Managing Small

Medium Enterprise
Session 7 – Finance & Small Business
As you analyse your business try to establish,
sensitively, how it was financed and compare it with
‘the average’
Managing Small Medium Enterprise
Session 7 – Finance & Small Business: what we will learn today –
after the session you should be able to:
- Understand the main sources of finance SME’s use to raise
resources
- Appreciate the differences and associated advantages and
disadvantages and the differences between debt and equity
- Understand some of the more creative and modern sources
of finance
- Appreciate how SMEs generally raise finance and the reasons
for this versus larger businesses
- Understand the concept of Return on Investment and the
‘cost of money’ related to Inflation
- Appreciate why markets are often seek to be ‘opaque’ and
the reasons for this
- Understand the difference between Venture Capital and
Private Equity
 Session 8 – Finance & Small Business

Ok: lets start with what you know

In pairs; how many sources of finance can you list?

 Session 8 – Finance & Small Business
In pairs; how many sources of finance can you list?
Write on board
Sources of finance 1 – by understanding the
terms you will be able to speak with authority

• Overdrafts – borrowing facility

• Grants or subsidised loans (often government backed
soft forms of finance)
• Term loans (capital plus interest over fixed period)
• Asset finance -
• Hire purchase: here the business owns the asset
• Leasing: ownership of the asset always remains with the
owner (lessor) rather than the business (lesee)
• Credit Cards - expensive
• Equity finance – buy a part share in the business
(informal and formal equity financiers)
Sources of finance 2
• Mortgage on home
• Gifts from friends and family
• Loans from friends and family (soft loans)
• Asset based finance:
• Factoring selling its invoices (its sales not yet paid) to a
third party (a ‘factor’) in return for a proportion of the
yet unpaid invoices.
• Invoice discounting involves the business borrowing
against its unpaid invoices, again for a fixed proportion
of the invoices
• Stock finance which raises finance against the stock a
business holds.
• Other (e.g. trade credit)
Common Sources of Finance for SMEs

• Crowd funding
• Peer to peer
• Bootstrapping
• Business Angels
• Venture Capital
• Private Equity funds

When researching your business - understand sources of finance that were

considered / used
Does the business need cash now – if so are some of these of potential?
 Creative Sources of Finance

• Crowdfunding: funding a project or venture by raising money from a large

number of people who each contribute a relatively small amount, typically via the
Internet. EG BREWDOG UK – Dragons rejected!

• Peer-to-Peer Lending enables individuals to obtain loans directly from

other individuals, cutting out the financial institution as the middleman.

• Customer Bonds; fairly new, innovative way to raise finance from the people
who know and trust you best – your customers. The idea is that you borrow money from
them over a short period of time, say 3-4 years, and pay interest on that loan during that
time Eg Hotel Chocolate

• Bootstrapping; building a company from the ground up; just personal

savings and, with luck, the cash coming in from the first sales. The term is also used
as a noun: A bootstrap is a business launched by an entrepreneur with little or no
outside cash or other support
Crowdfunding Classification
Equity Crowdfunding
• Most popular model after lending
• Largest amount of funds raised per project
• Due to the legal complications of equity issuance,
most countries impose sever constraints on equity
based crowdfunding and is subject to high level of
regulation
• Equity model has been developed effectively in UK
with appropriate regulation but less elsewhere
 Crowdfunding equity

Advantages Disadvantages
➢ Good, secure long term ➢ Investors will need to see
finance an exit route (liquidity
➢ Can be used to lever event
further loan finance ➢ Dividends may be
➢ Small amounts of equity expected
available ➢ Crowdfunding website
➢ Based on business plan charge fee based on funds
not security raised

Crowdfunding
Peer-to-peer lending
• Peer-to-peer websites, bring individual borrowers
and lenders together, bypassing traditional banks
• Lenders receive more interest than they would get
from a bank savings account, while borrowers pay
less than on a bank loan.
• Earn savers more than 7pc on their cash.
• However, these attractive returns come with risks,
there is no guarantee that their money will be
repaid
• Zopa, Ratesetter, Funding Circle
Bootstrapping
• Bootstrapping when an entrepreneur starts a
company with little capital, relying on money other
than outside investments.
• bootstrapping when entrepreneur attempts to
found and build a company from personal
finances or from the operating revenues of the new
company.
• To bootstrap you need to tap into a wide network
of contacts as possible
So how are small businesses generally financed?
Sources of finance for start ups
(Care data not very recent 2009)

