Potential Exam Q's:
1. Compare and contrast the use of loans and equity amongst small businesses?
2. What is meant by the SME finance gap? Does one exist, and if so, how might it be overcome?
- Students are expected to draw upon the main features of the entrepreneurial finance market place and, crucially, the implications of the informational opacity for SME finance to answer the first part of the question. The second half would require them to make links to various policies that governments have designed both in the supply and demand side of the financing issue.
Small vs. Large firms
- Small firms vs. large firms: small firms are not scaled down versions of large firms, they respond differently and are entirely radical types with various dimensions. The main difference between large and small firms is opacity (not all parties are perfectly informed! banks do not know what business is doing what and vice versa: there is a worry of losing out if they do tell each other, how can imperfection/opacity (Berger & Udell) be overcome?
- Opaque marketplace disadvantages: some good businesses do not get funding because the bank thinks they are a bad business=highly inefficient= a direct implication of the opacity issue. Hence why correct+accurate information=so important+in a good market place, we want good businessess to get funding. In opaque marketplace, some bad businesses are funded. UK sole traders+partnerships do not have to publish profit/loss a/cs, LTD companies do=adds to opacity.
- Small firms owned by clearly identifiable person or group of persons (i.e. can look this person in the eye). Firstly, personal characteristics of entrepreneur which is so different from a large firm on the stock exchange. Large firms’ preferences do not influence as strongly as the owners of small businesses. Secondly, stock exchange large firms likely to be there in 2,3 or 10 years times though. 2/3 of small firm starts will disappear within 3 years, hence why lending money to them is a very difficult business. Although small firms are personality driven, it is also VERY risky! Third difference, OPAQUE market – no way of knowing who is a very good entrepreneur.
Main Sources of Funding
1) Overdrafts: borrow money up to fixed £. Rates on overdrafts=reasonable! Overdrafts=mechanisms to even out cash flow- i.e. sell+not paid for 28 days so use overdraft to fund during the 28 days until £. Only pay interest on amount of overdraft (unless exceed). NB: when go over limit, charged fixed fee+interest(3 times). Not for long term borrowing. (25% use)
2) Grants/subsidised loans: (often government backed)
3) Term loans: fixed period of time normally for 1, 2,3 years. Borrow full £5k+pay interest on £5k. Not like overdraft. Often for buying kit. Jarvis 2006: prior to 90's, loans used to be 50% of SME indebtedness, by end of 90's shifted to 2/3rd+1/3rd overdrafts (Bank of England 2004). Loans thought of as more secure+couldnt be withdrawn, overdrafts stopped quick (Jarvis 2006).
4) Asset finance: more complex, often a bit of kit i.e. JCB digger – a) HP (bit of kit becomes yours at the end of the fixed term period) and b) Leasing (never owned by the business)
5) Credit cards (30% of businesses)
6) Equity: share ownership of business i.e. venture capital. Persuading someone to put money into business for a part ownership, NOT loan. VERY diff. Important as influences HOW people behave. Equity is least used(0.01%). Dragons den= unrepresented of SME finance.
Other sources of finance
1. Mortgage on home
2. Gifts from friends and families
3. Loans from friends and families
4. Asset based finance
5. Trade credit (i.e. ladies hat maker at weddings, doesn’t use any of the above sources of finances, but gets all of the material for hats on trade credit i.e. pay the supplier in 28 days once customer paid and this is trade credit). This is very important. Delaying of payment to enable to have effectively free credit for that period of time.
Small firms vs. large firms differences
- Ang (1991): In large firms, as close to perfect marketplace i.e. shares that are traded, shareholders have limited liability and produce a portfolio of diversified shares in their own interests. Large firms have access to capital markets. Small business have NO traded shares or publically traded securities. Owners are wrapped up in that business and what happens to their household finances depends on what happens in that business! Everything is tied up in that business for small firms – may have more than 1 business, but still do not have a notion of a diversified portfolio like larger firms. If a small firm goes bankrupt, the bank WILL take their assets and put them on the streets if they do not pay!!!! RUTHLESS!!!!
- Information: Stock exchange; how many brokers in London about what shares to buy? All of those companies are required to provide audited accounts on a ¼ basis. If in top 100/250 FTSE, you are required to give accounts and share price varies depending on how stock likely to get on in the future. Therefore a HUGE flow of information about how they are getting on and how the SECTOR is getting on and therefore the information is extensive, QUITE the opposite of small firms!!!!! What is going on in the grocery sector may bare NO relevance to what is going on in a small firm local grocery!!! No media coverage for small firms, FT tells you about large firms – look at how many pages are devoted to FTSE companies and how many devoted to small firms! Often 25/30 pages a day on FTSE companies, maybe one day a week there is something about small firms and thus the quality of information is very different.The banks perspective then is that small businesses are much more likely to fail.
From the banks perspective...
- 2/3rds of businesses that start today will not be there in 5-6 years time (high default rates), thus possible that many will NOT repay the bank. What do you do as a banker? Persuade that X is reliable, credible…have you got a house? If no house, lend £25k, could run off to the Bahamas. Need to be persuaded, if business goes down, have collateral!!!! (i.e. something can take in the event of not repaying and a house is very nice!) Reciprocation between bank and small business owner. CONFIDENCE in succeeding and persuading. Signalling to the banks that X is credible as it is too expensive for banks to collect good information.
