Ensuring companies with potential grow
Is there credit where it's due? Dr Neil Lee and Dr Ross Brown explain the findings of their latest research into access to finance for high growth small and medium-sized enterprises.
More than five years after the 'credit crunch' there are still major concerns about the availability of finance for small and medium-sized enterprises (SMEs). Many have argued that this lack of bank lending has been a key factor hindering economic recovery, and policy makers have actively tried to increase the supply of finance to these firms.
Indeed, the UK Government has introduced a range of policy initiatives to ease the flow of credit towards SMEs since the onset of the global financial crisis. Prominent among these has been the recent launch of the British Business Bank and the high-profile Funding for Lending Scheme. However, despite such policy initiatives the levels of capital investment within the economy remain well below the pre-credit crunch levels.
This sector was the focus of our research report into funding issues confronting high growth SMEs in the UK, published by ICAS.
SMEs are a diverse group. While some achieve high growth, many are lifestyle firms whose owners are not aiming to grow, but just make a living. Others lack the strategy, innovative products or entrepreneurial ambition to achieve rapid growth. Despite this diversity, many of the policy initiatives tend to target SMEs as a whole, irrespective of their growth potential. This flies in the face of what we know about business growth. Research shows that a small share of high growth firms - those growing at 20 per cent or more for a three-year period - are disproportionately important in creating jobs, increasing productivity and disseminating innovations throughout the economy.
As far back as the 1970s, the US economist David Birch first identified the job-generating potential of high growth firms, which he famously labelled 'gazelles'. This group is a very small part of the business base that disproportionately drives the economy, generating new jobs and spurring productivity growth. Should policy initiatives be focused on this specific group of small firms, which have the potential to drive economic growth? Towards this end, there is a developing consensus that policy makers - both within Holyrood and Westminster - should focus on this relatively small group of firms.
Whilst there is strong evidence on the importance of high growth SMEs to the economy, there is little evidence on the demand for finance from high growth SMEs and whether they face problems obtaining such finance. In our new research we considered these crucial issues. Based on a quantitative analysis of the Small Business Survey - a government survey of almost 9,000 firms - and a series of in-depth interviews with high growth entrepreneurs, we investigated the funding needs of rapidly growing SMEs.
There is an assumption that high growth firms face particular problems in raising the finance they need. They need finance for a number of reasons. In the first place, firms with the potential to become high growth firms need start-up capital to develop and commercialise new products. Finance is also important once growth is achieved, and high growth firms can have erratic and unpredictable growth paths, making it hard to manage cash flow and plan for capital investment. Rapid growth is often achieved through acquisition of other companies, and firms therefore need finance to fund these purchases, sometimes at short notice. High growth firms are also particularly likely to be innovative, and there is evidence to suggest that innovative companies find it harder to access finance - because new products can be risky, involve sunk costs and require specialist valuation.
Our research found that high growth SMEs are particularly likely to seek external finance and have a higher demand for capital than other SMEs. Almost 44 per cent of the SMEs experiencing rapid growth had applied for finance in the past year, compared to 33 per cent of other SMEs. Yet the proceeds of growth also gave these firms other options and many therefore used a 'mixed cocktail' of internal and external finance to invest in the business. The SMEs we interviewed were keenly aware of the need to maintain balanced growth and retained earnings were a popular way of doing this.
Given the volatile nature of growth, we anticipated that high growth SMEs would find it harder to access funding from external sources. But contrary to our expectations, we found no evidence that high growth SMEs found it harder - or easier - to access finance than other SMEs. Instead, banks and other lenders seemed to be focused on cash flow and repayment ability rather than risk. High growth SMEs were not disadvantaged in the market.
Nine per cent of SMEs undergoing rapid growth and applying for finance were doing so to fund expansion, compared with three per cent of other firms. High growth firms were also more likely to be applying for finance for acquisition.
Previous research on access to finance in SMEs has identified a group of firms called 'discouraged borrowers', who want external finance, but are discouraged from applying for fear of refusal from external lenders. This is a significant cohort in the economy and is roughly the same size as those who are turned down for funding.
High growth SMEs do not seem to correspond to this profile of 'discouraged borrowers'. Instead, we suggest that the problem for many high growth SMEs was not that they feared being refused finance, but that they were 'reluctant' to seek the finance they needed to successfully grow. Many were reluctant because they did not want to yield control of their business to outsiders. In our interviews, we spoke to a number of entrepreneurs who were confident that their business could do better, yet were unwilling to lose control or part with equity. These reluctant borrowers may be holding back their firms, and the economy as a whole.
What do these findings mean for government policy? In the run-up to the election, policy makers will no doubt be seeking to come up with proposals appealing to the small business community. Our first conclusion is policy makers need to carefully consider the way they target initiatives at particular types of firms. We believe that general measures to help all firms grow will be more expensive, and less successful, than efforts to improve access to finance for the minority of firms that have the potential to make a disproportionate impact on the national economy.
Our second key message is that policy makers need to ensure they understand the mundane reality of rapid growth. This gap between perceptions and evidence may stem from a romantic image of high growth firms as fast-growing technology start-ups, seeking finance from venture capitalists or other specialist lenders. In fact, the reality is more down to earth, with high growth firms being found across a variety of sectors and as likely to be established firms as newly founded enterprises. Also, of those applying for finance, only five per cent were seeking venture capital investment, compared to almost 50 per cent who were applying to banks. Many did not feel that risk capital met their needs and were reluctant to relinquish equity in their business.
Most of the firms we interviewed were established businesses from a number of traditional sectors, far away from the dominant portrayal of the rapidly growing high-tech start-ups associated with Silicon Valley. Yet many government schemes are strongly focused on improving the supply of start-up finance, especially to new high-tech firms. Policy makers need to consider how to provide finance to other types of high growth firms.
A third important finding concerns the nature of demand for funding. At present policy initiatives deployed by government strongly centre on increasing the supply of funding within the economy. This is the central thread underpinning current UK policy frameworks. However, our research suggests that supply-side policy initiatives may fail to yield a satisfactory impact unless the demand for external finance can be effectively stimulated. To date, initiatives to stimulate levels of demand have been largely absent.
Our findings around the demand for finance and reluctant borrowers has some important implications for policy makers. If a small proportion of firms are particularly important for economic growth, yet are disinclined to access funding or cannot obtain the types of long-term capital they need to sustain their growth, this presents a problem which will require attitudinal change on behalf of the entrepreneurs and perhaps change in the products offered by providers of finance. There needs to be serious consideration of how reluctant borrowers can be transformed into 'willing borrowers'.
It is now universally agreed that nurturing more 'gazelles' is crucial for increasing productivity and for enhancing the long-term economic growth of the UK economy. Furthering our understanding of the complex funding arrangements and debt management strategies within these dynamic SMEs could potentially help unlock the growth potential of the small and medium-sized business sector in the UK.
Dr Neil Lee is an Assistant Professor of Economic Geography at the London School of Economics. Dr Ross Brown is a Lecturer in the School of Management and a member of the Centre for Responsible Banking and Finance, University of St Andrews.