How SMEs can raise finance for growth
Robert Outram navigates the options for small businesses and start-ups looking for funds.
Imagine that a small business seeking finance to grow could go to a website where different funders could be compared as easily as car or house insurers.
Imagine that lending by your customers, suppliers or neighbours has become as important as traditional bank funding; or that institutions on the other side of the world could be as accessible to small and medium-sized enterprises (SMEs) as if they were on the other side of the street.
Some of this is already starting to happen, but most advisers agree that we are still a long way from where we need to be in terms of start-up and growth finance.
The 'funding gap'
The problem is that we are still some way from getting it right. For example, while the banks protest that they are very much “open for business” there is no doubt that their ability to lend to SMEs has been restricted since the financial crisis hit in 2008. Business owners themselves are also more wary about taking on debt.
Long-standing concerns over the “funding gap” continue to dog British business. Some firms can find they are too large for informal equity funding by individuals and too small to be of interest to private equity firms and venture capitalists (VCs). This problem was identified as early as the 1930s, but while the size and nature of the gap may have changed, it hasn’t been eliminated.
Edinburgh-based Skyscanner is fast becoming one of the world’s leading travel price comparison sites, but much of the finance that has supported its growth was not raised in the UK. In 2013 Skyscanner received a capital injection from California-based private equity fund Sequoia Capital, and more recently tranches of funding have been raised from, among others, the investment arm of the Malaysian Government, and Yahoo! Japan, a Skyscanner partner.
The question is: where will the Skyscanners of the future get their funding? Arguably, as well as the funding gap there is a “knowledge gap” about the range of options out there and about what is best for the business in question.
Funding routes for SMEs
The 'right pitch and the right people'
Andrew Ewing CA, corporate finance partner with Johnston Carmichael, says: “People who are busy running their own business may not have the time to explore all the facts….People don’t realise how much money there is out there looking for a new home!”
Becky Woodhouse CA, who left a Big Four firm to set up her own nail and beauty business PURE Spa, agrees that for a start-up it can be quite a task simply to gather enough information to make the right decision about funding.
She says: “It was a maze… I tapped my networks and that’s what I found really useful, talking to people who have done it before. Even if you are simply looking for bank funding, it is useful to speak to someone who has dealt with that bank.”
In the case of PURE, Becky was not looking for equity funding. She put in half of the investment she needed herself and the rest was made up with bank debt. PURE was generating cash from the outset, which made it possible to service the debt, and she had invested in a 15-year lease, which meant the bank had a physical asset as security.
As she points out, a different kind of business aiming at high capital growth but not generating cash in the short term – like a typical high-tech start-up – would be better off looking at equity finance.
Chris Fletcher CA, a member of the ICAS Business Policy Committee, and non-executive director of Spark Energy, has extensive experience advising growth companies and helping them to raise finance.
He says: “You need a business plan and the plan will need to include a two-page ‘elevator pitch’. Funders will, probably, not read your whole business plan when making up their mind initially, but just the two-page pitch.
“You also need to bring in the right people; friends and family members who know you can help to reinforce rapport, credibility and trust.”
The business angel syndicates
Serial entrepreneur Ian Ritchie CBE is chairman of several companies including cloud computing business Iomart and Computer Applications Services (CAS). In 2014 he chaired a working group commissioned by the Royal Society of Edinburgh, with ICAS and Scottish Financial Enterprise, to look into the issue of growth capital.
Ian says: “There are more than 20 angel syndicates in Scotland but we found getting to the next stage is difficult, and access to funding of £2m upwards is problematic. Scottish Equity Partners is one of the few funders operating in Scotland at that level, so effectively you have to go to London to raise that kind of money.
But what are business angels typically looking for? One of the best-known angel syndicates in Scotland is Archangels, which specialises in early-stage, high-tech businesses.
Chief operating officer David Ovens says: “We are looking for a clever piece of technology that will disrupt the market. It’s also important that the technology is based on intellectual property that is protected.”
Eligibility for EIS relief is also a must; it can mean 30 per cent tax relief on investments as well as freedom from capital gains tax, among other advantages.
Bridging the gap
One of the institutions bridging the gap between business angels and private equity houses is Business Growth Fund (BGF), an independent company backed by five of the UK’s main banking groups – Barclays, HSBC, Lloyds, RBS and Standard Chartered – and managing a fund of up to £2.5bn, for long-term equity investments. Typically, BGF will take a stake of between £2m and £10m and its policy is not to take up more than 40 per cent of the equity of a business.
