ACCA F9 Financial Management - 2010 - Study text

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Paper F9

Financial management

CHAPTER

Finance for small and medium

sized entities (SMEs)

Contents

1 ThecharacteristicsofSMEs

2 Thefinancingproblem

3 Venturecapital

4 Governmentaid

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The characteristics of SMEs

 Definition

 Relative importance

1 The characteristics of SMEs

1.1 Definition

While there is no universally-accepted definition of what constitutes a small or

medium sized enterprise, they are

 private companies

 owned by a few individuals, typically a family group

The precise definition of what constitutes a SME may differ according to the

industry in which the firm operates.

In the UK, the Department of Trade and Industry defines a small firm as being less

than 50 employees and a medium firm as having 50-249 employees. In the EU, a

small firm is defined as being an independent enterprise (i.e. not controlled by a

large company), having less than 50 employees and either having turnover less than

€7m or net assets (a ‘balance sheet total’) of less than €5m. A medium firm is also

defined as an independent enterprise with employees less than 250 and either

turnover of less than €40m or a ‘balance sheet total’ of less than €27m.

1.2 Relative importance

Of the total number of businesses in the UK and EU less than 0.5% are classified as

large businesses. In the UK, small and medium enterprises account for almost 55%

of employment and more than 50% of turnover. In the EU comparative figures are

66% and 54%. The majority of employment growth has come from small firms in the

EU and the US.

This means that small and medium-sized enterprises make up a very large part of a

national economy. For a company to grow its economy, it is therefore important that

SMEs should be able to grow their businesses. To do this, they need long-term

capital.

The problem of raising sufficient long-term capital to grow their business is much

greater for SMEs than for larger companies.

Chapter 15: Finance for small and medium sized entities (SMEs)

The financing problem

 Equity finance and SMEs

 Debt finance and SMEs

 Leasing and SMEs

2 The financing problem

2.1 Equity finance and SMEs

SMEs are normally owned by a few individuals. These existing owners are often

reluctant to issue new equity to new investors as this will dilute their control of the

business. External investors might also be reluctant to buy shares in a SME, because

of the high investment risk.

One possible source of new equity capital for a SME would be a new issue of shares

to the existing owners, who would then put more of their personal wealth into their

company. However the existing owners might not be willing to put more of their

own money into their company. Even if they were willing to put more money into

their company, they might not have enough personal wealth to meet the company’s

capital requirements.

If SMEs cannot raise extra equity capital by issuing new shares, retained earnings

are their only source of new equity. Even in profitable small companies, it takes a

long time to build up capital through retained earnings, and it might be too late to

take advantage of the required investment opportunities. Opportunities for growing

the business even faster might be lost.

Short-term sources of capital can be used to some extent to help a small company to

grow its business, but SMEs cannot rely extensively on short-term finance. SMEs

might even face difficulties in negotiating trade credit if they have not been in

business long enough to build up a track record for creditworthiness. Banks are also

reluctant to offer a large overdraft, unless the owner of a company is willing to

provide a personal guarantee for the facility (perhaps in the form of a bank

mortgage over the family home). Too much reliance on short-term finance also

increases the risk of overtrading, which was explained in an earlier chapter.

Without additional external capital, many SMEs are unable to grow as quickly as

their owners would wish. Many SMEs try to obtain finance in the form of medium-

term or longer-term debt, or to acquire assets through leasing.

2.2 Debt finance and SMEs

The main source of external finance available to SMEs is bank finance. There are

many problems for a SME in negotiating bank finance:

 SMEs are often limited companies or partnerships for which financial

information does not have to be published to a wide audience. There may be

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only limited requirements for external audit, or no legal requirement for an

annual audit. The SME will have to provide the bank with sufficient financial

information and also convince the bank that it has a credible business plan that

should ensure its ability to repay the money it borrows.

 The SME may lack experienced management and a bank may be unwilling to

trust them with its money. For example a bank might suspect that the profit

forecasts provided by the management of an SME might be far too optimistic

and inaccurate.

 The SME might have few assets to offer the bank as security for a loan. It is often

the case that long-term loans are easier to obtain as these can be secured with

mortgages against property (land and buildings) owned by the SME. The main

problem arises with short and medium-term loans, for which adequate security

does not exist, and this is known as the ‘maturity gap’.

 The high-risk nature of investment projects by SMEs might mean that even if a

bank is willing to lend money, it will require a high risk premium to be

incorporated into the interest rate.

2.3 Leasing and SMEs

SMEs make extensive use of leasing as a method of obtaining long-term assets. Both

operating leases and finance leases might be used. A feature of a lease is that the

leasing company remains the owner of the asset. In the event that a company cannot

make the scheduled lease payment, the lessor is able to take back the asset. This

provides some form of security. A lessor might therefore be more willing to agree a

leasing deal with an SME than a bank is willing to make a loan or offer a large bank

overdraft facility.

Chapter 15: Finance for small and medium sized entities (SMEs)

Venture capital

 Finance and growth

 Business angel finance

 Obtaining venture capital

3 Venture capital

3.1 The nature of venture capital

SMEs will usually try to raise the finance they need from retained earnings and

bank finance, and by leasing assets. Working capital requirements can be reduced

by negotiating credit terms with suppliers, and possibly by factoring trade

receivables and obtaining some factor finance.

For SMEs with an ambitious strategy for growth, these sources of finance are

unlikely to be sufficient. In some cases it might be possible to raise new finance in

the form of venture capital.

Venture capital is capital provided to a SME by one or more external investors, in

the form of equity capital, preference shares or debt finance – perhaps a mixture of

all three. Some investment institutions specialise in providing venture capital

finance to private companies to support their growing businesses.

Venture capital investors require large returns on their investment, because of the

high risks involved. They want the profits on their successful investments to cover

the losses they inevitably suffer on business ventures that fail.