- High default rate+ higher rates (i.e. 20%) – banks don’t do this, can still walk away w/money+no implications/losses+therefore happy to pay higher rate. Not preferred+much prefer collateral.
- Collect information: ultimately, know if X is a better entrepreneur than Y (that’s the distinction/importance and only lend to people who will repay!) But, OPAQUE issue, how can one know if X is better than Y, so need to collect information such as look at bank records or look at personal accounts to see if someone who has exceeded overdraft limit, credible person? Will the person actually repay? = collection of information. X must give positive signals, be confident to look at bank records, responsible person! OPACITY is overcome by sending signals. Collecting the information is expensive, i.e. if bank with another bank and collecting from the other bank is expensive and time consuming. Signals are not about confidence of business but about whether will repay without hassle!
From the small firms perspective...
What do small firms see as the problems?
- Persuade the bank that X is credible. Send positive signals. Offer money of another person who really knows X and has the information, thinks X is trustworthy and can secure their money in the event X does not pay. Guarantor.
- Offering collateral! = reaction of good business. As is showing credit history=good reaction!
- Reaction of bad business: ‘missing out on the business venture’, do not need all of this information or will go to another bank, fixed window, one chance = NEVER lend to them as this is the classic signal of a bad business.
- Documentation: lack of educational or an intrusion into privacy but if not prepared to do that, can’t expect bank to make those sort of decisions in your favour!
1. Principal agent: very charactersitic of finance. Bank=principal because they have to make the big decisions. Agent is SME borrowing £+expects agent to repay debt in full and timely manner. Bank sets out contract. Similar to student loans although most student loans arent repaid as they dissapear to other parts of the world or choose to earn less than threshold to avoid paying back=relationship, same relationship w/principal and agent. Once £ lent, bank(P) has only modest opportunities to ensure+enforce repayment. There are huge initial costs involved for the P in form of drawing up contracts, performance standards. P+A=diff projections and wants sometimes
2. Pecking Order & Bootstrapping: assumption that person who is running business prefers some sorts of finance to others (Watson &Wilson 1992) i.e. pecking order=clear priorities. Myers 1984 said large firms prefer 1 source of finance over another even when priced similarly (i.e. prefer internal sources retained profits over debt, debt over equity. Bootstrapping=bit of finance here and there, not a strategy, pulling different sources together to avoid having the business taken away from you. Banks are generally preferred to equity (Dragons den) though.
2. Information asymmetries: more info than the other party. 2 parties (P+A), but parties do not have the same information or 1 party has more=difficult to negotiate! It is assumed that P has less info than SME=no of implications:
a. credit constraints: easier for P to say no from outset then incur £ chasing dubious character (8-15% rejection rate), if SME turned down=angry=credit constraint (nb: most SME's get funding, maybe not from preferred lender, except in 08-09, but this doesnt indicate that the market is doing well as there are good+bad SME's. Another indication that market not working well=SME's discouraged from applying in light of others being turned down=information asymmetries. Discouragement in US and UK much lower than low income countries. Han et al(2009) said discouraged tend to be band borrowers anyway. Prime criteria market working well=good ones get £, bad ones dont. Not easy to identify whether a new starter is likely to succeed=OPACITY from P+A. Blanchflower+Oswald 1989: researched windfall gains i.e. lottery winners, most start business after win=shows was credit constrained. Cressy 1996: says no, bank will offer on human capital (education, entreprenerial talent, collateral, abilities). Evans + Jovanovic 1989: access to finance is a function of wealth not talent and talented indiv's more likely to be constrained so starting a business is largely a function of wealth, supported by Hurst & Lusdardi 2004.
b. discrimination: entrepreneurial quality vs. personal aspects influencing your ability to obtain funding. Race is prevalent (Cavalluzzo&Wolken 2005: date of those races who get declined vs. white), in USA 100% of African-Americans denied finance if no collateral vs. 53% whites w/out collateral. Clear indication of discrimination of race rather than entrepreneurial quality. Gender: data weaker here than race for rejection rates, some evidence that woman charged 0.5% more than men.
- Must demonstrate a good borrower and reliable i.e. staying w/one bank or banks nervous of hopping! Want to see long-term evidence that repay=relationship lending. Banks offer rewards for loyal service in the form of continuous loans. Banks rarely use interest rates as leverage. 'Switching plums and lemons'= want plums, lemons go sour and ripen quick i.e goes wrong quick!=not desired! Different in PIGS (where SME's bank w/many). P, to overcome info asymmetries=asks for evidence of collateral, but A's need an incentive, if P trusts A, will not need collateral. Banks dont want to repossess as bad for reputation. Banks like 'useless'and inaccurate business plans even though in reality SME's have 2/3rds chance of going bust in the first 3 years. TRUSTWORTHINESS. Postivite signals needed. Relationship, collateral, incentives and stability in banking and credit scoring to improve market information opacity.