Small and Medium Size Enterprises

Bolton Committee (1971), was the first who attempted to solve the definition problem when they implemented an “economic” and a “statistical” definition. Under their economic definition, a business is considered as small if it meets the following requirements. first, if the owner is part of the management or he is personally managing it and not through another formalized management structure. Second, If the market share is relatively small and lastly if its own governed in a sense of not being part of a larger Business. The ‘Wilson’ Report H.M.S.O. (1979)), identified problems for small and medium-sized independent owner-controlled firms employing less than 200, or 500 employees (SMEs). Most recently, The European Commission (EC) also categorized the small business sector into three components Micro-businesses with 0 to 9 employees, Small-businesses with 10 to 99 employees, Medium-businesses with 100 to 499 employees.

Banks remain the main supplier of external SME finance (Cosh and Hughes, 2003), though there may be various financing constraints (Kotey, 1999; Fraser, 2005). Access to finance is influenced by funding preferences (Hamilton and Fox, 1998), such as the pecking order theory (Howorth, 2001) or risk aversion of banks. This risk aversion can lead to a preference to fund less risky ventures or “better borrowers” (Cressy and Toivanen, 2001), which may exclude women and ethnic minorities who may not appear so credible to lenders. There is certainly evidence that ethnic minorities face difficulties raising finance (Ram and Smallbone, 2001; Ram and Deakins, 1996; Bank of England, 1999) Furthermore, I will illustrate a literature review about obstacles to financing SME’s in various methods of raising external capital. I also address requirements that the management is required to have and the issues that arise from that. Moreover, I state some solutions to this issues and recommendations that a student may find interesting and helpful. Importance of SME’s and major financial barriers.

The role of MSMEs relative to innovation and the promotion of industrial development, job creation and market competitiveness, has been recognized by both academics and policymakers F([1] Beck et al., 2005; [2] Thurik and Wennekers, 2004; [3] Ayagari et al., 2003; Davidson and Henderson, 2002; [4] Storey, 1994). It is known that both developing and developed economies ascribe great importance to Micro-Small-Medium-Enterprise. Small and medium size Enterprises SME’s are a major contributor to an economy and explicitly in Developing Countries. Formal SMEs contribute up to 60% of total employment and up to 40% of national income (GDP) in emerging economies. (World Bank, 2015) Internal and external barriers. Based on the economic state of the country businesses barriers change. For example, in developed countries, they have issues with the high level of competition or lack of innovation on the other hand developing countries have issues with labor resources or limited availability of financial services. For example, approximately 97% of business in Mexico and Thailand are micro-small business Kantis, Angelli, and Koenig,( 2004) Timmons, (2004).

In the United States, over 96% of businesses similarly have fewer than 29 employees (US Small Business Administration and Census Bureau, 2006) Institutional barriers for SME’s growth ‘’Related literature has shown that access to external financing is shaped by a country's legal and financial environment’’ (La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 1997, 1998; Demirgüç-Kunt and Maksimovic, 1998; Rajan and Zingales, 1998). ‘’A direct implication of these studies is that, in countries with weak legal systems, and consequently, weak financial systems, firms obtain less external financing which results in lower growth’’. Beck, et al., (2008) The seminal literature on entrepreneurial startup suggests that liquidity constraints can hinder or even prevent someone from creating a new venture (Evans and Jovanovic, 1989; Holtz-Eakin et al., 1994; Blanchflower and Oswald, 1998).

Traditionally, the focus is on obstacles created by commercial banks or equity funds, or on imperfections in the broader institutional environment (InfoDev, World Bank, 2004). However, it is important to notice that sometimes SME’s have a negative attitude towards loans and bank finance (Howorth, 2001). Therefore, there is a significant bearing on financial decisions from the demand side. (InfoDev, World Bank, 2004) It is also stated in 1980’s in the UK that, that when times were hard small businesses which were most dependent upon banks, protest vigorously about the apparently unsatisfactory nature of their relationship with them. (Binks et al. (1992), Cowling et al. (1991), Bank of England (1993).

For example, the impact of the US ``credit crunch'' of the early 1990s and the effect of the consolidation of the banking industry on the availability of credit to small business have also been the subject of much research over the past several years. Berger & Udell, (1998) Correspondingly, monetary policy shocks may have largely affected small business funding and this generated substantial research and debate on the mechanism like ‘credit channels’ that monetary policy is using. Management responsibilities for raising capital and Lenders constraints in terms of the management of SME’s A lot of empirical and subjective research in identifying causes of small firm failure appears to concentrate on the internal factors of the business- the principal of which is frequently perceived to be ‘poor management’ followed invariably by some financial deficiency such as undercapitalization or inadequate cash flow. Research published by Dun and Bradstreet (1991) Researchers have shown that a Small business normally is characterized by the unique set of skills and preferences of a single person, the manager of the business.

