Before reviewing some of the available funding options for SMEs, let us explore first of all what we mean by SMEs, why they are essential and why they frequently find it difficult to raise financing. We explore in this article the potential sources of funding to be used by a SME. More contemporary crowdsourcing and supply chain finance options will be given specific attention. We will finally examine how governments typically attempt to support the SME sector and why.
What is an SME?
The fact that a SME is something greater than those companies that are just a self-employment vehicle for their owners is universally acknowledged. SMEs are also unlikely to be listed in any stock exchange and own a relatively limited number of stockholders. Indeed, most stockholders come from a large family quite often. The term SME therefore applies to a wide variety of companies.
Why are SMEs important?
The word SME has a fairly broad spectrum of companies, as we have just shown. Thus, for the economy of many nations, the sector of SMEs as a whole is highly significant. Estimates vary greatly, but the UK small and medium sized enterprises are likely to account for around half the job and half the national revenue.
As tiny SMEs are typically flexible and more innovative than bigger firms. They are comparatively small. In fact, small and medium-sized businesses are frequently seen better to take up new technology and trends. It is obviously vital that this happens for any economy. For certain successful SMEs, it is also because they are purchased by a bigger firm with the financial wherewithal to make full use of the potential of the SME. The Small and Medium-sized Enterprises industry has been helpful in helping a bigger business to develop and to sustain its success in the future.
The SME sector is expected to continue to develop in economies, such as the UK, where the manufacturing sector has decreased as a share of overall economy activity and the service industry has grown ever more significant. This is because economies of scale are often less relevant in the service industry than they are in the production sector. SMEs are therefore simpler to survive and prosper in the increasing service industry.
Lastly, it is vital for SMEs to grow, as a few of today’s SMEs might potentially be tomorrow’s largest corporations.
Why do SMEs find raising finance difficult?
SME managers are regularly complaining that the lack of capital prevents them from developing and from making full use of beneficial investments. SMEs frequently call the ‘funding or funding spacing’ this gap between the cash available to them and the funding which they might employ productively. As consultants to SMEs, we must understand why this gap exists. We must comprehend.
First of all, there is a restricted provision of investment money. Once potential investors have fulfilled their requirements and want to spend and pay taxes, nothing remains to be invested. Another problem in the UK today is that investment returns on a common bank account are so low that they do not appear to be desirable for investment.
Similarly, the restricted supply of investor money has a competitive market. Governments and bigger corporations are very keen on funding and the small and medium-sized business sector might thus be squeezed.
The SME sector is tending to bear on account of the high degrees of uncertainty and risks that SMEs are seen as less appealing investment opportunities than many others. This risk perception is based on a number of causes, among which:
- SMEs generally have weak records in increasing investment and returning their investors appropriately
- SMEs typically do not have internal controls or are highly restricted
- The external controls in SMUs are frequently limited. For example, they are unlikely to comply with the regulations of any stock exchange and are unlikely to draw a lot of journalistic review since they are large. Many SMEs in the UK have no longer had to audit their annual accounts
- SMEs generally have a dominating owner-manager who cannot decide much.
- SMEs frequently offer little actual security asset.
As a result of it, investors are uncomfortable with investing in small and medium-sized enterprises as they are worried about how the funds may be used and their returns. So it is easy for an investor to refrain from investing in a SME, particularly if there are so many other investment possibilities for them.
Accountants can do nothing to change the availability of these funds or their competitive market, but can help by demonstrating how a SME is able to decrease its perceived risk, thereby increasing its capacity to raise funding. SMEs, for example, are more likely to be appealing to investors if they prove they have treated past investors well, have embraced important domestic regulations, and have a strict, documented approach to decision making.
What are the potential sources of finance for SMEs?
There are really several potentially financing options for small and medium-sized enterprises. Many have practical difficulties though which might restrict their effectiveness. Some of the main sources and constraints are mentioned briefly below. Crowdfunding and finance of the supply chain are therefore more carefully explored.
