating processes is the evaluation of the corporate structure and dependence on linked organisations or owners having a right to take or influence decisions. Ifthe company is a subsidiary of another company, it is important to look at the level of dependence on the holding company. If the dependence is strong and the subsidiary is strongly integrated, the credit rating of the hold­ing applies to the subsidiary as well. A subsidiary which is rated as ‘weakly integrated,’ gets its own credit rating. An additional agreement to improve (or rather not to adulterate) the credit rating, is the agreement of the transfer risk. This agreement has the advantage, that a bank lending a loan to a company has the security to refund itself by the central bank. Therefore, the company (borrower) needs also to provide the central bank with its balance sheet as a security. In case the borrower disagrees, the credit rating slightly adulterate, be­cause it is more difficult for the bank to refinance itself. The firm’s credit rating can be represented by a range of grades between 1 and 14 or 1 and 6. Each grade represents a certain Probability of Default (PD) for a company with an investment project (Table 1).

Additional to the working instructions accord­ing to the final score of the rating, some banks have superordinated working instructions. Ac­cording to Starke (2010), an example for such instructions would be an “industry-traffic-light - schematic,” where certain industries have a red light; meaning they are not being granted financial services (no matter how good the credit rating score is). The idea is to reduce the overall Prob­ability of Default concerning payback of loans. This is a problem for companies in the industry that have loyal customers and a product with a unique selling point to generate profit even in difficult times. Utilizing an “industry-traffic-light- schematic” can lead to a loss of profit; therefore the rating systems are getting more precise focus­ing on individual firms rather than just branches.

Survey to Assess the Financial Structure and Financing of SMEs

Focus Group and Type of Survey

In the focus of the conducted survey were 30 non-financial businesses from different states in Germany. These SMEs, (according to the defini­tion of the European Commission, described in paragraph 6.1.4.) were questioned by the mean of a questionnaire. The questionnaire, as a type of survey, was chosen because of limited resources and because questionnaires are easy and confort - able to answer and submit (via email, fax, letter). Moreover, the evaluation of a standardised ques­tionnaire is likely to be free of errors and simple to administer. The questions were designed in a defined sequence in order not to influence the respondent’s answers. The first questions were easy to answer and helped to classify the business; whereas the later ones were more detailed (e. g. about the use and knowledge of specific financing options). Besides questions about financial key figures (e. g. equity ratio), also questions about financing needs and preferences were raised to evaluate the firm’s financial situation. Further­more, the perception of funds availability was of particular interest. The questions take the last three years, the current - and future situation into consideration. The results of the survey do not raise the claim of representing all German SMEs in every state and sector with a respective statistical relevance, but it is rather used to validate first of all theories presented in literature and secondly larger surveys that have been conducted (like the survey of the BDI).

Discussion and Results of the Survey

The average polled firm has an age of 55 years, employs 30 people and earns less than 10 million p. a. in 85% of cases. Leaving the financial crisis behind, 92% of polled firms claimed to be in a ‘good and stable’ economic situation, whereas 8% claimed to be in a ‘not stable and close to crisis’ situation. These results raise hope for SMEs and underline the perceived importance of a high eq­uity ratio. According to the survey, 64% of polled firms have an equity ratio above 31%, which can be regarded as an outstanding result. 27% had an equity ratio between 10% and 30% the last 9% had a ratio below 10% (Figure 5).

According to an in-depth interview with an executive from a leading German bank, most of SMEs in the producing sector only have equity ratios below 20% and in the trading sector between 5% and 10%. The highest equity ratios of polled trading firms are between 10% and 30%. Further­more, to put it in an international perspective, German SMEs have been spoilt by favourable credit conditions during the last years due to the competition between financiers (especially foreign banks entering the market). In addition to an in­creased risk premium due to the crisis, the bank­ing regulations (Basel I - III) prescribe ratios in which a credit must be based on equity. Therefore,
the requirements for credits rose during the last years. The survey confirmed that not a single firm rated the lending requirements as ‘rather low’; not to mention the options ‘low’ or ‘very low.’ Compared to the last years influenced by the re­cession, polled firms judged the requirements to gain a credit as slightly higher in the next 3 years. Nevertheless, the perceived availability of finan­cial funds shows that in future the majority of polled firms (64%) are expecting no changes; nevertheless, 27% stated that it would be more difficult to receive the traditional financing funds like bank credits.

In accordance with the ‘Moral Hazard’ and ‘Adverse Selection’ effect, described in the theo­retical analysis of credit rationing in chapter 6, most firms (73%) agreed on the fact that the risk taken for an investment depends on the credit conditions. This leads to an increase of higher risk projects with worsening credit conditions.