Therefore, the longer-term outcome, in terms of success or failure of a specific small firm, may be strongly influenced by the personalities, expectations, and abilities of the founder and their fundamental motivation in establishing the enterprise Jennings & Beaver, (1995). It should also be noted that entrepreneurs and owners can destroy their business by the abuse or mismanagement of positional power. Beaver and Jennings, (1996). Being an Entrepreneur-manager-owner at the same time requires a high level of knowledge and innovation, some of the required skills are illustrated in the above tables. Failing to tackle this task the business may follow a period of business development, leading to a certain quantity of growth and expansion, that each role may become enacted by separate individuals (Jennings & Beaver, 1995). Irwin, et al., 2010 have publicized a research stating several factors (see appendix 1) at work which, together, make it more likely that certain groups are less able to articulate their propositions effectively or are less likely to be able to implement their business proposal effectively and are, therefore, regarded as too risky by the banks.

Hence, it is recognized that some personal characteristics are indicative of a higher risk (young people, for example, with no track record, no savings and no collateral). But, therefore they believe that there is no discrimination based solely on personal characteristics. Irwin, et al., 2010 research on Barclays customers who have successful business results shows that personal savings were the main source of finance for owner-managers which reflects 70 percent of all firms under study. Manager-owners that used Bank loans account for (7 percent business bank loans, 8 percent personal bank loans and 13 percent overall). Furthermore, Fraser (2005) found that 10 percent of businesses faced financial constraints, but Irwin, et al. (2010) found that some 16 percent of respondents experienced difficulties raising finance to start their business. The same survey suggested that ethnic minorities did face greater difficulties raising finance (Table III, appendix 1). Just 13 per cent of white respondents reported finance constraints compared to 22 per cent of Asians, 50 per cent of blacks, and 21 per cent within the other ethnicity group (including Chinese etc); this finding appeared tentatively to confirm prior studies (e.g. Curran and Blackburn, 1993; Ram and Deakins, 1996; Bank of England, 1999; Ram and Smallbone, 2001). Raising external debt finance Banks remain the main supplier of external SME finance (Cosh and Hughes, 2003), though there may be various financing constraints (Kotey, 1999; Fraser, 2005). Access to finance is influenced by funding preferences (Hamilton and Fox, 1998), such as the pecking order theory (Howorth, 2001) or risk aversion of banks. This risk aversion can lead to a preference to fund less risky ventures or “better borrowers” (Cressy and Toivanen, 2001), which may exclude women and ethnic minorities who may not appear so credible to lenders. There is certainly evidence that ethnic minorities face difficulties raising finance (Ram and Smallbone, 2001; Ram and Deakins, 1996; Bank of England, 1999)

In Corporate Financial Management (Arnold, 2013), financing is considered to have 3 main obstacles that may prevent the process of financing an SME. This is said to be, Information asymmetries between small businesses and lenders or other investors, the underlying risk that is associated with smaller scale businesses and the transaction cost that is associated with Handling SME financing. Berger & Udell, (1998) stated that high risk-high growth enterprises whose assets are mostly intangible more often obtain external equity, whereas relatively low risk-low growth firms whose assets are mostly tangible more often receive external debt. Studies conducted by the likes of Binks (1992) & Deakins and Hussain (1993) have focused upon imperfect information within credit markets and the impact of asymmetric information upon small business borrowing.

In contrast, Berger & Udell, (1998) identifies that small businesses are generally not publicly traded and therefore are not required to release financial information on 10K forms (annual reports), and their data are not collected on CRSP tapes (Centre for Research in Security Prices) or other data sets typically employed in corporate finance research. Data provided by the World Bank demonstrate that “entrepreneurs typically possess privileged information on their businesses that cannot be easily accessed—or cannot be accessed at all—by prospective lenders or outside investors’’. (InfoDev, World Bank, 2004) This lead to two problems, the first regarding the lender or investor who is not aware of the risks involved and the real value of the investment. This may also lead to financial difficulties as potential loans will not have a sufficient rate due to asymmetric information that results in a high-risk portfolio for the lender. However, Kon and Storey (2003), for example, had found cases of potential borrowers who may offer perfectly reasonable business proposals but who “do not apply for a bank loan because they feel they will be rejected”.

