Study On The Financial Sources For SMEs

Introduction

SMEs are those industries, which are unquoted in a stock exchange, run by few individuals or a type of family businesses having connection with shareholders. According to South West Venture Fund, SME is a company or business that has less than 250 employees and has an annual turnover not exceeding approximately £24 million.

SME sector is very large in UK economy. There are 3.7 million businesses in UK according to the survey conducted in 2003 by Department of Trade and Industries (DTI) and 99% of those are small and medium sized and survey also suggested that UK gains 50% of its total turnover from SME sector. On the other hand according to the report of HM Treasury 2008 there are 4.7 million SMEs in the UK and are responsible for more than 52 per cent of total UK business turnover. Therefore it can be seen that SMEs have an important role to play to drive UK growth and the average productivity of SMEs has increased in the last ten years.

On the other hand SMEs are struggling in accessing to finance whereas there are many sources of finance available in UK. The main problem with SMEs to obtain finance is that of uncertainty. Investors most of the time don’t rely on SMEs in investing because SMEs does not have a long track record of success. Banks are quite nerves of SMEs to investment because SMEs represent high credit risk. The problem is, banks are not increasing the loan amount without increasing security given and most of the SME owners are unable to provide security. There are many SMEs without tangible assets to use as a security for all lenders.

All the financial sources for SMEs are listed below with brief description.

Business Angles

Business angles are private individuals who invest their own assets in SME or start-up businesses. Business angles also share their personal business experience with other entrepreneurs. LBA (London Business Angles) provides great services to innovative starting-up businesses who seeks the capital more than £100 k for their future growth. London Business Angle runs by Greater London Enterprise (GLE). The main reason behind investing by business angles is that they are very experienced and successful entrepreneurs and they not only provide finance they also train new business through sharing their experience. The fact on the other hand is only few companies can find business angles, LBA receive 1000 business plan and after the whole selection procedure only 42 business have been invited to invest with. Another group of business angles BBAA (British Business Angles Association) is also working to provide financial help to early stage businesses. Every year private individual or these business angles invest between £800 million to £1 billion in starting-up business and SMEs.

Overdraft Financing

Overdraft financing is another most popular way of accessing to finance for SMEs. In overdraft financing, payments are made from the current account of business when the amount exceeds the available balance. Through the overdraft facility business gets short-term funds whereas the amount which is loaned is repayable according to the bank demand. There are some benefits of overdraft facilities such as the borrowed amount can be changed within the limit and interest is only payable on the amount borrowed. The main disadvantages of overdrafts are, bank can ask to pay back the money very sooner than expected time, overdraft limit can be changed at any time by the bank, overdraft facility cannot be used if large amount is needed and the interest rate is higher than the bank loan. Some other factors must be considered when using overdraft facility to obtain finance. Such as the amount that is borrowed should not go beyond the given or agreed limit, interest also differs according to the amount borrowed and the interest rate is higher than the bank base rate , sometime bank can charge the overdraft fee and finally overdraft cannot be obtained for long term. One more difficulty for SMEs to obtain finance through overdraft is SMEs can be asked to provide some kind of security depending on the size of overdraft facility. Security may be of any type for an example it can be tangible fixed assets or personal guarantees given by company directors.

Venture Capital

Venture capital provides long-term, committed share capital, to help unquoted companies grow and succeed. If an entrepreneur is looking to start-up, expand, buy-into a business, buy-out a business in which he works, turnaround or revitalise a company, venture capital could help do this. Obtaining venture capital is substantially different from raising debt or a loan from a lender. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the success or failure of a business . Venture capital is invested in exchange for an equity stake in the business. As a shareholder, the venture capitalist’s return is dependent on the growth and profitability of the business. This return is generally earned when the venture capitalist “exits” by selling its shareholding when the business is sold to another owner.

Venture capital in the UK originated in the late 18th century, when entrepreneurs found wealthy individuals to back their projects on an ad hoc basis. This informal method of financing became an industry in the late 1970s and early 1980s when a number of venture capital firms were founded. There are now over 100 active venture capital firms in the UK, which provide several billion pounds each year to unquoted companies mostly located in the UK.

REVIEW OF LITERATURE

Introduction

It being any country, small and medium enterprises has become an integral part of it and provides remarkable contribution to its economy. SMEs play a pivotal role in job creation and in progress of country. Like UK, many countries now understand the importance of small business and started to diversify it for job creation and also for the long term development of the country’s economy. .