The most common financing options of polled SMEs were long - and short-term bank loans as well as leasing. Medium-term bank loans in the second place and deposits by partners in the third place (Figure 6). Factoring as well as types of private equity (as some non-traditional financing options) do not seem to be common financing tools at this stage. This can be explained either by the fact that firms do not want to give any financial information to external bodies or simply by not knowing their financing options. 40% of polled firms stated that they have a lack of information concerning non-traditional financing options.

As shown in Figure 7, the credit rating of 36% of firms has improved during the last 3 years, while 18% of firms stated that their credit rating has decreased. A reason for this negative develop­ment might be the fact, that 46% of polled firms do not employ financial experts for their financial planning and do not have a strategy to improve their credit rating (30%). A critical result of the survey was the statement that 60% of firms do not regard offered financial solutions as being based on the firm’s needs.

Recommendations and Possible Solutions

The lack of expertise in financing as well as research and development is a major barrier for SMEs. According to the executed survey, most firms do not seek advice from financial experts to

develop a strategy to improve the credit rating and cash flow. With a clear strategy employing non - traditional financing options, SMEs can become less dependent on bank financing. However, firms have to be ready to give away some confidential business information in order to overcome the information barrier. Therefore, the creation of a long-term relationship with financiers based on

trust should be aimed. The classical ‘house-bank’ relationship is especially important during a credit crunch because lending conditions make it difficult for SMEs to obtain funds. In order to stabilize the business for the future, lack of innovations and resources can be compensated by Strategic Alliances and ‘Business Angels’; profiting from the expertise and resources of others. In order not to loose too many shares of the business, exit strategies for investors and business partner might be helpful.

FUTURE RESEARCH DIRECTIONS

Future research could address the problem of achieving transparency of risks and opportunities related to innovations in order to ease the credit application process. Furthermore, it would be helpful to analyse why firms employ non-tradi­tional financing rarely and how non-traditional financing can fill gaps of traditional financing. Furthermore, future research could address the following questions:

• What criteria does a Credit Rating System have to fulfil to be focused on individual firms rather than branches?

• To what extend should firms be financed through bank loans and what are the in­fluencing factors (comparing USA and Europe)?

• How to develop an investor’s exit strategy to regain independence?

CONCLUSION

Boosting the economy by supplying SMEs with loans and maintaining a risk sensitive credit rat­ing system can be a trade-off for banks in the lending sector. While during a financial crisis the risk premium of loans rises, the media ask for more financial funds to support struggling SMEs. Therefore, it is critical how a lender’s credit rat­ing system judges the credit worthiness of firms. As the in-depth interview with the executive of a leading German Private Bank confirmed, some banks apply a so called “industry traffic light schematic” which looks at the economic situation of specific sectors rather than at individual firms. This might lead to a scenario where an innova­tive firm with a ‘core competency’ is refused a loan because of its branch ranking. Fortunately, the credit rating systems evolve towards a more individual and differentiated rating. On the other hand, bankers complain about low equity ratios and in-transparent capital structures of SMEs due to grouping structures, creating of reserves and assessment of materials and “semi-finished prod­ucts” in order to minimize taxation (by lowering retained earnings).

Besides the traditional banking loans, there are other options for SMEs to obtain funds. Especially for start-ups or entrepreneurial busi­nesses, so-called Private Investors provide funds, expertise and contacts in exchange for a business share. This funding process has to be carefully planned as it has a bigger impact on the business than a traditional bank loan (especially in terms of independence). Two critical aspects (which are sensitive topics for owner/manager of SMEs) are the necessity for transparency of business infor­mation and operational interference.

Finance can also be regarded as an Organisa­tion’s Creative Area (OCA) that can develop core competencies especially with the help of Private Investors, controlling and monitoring the realisa­tion of product and service innovations. Other types of non-traditional financing are short-term direct loans from online market places offered by private persons. Major aspects influencing SME financing:

• Capital structure (e. g. Equity Ratio)

• Grouping (acting on behave of group inter­ests rather than own interests)

• Traditional financing (long-term ‘house - bank’ relationship)

• Non-traditional financing (Knowledge Management, Mezzanine capital)

Drawing a conclusion from the conducted sur­vey and the literature review, it has been confirmed that most SMEs do not use much non-traditional financing options; missing out an opportunity to improve their capital structure for instance by the mean of Mezzanine capital. Simultaneously to the improved capital structure, the credit rating would improve as well and the dependence on traditional bank financing through loans can decrease. Es­pecially for German SMEs, being in favour of a highly competitive lending market within the last decades, the use of non-traditional financing options seems to be crucial to adapt to changed credit conditions impaired by the financial crisis.