SME’s guide to raising finance

With the government stating the small to medium sized enterprise sector (known as SME’s) being a driving force of economic recovery, it will prove to be important times for these businesses.  The following article aims to highlight the alternative forms of finance available to such companies.

With no single accepted definition of an SME, generally it is agreed that they include businesses with annual turnover of less than £25 million and would normally employ no more than 250 employees.  They employ the majority of the UK’s workforce and are rarely quoted on the stock exchange.  Ownership of these businesses is usually between a few individuals and they more often than not have a family connection.

There comes an expectation for SME’s to compete for public sector contracts and to aid with the current high unemployment levels, so the private SME sector will play a crucial part in lifting the UK out of tough times.  In the 2010 budget additional funding was made available for SME’s and recently the Chancellor has announced in the 2011 Budget reliefs for SME’s, including capital gains tax and research and development tax.  So whether an SME is starting out, maintaining its current state or developing further, financing of the business plays a vital role and becoming over reliant on bank lending could risk putting them out of business, this is why alternative forms of finance need to be investigated.

The main issues with SME financing is uncertainty as there is no track record for investors to read into.  As larger companies usually prepare very detailed financial information, which assists in the finance raising process, SME’s are unable to go into such detail with their proposals and so prove to be a greater credit risk for banks.

In modern times banks are keener on dealing with existing customers and deposit taking rather than lending.  They will not want to increase the loan funding without an increase in the security taken, which SME owners will be reluctant to give away.

As information about SME’s is not available on the stock exchange they provide their own information to potential investors in the form of a business plan which includes asset valuation, cash flow predictions, experience of managers/company executives and how they can give security for providers of finance amongst others.  These unlisted SME’s may want to raise funds privately or go onto an initial public offering (IPO).

Private fundraising is a cost efficient way to raise funds and prepares companies to be listed in the future, avoiding bank debt or costs associated with an IPO.  There is no need to produce an official admission document and it offers a higher risk and return for possible investors.  So raising finance privately is a quicker, simpler and less costly method avoiding all the rules and regulations that come with launching an IPO.

A company may opt for the IPO route in order to raise finance for funding expansion plans and growth, or to raise the profile of a business which leads to improved perception of stability and a better status.  It also enables investors to realise their investments and allows incentives to be offered to employees such as granting share options.  Capital markets become accessible and there are greater opportunities for acquisition.

So when companies decide to list their businesses they must consider which market they wish to join.  Factors to take into account include the size and status of the company, the liquidity available for potential investors, amount of capital fundraising available, terms and conditions of joining and how public profile and accountability will be scrutinised more, potentially affecting share price.  Additional costs also build up like administration and regulation adherence, e.g. a detailed admission document must be written and approved beforehand.

There are three markets available for entering; Main Market, Alternative Investment Market (AIM) and the PLUS quoted market.  The Main is normally for larger companies as there is more regulation and costs associated.  However it offers the highest profile, is the most liquid for its shares and attracts more investors.  The other two are more suitable for smaller businesses.

Once on a market an IPO can choose to structure itself in three main ways;

Introduction, most cost effective where at least 25% of shares already in public hands, so no need for fund raising

Placing, offering shares to certain investors rather than the general public, more suited to AIM.  Lower costs and selected investors but has less liquidity in the short term as there are less share holders

Public offer, offering the public shares can raise the most funds but is also the most arduous and costly

Banks are trying to offer more varied forms of financing, such as loan accounts where there can be a fixed interest rate and loans can run for longer or shorter periods of time.  Invoice financing is where finance is raised using a debtor book, advantage here is that cash flow is directly linked to business expansion.  Also asset finance is used to fund purchase of equipment where payments are spread over a period of time.  However banks will scrutinise a lot more by doing background checks to assess the qualifications and suitability of a person to run the business.  The purpose of requesting financial assistance will be looked into deeper also and they will require a cash flow forecast with a professional business plan. 