As you analyse your business try to establish,

sensitively, how it was financed and compare it
with ‘the average’
Comparing this to larger business?
Sources of finance for established
businesses
Business continuum and sources of finance;
as businesses grow and time passes
sources of finance change

Time/Size
Importance of sources of finance
over time

When was your business founded? The cost of

money may well have influenced how financial
sources were used.
Business angels
Comparing equity and debt
 Which forms do large and small businesses
prefer? Pecking order and bootstrapping

• Myers (1984) showed that large businesses prefer one

source of finance over another even when priced similarly
- Prefer internal sources (retained profits) over debt: debt
over equity

• Watson and Wilson (2002) say small businesses follow

pecking order and emphasis on bootstrapping*

Anyone who's started a business on a shoestring is adept

at bootstrapping*, or stretching their own resources--both
financial and otherwise--as far as they can.
‘Entrepreneurial’ finance market
Three key differences between finance for large and
small businesses:
1. Personal characteristics of owner-manager
2. ‘Downside risks’ associated with business (failure)
3. ‘Information’ opaque marketplace; money is often
borrowed and loaned through friends and family in a
way which is less formal
Importance of sources of finance
over time
Case Study / Break
Why is there such a wide variety of ‘rates’
charged in the finance arena?

Markets are opaque

Five features of opaque market-places

1. Evidence on ‘credit constrained’

2. Discrimination (e.g. ethnic minorities, females)
3. Higher interest rates
4. Better terms
5. Need for more collateral

As you analyse your business try to establish

whether it has been credit constrained due to
any form of discrimination

Going through these in a little more detail….

1. Credit constraints
• Most small businesses obtain finance even in difficult
macro-economic conditions
• Han et al. (2009) shows that discouraged tend to be
‘bad’ borrowers
• Evans and Jovanovic (1989)
• Access to finance a function of wealth not talent
• Talented individuals more likely to be constrained
• Starting a business largely a function of wealth
 2. Ethnic discrimination in the US

Table 17.4 Small business loan turndowns, personal wealth and discrimination (%)
International evidence
• Mixed evidence for the UK
• Strong US evidence
• Other international evidence supports presence of
ethnic discrimination
Discrimination against women
• Evidence on application rate – some
• Evidence on rejection rate – weak
• Evidence on interest rates – some evidence
 3. Interest rates

Interest rates charged to small businesses: some international

Table 17.6
comparisons
 4. Better terms

• Relationship lending
• Switching: ‘plums’ and ‘lemons’
LEMONS AND PLUMS, in finance, LEMON is an investment
with a poor or negative rate of return; and, PLUM is an
investment with a healthy rate of return.
• Multiple banking
• Provides wider range of services
• Potentially less constrained
• May get better deal

What terms did your business get when it raised capital; were
these terms fitting with the risk – was it a Plum?!
5. Collateral
• No need for collateral in fully informed market
• Banks rely on it because information is opaque
• Collateral pledging common but is influenced by human
capital
• Assessing ‘value’ of some collateral (housing) is problematic

Was collateral asked for when your business raised finance?

 What type of capital; VC or PE?
• Difference between venture capital and private equity
• Formal and informal venture capitalists
• Aims of venture capitalists
• VC funding not new but different between the US and
elsewhere
 Structure of VC funds

Figure 18.1 Structure of a VC fund

Demand for equity
• Advantages:
• No interest payments
• Difficulty in accessing other funding
• Leverage other borrowing
• VC provides support
• Money is patient
• Disdavantages:
• Loss of control and ‘free rider’ problem
• Dilution of equity
• Hastily pushed towards IPO
Clearing the market
• Dragon’s Den:
• No deal
• x per cent of the business for y price
• Valuation very tricky – principally dependent on net
present value
• In practice, difficult to value because of uncertainty
• Presence of trade sales and IPO
Ang’s (1991) stylised differences comparing
large and small differences
• A large business has access to capital markets for debt
and equity. Their shareholders have limited liabilities
and own diversified portfolios
• A small business has no publicly traded securities.
Owners have undiversified personal portfolios.
Limited liability is absent or ineffective. Owners could
be risk lovers
Information and performance: comparing
large and small businesses
• Highly developed information ‘industry’ on large
businesses
• Very limited knowledge of small businesses –
information is highly imperfect
• High likelihood of failure of small businesses
• High variation in growth performance rates
Agency Theory