The SME owner, family and friends
This might be a very strong funding source because those investors are not only financial, but also might want a lesser return than many other investors. The fundamental constraint is that most of us have a fairly restricted financial resources we can raise individually and through friends and families.
The business angel
The company angel is a rich person ready to risk investment in small and medium-sized companies. One restriction is that these people are not widespread and very frequently are quite specific about what they are willing to invest in. If an angel is interested, he may become quite beneficial for SMEs, since they frequently have tremendous business skills and numerous useful relationships.
SMEs can accept loans from their suppliers, like any other firm. However, this is short-term and, in fact, the ability to extend the credit duration can only be limited if your suppliers are major firms that have recognized them as a potentially dangerous SME.
Factoring and invoice discounting
These two methods of funding have effectively enabled a firm to raise funding against the safety of its outstanding debts. Again, this funding is only short-term and frequently costs more than an overdraw. However, one aspect of these financing sources is that when a SME expands it will increase its outstanding receivables and thus it will also increase its quantity of borrowing from its factor or an invoicing discount. Factoring and discounting of invoices are two of the very few financing sources that expand automatically as the company grows.
Rather than buying leasing assets is frequently highly helpful for a small and medium-sized business since it avoids increasing capital costs. However, only physical things such as automobiles, machinery etc. truly are feasible to lease.
Banks may be prepared to give some kind of overdraft and willing to make long-term loans when this loan may be secured in large assets like land and buildings. However, it is generally more difficult for SMEs to get medium-term credit for financing transactions, because banks are traditionally relatively conservative. The losses from a defaulting loan require several excellent loans to restore this loss. That is understandable. Many SMEs are so ending up funding short-range financing, for example, for medium-term and perhaps longer-run assets. It’s badly matched and not very good. This problem is sometimes referred to as the maturity gap, because the maturities of assets and obligations in the company are inadequate.
In addition, banks are typically forced by the owner-manager of the SME to provide personal guarantees, which implies that the owner-manager must risk his personal property in order to finance the firm.
The venture capitalist
Very frequently a risk capitalist firm is a subsidiary of a corporation which has large cash assets to invest. A risky, perhaps high-return portion of its investment portfolio is the risk capital subsidiary. Many banks will thus have venture capitalist affiliates. A corporate idea has to be developed by the risk capitalist in order to attract risk capital investment and to produce the high returns. Therefore, venture capitalist financing may not be viable for many SMEs operating in normal businesses. Moreover, a venture investor does not want to continue to be involved in the long term, and so every proposition to him must explain how after a number of years he may “walk out” or release his value. This frequently happens if the firm is sold to a larger company in the same business or the company is grown to such size that it may have a stock exchange list.
A SME would become a listed business by creating a stock exchange list, which will mean that the increase in funding is less problematic. However, the firm must develop to such a level that a listing is viable before a listing may be considered. Many small and medium-sized businesses can never expect to do so.
Supply chain financing
The financial sector tracks the value of the supply chain financing (SCF). The SCF, since it fosters collaboration among buyers and supply chain salespeople, is relatively new and is distinct from typical working capital funding techniques, such as settlement factoring or giving discounts. There was traditionally rivalry since the purchaser sought extended credit and the vendor wanted rapid payment. SCF works particularly effectively if the buyer’s credit rating is better than the seller.
Company A buys products from company B (with A+ credit rating)
(Who has a rating of B+ credit). Co B agreed to grant credit to Co A for a period of 30 days.
Co B invoices Co A.
Co A approves the invoice.
Co A is expected to pay the amount due to its financial institution – ‘Bank C’ –
in 30 days at which point the funds are immediately remitted to Co B.