The main difference between borrowed money (debt) and equity is banks require interest payments and capital repayments, you are tied into a contract with the bank and it can place a company into administration or bankruptcy if it deems the business to be failing or if loan repayments are not kept prompt.  In contrast equity investors take the risk of failure like other investors and profit from an upturn in business and may require more complex investments like preference shares.

Some SME’s that are finding it difficult to raise money from banks may be looking into pawn brokering as a short term option.  Online sites offer a fast, effective, secure and confidential service for those wishing to raise capital by selling items such as gold jewellery.  Loans against the value of items can also be given and this can be done within 24 hours.  Even though there is still some stigma attached to this type of service certain companies who only operate online claim to be breaking through this and attracting the interests of a wide range of people. 

Equity finance is what the majority of SME’s may opt for as an alternative; however it is harder to secure at the smaller end of an SME business.  SME’s don’t like giving away equity in their business but may be an option they have to resort to.  Smaller businesses may turn to friends and family for raising funds.

Venture capital- institutional investors that usually target high growth companies, may make co-investments with business angels.  Require forecasts and cash flows for long term revenue plans, and may choose to take an active role in the business.

Trade credit- using a buy now pay later scheme for purchasing equipment or machinery 

Government funding-

With the Budget 2011, further measures have been introduced to try and aid SME’s such as exemption from regulation for three years for smaller firms and rises in tax credit for research and development.  However their remains much regulation in place with hiring new employees for example that makes it hard for SME’s to truly flourish.  Other measures introduced include a rise in the number of apprenticeships offered; this could prove useful for SME’s as they employ the majority of young people on these.  There has also been a slight cut in fuel duty.  Governments may need to further ease tax burdens for SME’s and encourage growth in manufacturing.

Grants and soft loans are normally taken to facilitate the purchase of assets and help with the creation of jobs and training.  Usually found through Governments, Local Authorities, Local Development Agencies and the European Union, as there is now more emphasis on this area further sources may become available. 

The Business Growth Fund was introduced to help businesses with turnover of £10 to £100 million, by supplying £2 to £10 million of finance in return for equity stakes in the business.

Business angels- wealthy entrepreneurs who invest in a company and may also play a part in the running of it.  As it is usually hard to secure finance in the region of £10,000 to £250,000 business angels can be used, they can also make investments of up to £750,000 for start ups.  By taking a risk in investing in the company they expect it to grow and expand.

However for this to happen there are some conditions:

Businesses must be willing to sell shareholding for investment and must be a reasonably viable business to lend to, so should be producing money on the balance sheet.  A personal relationship will be developed with the investor and the manager of the business as business angels usually take a hands on approach without day to day control, making important executive decisions as to where the business should be heading.  Businesses will give a high return to potential investors, usually between 20 to 30% per annum.  They should have a strong business plan and demonstrate knowledge of the market area, along with a strong existing management and sales team; otherwise the angels may want to replace them.  There must also be an exit option for the business angels.

So in conclusion the aim of a successful business when it comes to finding alternative sources of finance is to minimise the amount of debt and to avoid giving too much equity away, this enables the company to stay at an optimum financial level avoiding as much risk as possible.

Successful SME’s would do well to invest in people, embrace technology and recognise the importance of flexibility.  Along with this better customer service would help businesses to prosper during a downturn.

Bank lending to SME’s is currently a top priority as they are seen to be able to drive the economy back to recovery.  However successful SME’s are surviving by cutting costs, managing cash flows more efficiently and avoiding debt.  So becoming less reliant on bank lending would be a useful survival strategy.  Along with this, SME’s could be using the facilities they already have like restructuring finances or holding back expenditure plans.  Raising finance through the sale of assets, or input from shareholders and directors (owner financing).  In general adopting a more defensive approach and waiting for the right time to expand would do well.  An example being the LEAN system which has been introduced by many organisations emphasising on cost cutting measures that will help companies survive. 

The high and unstable petrol prices have also had a negative effect on SME’s, with the current cut in fuel duty only time will tell whether the tax reliefs will help SME’s in the long run, for now they need to concentrate on alternative forms of financing and cost cutting.