• Agency theory
addresses the
relationship where in a
contract ‘one or more
persons (the principal
engage another person
(the agent) to perform
some service on their
behalf which involves
delegating some
decision making
authority to the agent’
For example - taking Banks: Agency theory

• Bank (the principal) seeks to ensure that the agent

(the small business) pays capital and interest in full
and on time
• Seeks to enforce a (debt) contract that enforces
payment and limits moral hazard
• Problem is that it is difficult to monitor the activities
of the small business
• Bank (principal) faces fixed agency costs:
• Drawing up and managing contract
• Setting performance standards
• Enforcement mechanism in event of default
Information asymmetries;
Banks v small businesses
• Usually, the small business has more information
than the bank:
• Adverse selection
• Moral hazard
• Exception is when the business starts: bank usually
has accumulated information on similar start ups
• Bank uses credit scoring and collects information
(source of competitive advantage)
Failure costs
• Bank knows small business is more likely to fail so
wants to be close to front of creditor queue
(preferred rather unsecured creditor)
• May charge higher interest rate
• Seeks collateral (usually owner-manager’s house)
but imperfect asset:
• Subjective valuations
• Transaction costs
• Asset realisation less in recession
• Negative publicity
 Small business signals of creditworthiness

• Relationship factor
• Provide information (e.g. business plan)
• Collateral/third party cover
• Entrepreneurial talent
• Group lending or mutual guarantee scheme
• Provides collateral
• Reduces moral hazard
• Potentially solves problems for low wealth borrowers
As you analyse your business try to establish
how it was financed and the ways in which it
developed its ‘creditworthiness’
 Problems with group lending or
crowdfunding
• Peer selection
• Peer monitoring
• Peer pressure
• Social capital (e.g. community ties)
• Peer selection and social capital are most important

As you analyse your business understand if the

owners considered crowdfunding and/or if they
should consider for the future?
Net present value
• The value in the present of a sum of money, in contrast to
some future value it will have when it has been invested at
compound interest.
• Having money today is worth more than having money
tomorrow (so one has to factor in an incentive such as
interest)
• Net present value (NPV) is the difference between
the present value of cash inflows and the present value of
cash outflows over a period of time. NPV is used in capital
budgeting and investment planning to analyze the
profitability of a projected investment or project.
Eg £110 due in 12 months' time has a present value of £100
today, if invested at an annual rate of 10 per cent
Discounting – Net Present Value

t = the amount of time (usually in

years) that cash has been invested in
the project
N = the total length of the project
i = the weighted average cost of
capital
C = the cash flow at that point in
time.

You need not learn the formulae; it is

the principle that is important
 How VCs look at their portfolio outcomes

Table 18.3 Outcomes from a VC portfolio

 VC returns

Table 18.4 Return to a VC fund over seven years

 Lease finance

Advantages Disadvantages
➢ Guarantees not required - ➢ Expensive compared to
security is on assets rates of interest charged
purchased on loans
➢ Requires adequate cash
flow to meet regular
payments
Factoring
• What is meant by factoring? Describe the role that
it might play in financing a small business.
 Customer Bonds

What sort of businesses can raise funds from customers? Give examples

Peter Harris
Discussion
1. Since it costs so much to recover a bad debt, it is little wonder
that banks are reluctant to lend without collateral or a good
knowledge of the loan applicant. Discuss
2. What sources of start-up finance most attract you? Why?
3. Lending is about discriminating between ‘good’ and ‘bad’
borrowers. Discuss.
4. Should peer-to-peer funding and crowdsourcing be regulated?
5. If you were a business angel, what would you be looking for in
an investment?
6. What are the advantages and disadvantages of having a
business angel invest in a firm?
7. Where might the interests of the owner-managers and external
investors conflict?