SMEs constitute the majority of economies around the world, these highly contribute in private sector and one of which seems to be growing in folds with time. According to the reports of Bank of England (2003), approximately 54% of the total value is added by small and medium firms in the UK. In fact, in some sectors SMEs have contributed more than larger firms

Entrepreneur and Entrepreneurship

The word entrepreneur has been defined numerous times by the researchers in their research. There is no specific definition of entrepreneurship but there is a generally accepted definition which highlights its significant contribution in the growth of economy.

An entrepreneur has the ability to provide momentum for the change, innovation in the traditional strategies and approach. They always try to introduce new ideas in the business market. Entrepreneur is someone who can gauge the financial risk during the business startup and has the ability to capitalize the opportunity of benefit of an enterprise.

Besides, various researchers have determined different characteristics of an entrepreneur. For instance, according to Adler, 2002; Aldrich, 1989; Alstete, 2003; Anderson et al, 1992; Anna et al, 1999, an entrepreneur is very creative, skilful, innovative and always keen to explore new ideas and strategies. While, according to others the traits are

• Hunger for achievement
• Desire of total control
• Need of independence and leadership
• Low traditionalism
• Risk taker
• Dominance

Moreover, Yonekura in 1984 suggested the characteristics like ‘assertiveness, insistence, forward looking, critical thinking, creative, innovative, broad minded, creative etc. On the other hand, Burk (2002) proposed that optimistic, hard working and desire to achieve are the qualities which are common in entrepreneurs.

There are various reasons for people to choose entrepreneurship and start their own business. This area has also been widely researched (Walker, 2004). Result of most of the studies done in this area show that people are motivated by personal and financial reasons like achievement need, independence, and the creation of wealth (Bird, 1989; Birley and Westhead, 1994; Burns, 1996; Hisrich, 1986; Kuratko et al., 1997). Generally, most of the studies suggest that personal internal reasons are more important motivations as compared to financial reasons in going into entrepreneurship (Gray, 1993).

Despite of the above mentioned reasons, his/her present job situation also plays an important part and can influence them for business adoption. According to the Moore and Buttner (1997), unfavorable conditions experienced within the organization, for instance- lack of opportunities and less salary may also push them to start their own business.

Furthermore, people who are jobless are also sometimes forced to become entrepreneurs (Still and Guerin, 1991), even though the clarity of the entry of business and its form are not that clear to them at the start (Praag, 2003; Vodopivec, 1998; Walker, 2004; Walker and Brown, 2004; Burke et al., 2002; Burns, 1996; Buttner & Moore, 1997;

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Process Involved in Business Start up

Over the period of time remarkable changes have taken place in the work environment and culture of small and medium enterprises. The failure or the success of any organization depends upon the initial or the kick off stage of the business. The start up of any business activity depends upon the manner or the way in which the business makes arrangements or provisions of funds.

The growth of the firm is the most important aspect and has to be done with taking care so that it can grow up to its full potential (Carter et. al., 1996; Carter & Anderson, 2001; Carter & Cannon, 1988; Chaganti & Parasuraman, 1996; Cliff, 1998).

Steps involved in the start up of any business activity can be classified as under:-

Business Start up:-

The theoretical aspects behind the set up or start up of any business are quite different from the practical ones which can be classified as under:-

The creation of an idea

Theory:- The start-up of the business by the entrepreneur begins with the setting of an idea. Idea is the stepping stone on which the business relies and most of the aspects of the business are considered in the initial idea itself. There are pros and corns to everything and in the business set-up the setting of idea itself leads to the same.

Opportunity Recognition

The recognition of the right opportunity at the right point in time is what the entrepreneur must be able do. The task of recognizing opportunity for the same is not an easy task at all. There may be loads of opportunities which arise in the market like they may be in the form of a new product or service that has to be offered to the customer (Kotler, 1972; Deshpande, 1983).

Research of the market and forming of the Business plan

Research plays a key role before the starting up any activity and business also demands for the same i.e. to conduct research and then formulate a business plan. The key role in set up of any business plan is by carrying out SWOT analysis of the same which means to recognize the Strength Weakness Opportunities and Threats that the organization has to offer (Kotler, 1990; Dyer, 1994).

Finance Arrangement

Finance is the blood stream of any organization and without the induction of finance no organization can operate. There are loads of sources available for the firms both small and medium sized. Basically for the small and medium enterprises there are mainly two sources of finance internal and external. The basic difference between the internal and external source is the element of interest. Internal sources as the name suggest is from friends family and the saving element and external is all that which leads to the payment of interest basically borrowed funds from sources such as banks, financial institutions etc. (Feldman & Bolino, 2000; Fielden et al., 2003; Fitzgerald and Muske, 2002; Leazar, 2002).