Second, ‘’once the lenders/investors have supplied the funding, they may not be able to assess whether the enterprise is utilizing the funds in an appropriate way’’ (InfoDev, World Bank, 2004). Irwin, et al also stated that some people exhibit certain characteristics that make it more likely that they will fail to secure the funding that they need, Irwin, et al., (2010). To further tackle this problems bankers may avoid financing an SME and adapt cautious attribute towards SME’s. InfoDev, World Bank, (2004) identifies that this problem is most viewed in developing countries in smaller scale businesses compare to large ones due to the lack of detailed information or insufficiencies in accounting and data analytics. Irwin, et al, (2010) also stated that there is sufficient and readily accessible finance but the propositions are perceived as not viable, or the applicants are perceived as incapable of achieving the objectives, or there is insufficient collateral, and so the whole proposition is too risky for the banks.

From a lender perspective, a lack of collateral will prevent them from further financing the SMEs. InfoDev, World Bank, (2004) identifies a number of reasons why SME’s are riskier than larger companies. First, Large companies have an advantage in the competitive environment that SME’s are also operating in, they have a higher failure rate and a more variable rate of return. Second, SME’s in comparison with Large firms possess a lower level of capital and human resources in economic activities. Third, the problem with inadequate accounting systems, which reduce the level of accessibility and reliability of the information concerning management accounting measures of profitability and capacity for repayment. The World Bank also states that Irrespective of risk profile considerations, the handling of SME financing is an expensive business. InfoDev, World Bank, (2004)

The transactions costs for undertaking a loan are (i) administrative cost, (ii) legal fees and the (iii) cost related to the acquisition of information. In the case of smaller loans or investment, it is more difficult to recoup these costs. InfoDev, World Bank, (2004). This problem is more critical in developing countries for the following reasons: (i) lack of adequate management information systems in financial institutions, (ii) the undeveloped state of the economic industry and (iii) the poor state of certain public services, such as the registration of property titles and collaterals. InfoDev, World Bank, (2004) Lastly, Chang Andrew under the federal reserve board he published a paper that suggests banking consolidation worsened the market failures. Chang, (2016) Equity Finance As Arnold (2013) stated, the financing gap between larger more mature firms and SME’s is covered through various methods of raising equity capital or funds with or without the interpretation of stock exchange Arnold, (2013). For example, private equity funds, venture capital, and angel investing. There has been rapid development in the private equity industry over the last 40 years Arnold, (2013).

Furthermore, Bergemannna & Ulrich claim that venture capital is now the financing mode of choice for projects where “learning” and “innovation” are important. They also state that the innovative nature of the projects they carry a substantial risk of failure, only 20% are high return investments. Bergemannna & Ulrich, (1998) Berger & Udell suggest that financial intermediaries play a critical role in the private markets as information producers who can assess the small business quality and address information problems through the activities of screening, contracting, and monitoring Berger & Udell, (1998). The intermediary can also address the risk profile and appropriate valuation of the firm as well as assess compliance and financial condition to support the firm engaging in exploitive activities or strategies. This is feasible, through the means of directly participating in managerial decision making by venture capitalists or renegotiating waivers on loan covenants by commercial banks.

Berger & Udell, (1998) Moreover, Berger & Udell, (1998) stated that angel investing it is often required at a very early stage of the firm, while the entrepreneur is still developing the product or business model. Angel finance is indifferent to other methods of raising external finance, is used for direct finance through an equity contract. It is also required when a small scale of production has begun with a limited amount of marketing effort. This ``start-up stage'' is often associated with the development of a formal business plan which is used as a sales document to obtain angel finance. Berger & Udell, (1998). Arguably, angels are willing to inject the required amount of capital without providing financial expertise and control over the company. Wetzel Jr concluded that angels typically provide finance in a range of about $50,000-250,000, below that of a typical venture capital investment. Wetzel Jr., (1994). Berger & Udell, on the other hand, stated that unlike the angel market, the venture capital market is intermediated Berger & Udell, (1998). Tyebjee and Bruno identified the processes like so, they take funds from a group of investors and contract portfolios in investing to informationally opaque issuers. In addition to screening, contracting, and monitoring, venture capitalists also determine the time and form of investment exit. Tyebjee and Bruno, (1984) & Gorman and Sahlman, (1989).

Furthermore, Berger & Udell explained that the minority of firms will be successful enough to take public and the second-best exit is selling it to another larger company. Alternatively, if a firm does not perform well, it might be put back to its original owners or if failed it might be liquidated. Mostly, they focus on gaining return from the outperforming firms of the portfolio. They are considered active investors investor that also participate in strategic planning and occasionally in operational decision making.