Co B may nonetheless ask bank C for funding before the deadline. If you do, you will be paid less a reasonable discount. This discount is probably lower than if Co B uses standard factoring or discounting invoices. Because they utilize Bank C (the financial institution of Co A) and profit from a higher credit rating from Co A, the debt being the debt of Co A, and this was verified by the approval of the invoice Co A.
Likewise, if CoA want to withhold payment after 30 days, it may. However, some interest will be payable when Co A eventually pays Bank C. This interest rate obviously reflects Co A’s credit rating.
In order to efficiently link the customer, seller and financial institution, technological methods are utilised. These technologies efficiently automate the business and financial process from start to finish.
SCF may provide substantial advantages to the supply chain and span more than a step. Perhaps most importantly, when the supply chain, as is the case in the automobile trade, continually moves with substantial value. Currently, SCF is only utilized among a small number of firms, but its utilization is projected to increase substantially. This source of funding is, like with factoring and invoicing discounting, limited short term.
SCF may of course offer significant support for small and medium-sized businesses that provide a high credit rating, or even for suppliers of bigger firms. As the technical solutions necessary for SCF work are spreading and SCF growing, more and more small and medium-sized enterprises are expected to profit.
Crowdfunding includes the financing of a company via the increase of funds from many individuals (the crowd) and quite frequently over the Internet. Crowdfunding has risen fast, with crowdfunding projected to raise more than US$5 billion worldwide in 2013. More than 500 crowdfunding sites are available on the internet currently, and every day more than 400 crowdfunding actions are started.
The online platforms are set up and maintained by moderating organizations that connect the initiator of the initiative together and organizations and people that support the concept. Different platforms have various rules to evaluate the concepts they support and monitor those who are prepared to offer funding. So while using these platforms considerable vigilance is essential.
Crowdfunding finance may be invested in the debt or the capital of the financing initiatives. Some crowd-funding is done “always” where the recipient keeps any cash received, some are made “always or nothing” in which the recipient receives the funds only if the sum necessary for funding the project is raised within a certain timeframe. A charge is borne by the crowdfunding platform, generally a percentage.
Crowdfunding is characterized by allowing individuals to look for ideas and initiatives in which they believe or believe. These investors are therefore occasionally ready to take greater risk and/or accept fewer profits than normal. Also, there is the opportunity to engage within the crowd, just as in a real crowd. So, quite frequently, strong advocates of a certain concept urge others to engage.
Very often in early crowdfunding camps, art such as bands and films was the center of the campaign. However, this funding has now been given for all kinds of projects and a strong focus has been placed on innovation and new technologies.
The potential of crowdfunding is highly useful for small and medium enterprises. It allows them to contact investors directly that may risk financing the new technology and inventions that are typically produced by SMEs. It enables them to contact and appeal directly.
Why and how do governments help finance SMEs?
The governments are frequently willing to contribute so as to prevent SMEs from raising funds for their profitable initiatives, to the decline of the investment prospects and, thus, to the lower level of domestic wealth. Furthermore, governments are committed to encouraging innovation, an area which is frequently excellent for SMEs, and they are committed to helping small and medium-sized enterprises develop since it promotes employment.
There are a number of important ways that governments help:
- Facilitation of subsidies.
- For example, tax benefits can be provided for individuals prepared to accept the risk of investing in SMEs by providing tax discounts.
- Advise – for instance there is a publicly supported organization in Scotland called the “Business Gateway,” which supports individuals who set up and operate a business, providing advice on getting funding.
- Ensuring loans – a substantial part of a bank advanced loan is guaranteed by the government for a nominal charge, for example from the SME. Since this reduces the bank’s risk considerably, the bank may be more inclined to lend. The ‘Enterprise Finance Guarantee‘ plan is now known in the UK.
- Capital investment provision – Many nations have government-backed corporations who are prepared to invest in SME stock. This is frequently done in conjunction with any equity investments received from another source by the organization. This is done by ‘Enterprise Capital Funds‘ in Great Britain while ‘Small Business Investment Company’ is available in the United States.