The small and medium firms in the initial stage cannot afford to bear any additional cost and the interest element also becomes a burden for them and they are mostly concerned with the internal sources of finance i.e. the money invested in the firms by family and friends (Lee & Mathews, 1999; Hisrich, 1986).

The other aspect of business is the big business houses which have their operation on a large scale and the finance is procured by them from banks and other leading financial institutions.

Optimum Use of Resources

Resources are the tools and materials which form the crux of any organization and making a proper use of the same plays a very important role in the growth and overall development of the organization. It is vital to make the best possible use of resources as in small towns the scope of business activities is limited as compared to big cities wherein the opportunities as well as the resources required are more and readily available Gimeno, 1997; Gray, 1993; Gatewood et al., 1995; Gundry & Welsch, 2001)

Resources are portrayed as being distanced from main markets and main centres of business activity, have lower and more dispersed population, a weaker infrastructure, local markets are limited due to lower population.

‘Despite the apparent difficulties in starting up and running a business to towns, the number of businesses has grownâ€?. (Anderson, 1997)

Problems in Starting Up a Business

When starting up a business, the owner is bound to face some problems. There are basic steps and procedures that should be followed by the entrepreneur, while starting a business. But the problem arises when the successful implementation of these steps becomes difficult, due to the problems in the market. Sometimes things do no happen in reality as they were expected and also it may take longer time than expected (Martins et al., 2002; Marschack, 1994; Morrison, 2000; Olson, 1992; Praag, 2003; Rainbird, 1991).

Major problems in starting up a business can be classified as:

– Goodwill- When a business is new, it lacks good reputation in the market, which is called Goodwill. In business, it is very important to have goodwill. It means that the business has trustworthy image in the market. Sometimes, just because of lack of goodwill, customers don’t trust the company (Reynolds, 2000; Robichaud et al., 2001).

– Market Prediction- It is essential for the entrepreneur to have the market predictions. The market trends keep on fluctuating. Thus the entrepreneur has to mould himself according to the market situations. If he does not maintain pace with the market trends it becomes very difficult to be in the race. This is not a very easy job (Robinson, 1994; Shane, 1995; Smith, 2000).

– Financial Gap- The existence of a financial gap arises because demand from small firms is greater than the willingness of financial institutions to supply the finance at current market conditions. For finance such as bank loans, these gaps may be termed as credit rationing (Stanworth & Stanworth, 1997).

– Getting the premises in prime location- Getting a good location to set up the business is a very big issue. The entrepreneur should keep in mind to get the best location. If the location is good and is very close to all the available resources then he can grab the opportunities of using these resources (Taylor, 1980).

– Judging the customer expectations- It is very hard to match the ever changing expectation and demands of the customers. It is very difficult to have an exact idea about the choice of the customers. In this case it becomes very difficult for the new firms to have an idea about the customer expectations (Timmons et al., 1985).

Small and Medium Enterprises in the United Kingdom

Source: http://stats.berr.gov.uk/ed/sme/smestats2008-ukspr.pdf.

According to the department for business innovation and skills the profile of the small and medium scale enterprises are as follows:

As per to the reports there were approximately 4.81 million private sector enterprises in the UK during the starting of 2008, which showed the increase of 104,0003 (2.2 per cent) since the start of 2007. These are the highest levels after the time series began in 1994. Approximately, 23.1 million people were employed by these enterprises with an estimated combined annual turnover of £3,000 billion. Moreover, 99.9 percent of all enterprises were together accounts by the Small and medium-sized enterprises (SMEs) and 59.4 per cent of private sector employment and 50.1 percent of private sector turnover.

‘Employment in SMEs is estimated at 13.7 million, 287,000 (2.1 per cent) higher than in 2007.Turnover in SMEs is estimated at £1,500 billion, £61 billion (4.2 per cent) higher than 2007.More industries experienced growth in the number of enterprises between the start of 2007 and the start of 2008, than experienced a fall. In percentage terms, the biggest increases were in the Mining and Quarrying; Electricity, Gas and Water Supply (19.3 per cent) and Financial Intermediation (10.2 per cent) sectors and the biggest falls in the number of enterprises were in the Manufacturing (- 6.9 per cent) and Other Community, Social and Personal Service Activities (-4.7per cent) sectors (http://stats.berr.gov.uk/ed/sme/smestats2008-ukspr.pdf).â€?