Patrick Graham has been an investor with BGF for the past four years, covering the central belt of Scotland, and Northern Ireland. As he explains, there are two key questions: “First, do we buy into the existing management team and, second, will funding unlock the value in the business?”
“We have a dual remit – we want to do good deals and make a return for our shareholders, but we also want to help build UK business.”
Alternative sources of finance
Another way to tackle the funding gap is to look at alternative sources of finance. For a start, as Andrew Ewing points out, you should be aware of the grant funding that may be available.
He says: “It’s worth looking to see what help you can get from Scottish Enterprise and, in the form of mezzanine finance, from the Scottish Loan Fund. Regional selective assistance (RSA) grants can also be available for early stage funding.”
In England, local enterprise partnerships (LEPs) – which replaced regional development agencies – are partnerships between local government bodies and the private sector. They manage England’s 24 enterprise zones and have access to the £730m Growing Places Fund to invest in local infrastructure. Many LEPs focus on a particular industry or sector, depending on the needs of the local area.
Ewing adds that, with more independent players than ever as well as the major banks, the invoice finance and asset-based finance sectors are increasingly competitive and shopping around could net you a good deal.
Crowdfunding – equity raised from a large number of small stakeholders – and peer-to-peer lending are also creating a buzz despite their relatively tiny share of the market so far.
Gary Deans CA, head of family business in the UK with KPMG, believes that business could benefit from thinking more laterally about sources of funding.
He says: “Entrepreneurs and family businesses both tend to take what is given rather than understanding what is available. A lot of the time the discussion centres on ‘what can the bank lend me?’.
“For example, a family business we worked with down south went to the US and raised debt funding from insurance companies, which wanted to make a long-term loan to match their long-term liabilities. I don’t think people are as aware as they could be of the alternatives. Another example is a company borrowing from a large corporate so as to be able to take advantage of an early payment discount, and sharing the discount with the lender.
“And you could also find two family businesses that have known each other for many years agreeing a loan deal, based on mutual trust. It’s a source of funding that is not being tapped at present.”
The Small Business, Enterprise and Employment Act 2015 will make it mandatory for banks to forward details of businesses that have had a loan application refused, with the permission of the business, to an online platform. This way, the business could find that an alternative lender or equity funder is interested in proposing an alternative deal.
Royal Bank of Scotland, however, has not waited for the legislation to take effect. As Susan Fouquier, regional managing director, business banking in Scotland for Royal Bank of Scotland, explains, RBS has been piloting a similar scheme in Scotland and the south west of England. The scheme puts companies in touch with two alternative funders, Funding Circle and Assetz Capital.
Meanwhile, Susan stresses that SMEs may be underestimating their chances of a bank loan. She says: “As well as a funding gap and, perhaps, a knowledge gap, there is, perhaps, a ‘confidence gap’. Acceptance rates for loan applications are higher than many people would anticipate.
“We are very keen to lend to small business! We have been issuing ‘statements of appetite’, that is letters to clients or to their accountants, setting out what we might in principle be prepared to lend to that business.”
Finding a mentor is another way for a new business to learn from the experience of others. ICAS has been working in partnership with the Scottish Chambers of Commerce to deliver a one-year pilot mentoring programme for business start-ups. The pilot is now in the final quarter. ICAS identified experienced CAs who were willing to mentor a start-up on a voluntary basis, and the Scottish Chambers matched the mentors with businesses and monitored progress.
Alice Telfer, assistant director, business policy and public sector with ICAS, explains: “An independent evaluation was undertaken which demonstrated the value to the businesses that took part in the pilot. At the time of the evaluation there were 18 mentors matched to businesses. The results are excellent.”
Examples of feedback from the scheme include: “participants… have had an overwhelmingly positive experience” and “there is a real sense of importance and credibility from being accepted on the ICAS mentoring programme... this perception of status further boosts confidence and determination to succeed.”
One thing is clear: success in tackling the three gaps in SME finance – funding, knowledge and confidence – will not be achieved through one policy reform alone but by a readiness to apply fresh thinking across a range of measures.
The full version of this article appears in the April 2016 edition of CA magazine.