Berger & Udell, (1998) Venture capital would typically come at a later stage to support in full scaling up the marketing and production processes. When product development costs are substantial then venture capitalists can inject funds in exchange for stocks, for example financing clinical trials or biotechnology industry Berger & Udell, (1998). The negative attitude towards equity finance The following paragraph relates to the unwillingness of enterprises to relinquish control over the company to outsiders. InfoDev, World Bank, (2004) Bergemannna & Ulrich, (1998) have found a simple model to analyze the optimal financing of venture projects when learning and moral hazard interact. After the agreement between an entrepreneur and a venture capitalist is been done for funding the project, A higher investment level will be needed to accelerate the process of discovery.

Further the project continues to receive financing without achieving success and the agents change their assessment about the likelihood of the future success. Eventually, the prospects may become too poor to warrant further investment. ‘The entrepreneur controls the allocation of the funds and the investment effort is unobservable to the investor. The control over the funds implies that the entrepreneur also controls the flow of information about the project. The solution of the agency conflict has to take into account the intertemporal incentives for the entrepreneur.

Suppose, in any given period, the entrepreneur would consider diverting the capital flow for her private consumption’. Based on Berger & Udell, (1998) moral hazard issues can make debt contrast quite problematic. They stated, that Moral hazard problems are likely to occur when the amount of external finance needed is large relative to the amount of insider finance (inclusive of any personal wealth at risk via pledges of personal collateral or guarantees). This shows that external equity finance, explicitly angel and venture capital, may be particularly important under this condition and the moral hazard problem is acute. This is mostly for companies that raise a substantial amount of finance through venture or angel investing prior to raising external debt finance. Berger & Udell, (1998) conventional wisdom argues that bank or commercial finance company lending would typically not be available to small businesses until they achieve a level of production where their balance sheets reflect substantial tangible business assets that might be pledged as collateral.

Nachman and Noe, (1994) arguments suggest the optimality of debt contracts after insider finance has been exhausted. These debt contracts could include trade credit, commercial bank loans, and finance company loans. Furthermore, in relationships between venture capitalist and entrepreneur, an agency problem may arise if the entrepreneur lacks sufficient information or skill to make optimal production decisions. The problem may be compounded by the fact that information in general about the value of the project is imperfect and revealed over time (Cooper and Carleton, 1979; Bergemann and Hege, 1998). Solutions in raising external capital The situation is changing rapidly, as several data sets have recently become available that make it much easier to describe the state of small business finance and to test the extent theories of financial intermediation and informational opacity Berger & Udell, (1998). Berger & Udell, (1998) quantified that National Survey of Small Business Finance (NSSBF) and National Federation of Independent Business survey (NFIB) Both canvas small businesses analyzing ‘’their balance sheet and income date as well as their use of financial intermediaries, trade credit and other sources of funds.’’ These data allow new information regarding the state of the business and the risk associated and can be used in further raising debt capital from banks.

Further, it allows researchers to measure the cost of availability of deferent types of external finance and how it varies based on the characteristics of each small firm. In contrast, Community Reinvestment Act (CRA) data that were first collected in 1997 help augment these data by giving more information on the size of the borrowers (annual revenues above versus below $1 million), and their location by census tract (Bostic and Canner, 1998). Data is collected also from private equity and venture capital activities from organizations such as NSSBF (National Survey on Small Business Finance) and SCF partners. Overall, Large banks tend to finance or lend out money to Larger firms with tangible assets in a more mature state using ‘Hard quantifiable information technologies’ while small banks tend to lend money to smaller firms associated with higher risk using ‘soft qualitative information technologies.’ As firms increase in size, they tend to have higher-quality financial statements, yielding an implied increasing advantage in hard technologies.

Berger and Udell (2006) Small-banks are focusing on more qualitative data that are often more difficult to collect because it is based on the relationship between bank and borrower. However, Berger & Black, (2011) permit the comparative advantage of large banks or small banks to be increasing, decreasing, or nonmonotonic in firm size. Based on Berger & Black is because all hard technologies employ some combination of hard and soft information. Thus, ‘for some hard-information technologies, the comparative advantage of large banks in using the hard-information component may be offset by a comparative advantage of small banks using the soft-information component’.

However, based on the same source, Large banks may have only a slight comparative advantage in obtaining and processing the appraised values, whereas small banks may have a significant advantage in the soft-information component, based on relationships with the borrowing firms or loan officers’ knowledge of the market and local business conditions.