3.2 Business angel finance

Business angels are wealthy individuals who invest directly in small businesses,

usually by purchasing new equity shares. The business angel does not get involved

personally in the management of the company, but hopes to make a large return on

his investment from dividends and eventually from the sale of the shares when the

company has grown.

The main problems with business angel finance are as follows.

 There are not many business angels, and it is usually very difficult for a small

company to identify an individual who might be willing to consider making an

equity investment in the company.

 Since there are not many business angels, there is far too little business angel

finance available to meet the potential demand for equity capital from small

companies.

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3.3 Obtaining venture capital

The term ‘venture capital’ is normally used to mean capital provided to a private

company by specialist investment institutions, sometimes with support from banks.

Venture capitalists might be willing to provide finance to new businesses in return

for an equity stake in the business. In addition to equity capital they might also

agree to provide extra finance in the form of preference shares. With some venture

capital arrangements, a bank might also be willing to provide loan capital as part of

an overall financing package for the company.

The company will have to demonstrate to the venture capitalist organisation that it

has a clear strategy and a convincing business plan. It must demonstrate that its

management are experienced, have sufficient skills to make a success of the business

and are committed to achieving success. Sometimes the venture capital organisation

will require a representative to be on the board or will appoint an independent

director.

Exit route for the venture capital investor

A venture capital organisation will not invest money in a company unless it is

satisfied that there is a strategy for the company that will enable them to withdraw

their investment at a profit, of the company is successful. This is known as an ‘exit

route’ for their investment, and a venture capitalist might expect an exit route to be

available after about five years or so from the time of making the investment in the

company.

The exit route might be:

 A stock market listing, if the company grows quickly and is successful. When the

company’s shares are brought to the stock market, the venture capitalist can sell

its shares.

 A ‘trade sale’ of the company to a larger company. A venture capitalist investor

might insist that the company should be sold to a larger rival, so that they can

take their profits and disinvest.

 Refinancing by another venture capital organisation. A venture capitalist might

be able to transfer its investment in a company to another venture capitalist.

Problems with obtaining venture capital finance

The main problem with obtaining venture capital finance is finding a venture

capital organisation that is prepared to look at the possibility of investing in the

company.

The problem is particularly severe for companies that want to raise ‘seed corn’

finance to build up their business from a very small beginning. Venture capitalists

are often reluctant to spend time and resources in looking at small ventures where

the potential returns are likely to be small. They are much more likely to be

interested in financing well-established medium-sized private companies, such as

private companies that gain ‘independence’ in a management buyout. Medium-

sized businesses often need new equity to enable them to build their business to a

Chapter 15: Finance for small and medium sized entities (SMEs)

point where a stock market flotation is possible, and the risk of business failure is

lower than with smaller ‘start-up’ ventures.

In the UK, for example, most of the larger venture capital organisations are not

prepared to consider providing finance for start-up companies or newly-established

small companies, and focus instead on more well-established companies such as

management buyout companies.

On the other hand there are some very large financial institutions that provide

venture capital to companies on a global scale, including the provision of capital to

companies in China and India. For example in April 2008 US-based private equity

group Warburg Pincus announced the creation of a $15 billion global fund for

investing mainly in venture capital investments and ‘growth capital’ for private

companies. The company announced at the time that it was looking at a five-year to

seven-year time frame for its investments.

Paper F9: Financial management

Government aid

 Loan guarantee scheme

 Enterprise investment scheme

 Venture capital trusts

 Enterprise grants

 Finance for SMEs: summary

4 Government aid

Many governments are aware of the importance for the national economy of SMEs

and want to encourage SMEs to develop and grow. Some governments offer specific

schemes to assist SMEs and give them access to finance either through direct

financial assistance or by means of tax incentives to investors. The following are

some of the schemes offered by the UK government.

4.1 Loan guarantee scheme

This was introduced in 1981 to help SMEs get bank loans even if they have

insufficient security for a loan in normal commercial circumstances. The

government encourages banks to lend to SMEs by guaranteeing 75% of each loan up

to £100,000 for new companies and £250,000 for existing companies with the loan

being guaranteed for two to ten years. In return the company pays an additional

rate of interest to the government. The loan guarantee has assisted some small

companies but has not been used extensively.

4.2 Enterprise Investment Scheme (EIS)

This was introduced in 1994 to encourage equity investment in small unquoted

companies. It offers income tax relief at 20% on annual investments of up to

£150,000 made by individuals who are not connected to the company. Capital gains

made on the sale are exempt provided the shares have been held for a minimum

qualifying period. The scheme therefore gives wealthy individuals a tax incentive to

invest directly in unquoted companies.

4.3 Venture capital trusts

Venture capital trusts are investment trusts, approved by the tax authorities, which

are established to invest in small companies. Investors put their money into a

venture capital trust rather than directly into small companies, and the venture

capital trust makes investments in a number of small companies. In this way

investors in venture capital trusts obtain an indirect investment in a portfolio of

small companies, and receive tax relief on their investment. They are exempt from

income tax on their dividends and are also exempt from capital gains tax on

disposal of the shares, provided they have been held for a minimum qualifying

period.

Chapter 15: Finance for small and medium sized entities (SMEs)

4.4 Enterprise grants

The government or government agencies might award cash grants to small

companies. For example in the UK an enterprise grant scheme allows SMEs to apply

for a grant of 15% of their fixed costs up to a maximum of £75,000 when they are

investing up to £500,000.

4.5 Finance for SMEs: summary

The success of government initiatives to assist SMEs to obtain capital to grow their

business is limited. Most SMEs face serious problems with raising long-term capital,

and the supply of long-term funding for small companies falls well short of the

demand from SMEs for capital.

Paper F9: Financial management

ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing

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