As such, out of the 4.81 million private enterprises in the United Kingdom, 99.9 percent are classified as small and medium scale enterprises (SMEs) and they are responsible for 59.4 percent of employment in the country as well as 50.1 percent of private sector turnover.

The sector also experienced growth from 2007 to 2008 (http://stats.berr.gov.uk/ed/sme/smestats2008-ukspr.pdf). Most of these private enterprises are (see Table 1) small which is 99.3 percent of the total and they employ about 0 to 49 employees per enterprise while the medium enterprises is 0.6 percent which numbered at 27,000 enterprises and employs from 50 to 249 employees per firm. The large enterprises employs more than 250 employees per firm percent which numbered at 27,000 enterprises and employs from 50 to 249 employees per firm.

ISSUES FOR SMEs AND ENTREPRENEURS

According to Deakins and Freel (2003), small and medium sized firms do not easily get finance because of the restrictions imposed on them. Notably these SMEs have very less equity and very high risk is associated with them. As a result, most of the sources of finance are not accessible, for instance Stock Exchange.

There are mainly two sources that entrepreneurs use that is Internal Source and External Source. Internal source includes personal equity, which are usually remortgages, savings and money taken from friends and family members. While external sources of finance comprises loan taken from bank, venture capitalist, formal investors. Few more sources include leasing, hire purchase and factoring.

However, there are various sources of finance available for the SMEs; it is worth discussing the problems faced by the entrepreneurs and constraints of financing. Major issues for SMEs are

• Financial gap
• Getting finance from bank
• Role of security
• Credit scoring

Financial Gap: It mainly occurs when the financial need of SMEs is not fulfilled by financial institutions because of the current market conditions the present situation (credit crunch) further adding problems to the same. It happens when the demand side of the curve exceeds the supply.

However, it is still a debatable topic whether this gap is the result of information asymmetries or it is due to the reputational effects. Informational asymmetries are basically considered as the imperfect information provided to the financing institutions, which suggests that there will be insufficient funds available for the firms (Stiglits and Weiss, 1981).

According to Shane and Cable (2008), it is likely that few firms specially manufacturing and technology based companies are often reluctant to give full information about their company to avoid the disclosure which can make it easier for others to use it. Moreover, there are few more categories which can face financial gap, such as young entrepreneurs and those who belong to remote areas. Young entrepreneurs mainly lack to provide the security, while for the entrepreneurs in the remote areas, it is quite difficult to get access with the banks (OCED, 2008)

Getting finance from bank: However, banks are easily accessible; it is less likely that entrepreneurs get favourable offers from them. Short-term financing given by banks only looks theoretically attractive.

Besides, banks also face issue in assessing the proposition from the borrower, which generally arises when both provider and borrower share different set of information.

For banks, two main issues are:

• Adverse Selection
• Moral Hazard

Adverse Selection: This arises when a bank is unable to assess a proposition correctly. For instance, when it refuses to provide for a proposition which could have been successful or when it accepts the position which results as failure.

Moral Hazard: It causes more serious problem for banks and ultimately causes problems for the entrepreneurs having less/no security to offer. It can occur when a firm misuses the security-free financing from the banks, as there is no guarantee taken from the firm to repay the loan.

This is a monitoring problem for banks and for comparatively smaller amount of loans; it is not economic to observe them closely. However, this creates problem for the entrepreneurs who lack sufficient equity and security.

Role of security: This has now been widely used to overcome the shortcomings like moral hazard and adverse selection. However, bank officers can also choose to have frequent monitoring of the information to reduce the adverse selection, a cost minimisation approach (role of security) seems to be a better option.

Furthermore, collateral seems to be a better option because it ensures commitment from the borrower and allows bank to make safer deal. It also enhances the chances of loss recovery in case of adverse selection.

Credit Scoring:- Nowadays, this computerized technique has been widely used by banks. Credit scoring is based on considering various variables of the borrower such as, occupation, post code of home address, previous payment records and other commitments Taking all the above mentioned things into consideration, a computerized acceptance or rejection report is generated.

Credit scoring has brought a remarkable reduction in decision making for the bank managers. In most of the leading banks of UK like NatWest, Barclays, Lloyds/TSB, Bank of Scotland, use different systems to measure credit of the loan applicant. Albeit, few above mentioned banks have adopted this technique completely, there are some banks still relying and using both methods (Credit scoring and decision making)

However, credit scoring has proved to be a boon for the banks, it has some demerits as well. It only judges the applications on the basis of past records. This technique may reject the proposal which sounds beneficial and successful but don’t have good credit history and past records.