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ISR Business finance and investment studies
Small and Medium-Sized Business Finance: 
A Review 




1. Introduction


2. The main types and sources of SMB finance


3. Influences on the demand for business finance


4. Bank finance


5. Stock market finance


6. Venture capital


7. Efficiency and competition issues


8. The political-legal environment


9. SMB finance in less developed countries

1. Introduction
Small and medium-sized businesses are a major part of the economy and the effective financing of such businesses makes a significant contribution to economic growth and performance generally.
Over recent decades, general economic and political-legal conditions for business financing have been comparatively favourable in countries such as Britain and America. The financial sector is relatively developed, open, and competitive and firms have a wide range of bank, stock market, and private equity capital products and suppliers to choose from – foreign as well as domestic. However, there can still be significant scope for further increases in cost-efficiency and competition in this area in even the most advanced industrial economies.
This article reviews key topics and issues in small and medium-sized business financing in the UK and elsewhere. It looks at the main forms of SMB finance and the factors affecting the supply, demand, and costs of that finance. It examines the differing financing requirements of different kinds of enterprise; and it considers wider economic and political-legal influences on business finance, investment, and growth.
The article draws on material from a number of ISR books published in the business finance, investment, and growth fields – including The Business Finance Market: A Survey and The Management of Business Lending: A Survey.(1)
2. Major types and sources of SMB finance
Major means of financing small and medium-sized businesses are:
     1.  internal funds;
     2.  overdrafts and bank loans;
     3.  leasing and hire purchase arrangements;
     4.  stock market equity and corporate bond issues;
     5.  venture capital or private equity;
     6.  asset-based finance such as factoring and invoice discounting; and
     7.  trade finance.
Internal funds are the largest single source of business finance and some element of internal funding is involved in most significant investment projects.
As far as external funds are concerned, bank overdrafts or similar short-term credit facilities are the main means of funding working capital requirements in Britain. By contrast, term loans of varying lengths are typically used for asset purchasing and other business development and investment purposes over time. However, overlaps between the two main forms of business debt finance are common. For example, overdraft-type finance is often used directly or indirectly for capital investment purposes – while term loan finance is often used to cover additional working capital requirements arising out of higher-volume production and sales.
As an alternative to buying capital equipment outright, these items might be acquired through leasing or hire purchase. In the mid-1990s in the UK, some 30% of all business plant and machinery annually was acquired through leasing and hire purchase – rising to 60% in the case of small and medium-sized businesses. The attractions of this method of investment financing to businesses include not only the avoidance of heavy immediate drains on business financial resources/costly borrowing commitments but also opportunities to obtain the latest capital equipment on a flexible short-term basis when required and guaranteed professional maintenance cover.
A significant financing variant here is for businesses to sell and then buy- or lease-back assets that they already own.
However, outside equity capital is by far the most important alternative or substitute for conventional medium-to-long-term business debt finance. Equity is especially used to finance larger, longer-term, and higher-risk/higher-reward projects and investments. It is also often used by firms to whom debt finance is not available because (e.g.) they are already very highly geared – and may be resorted to more generally by businesses when base interest rates are high and debt capital is available only on relatively unfavourable terms and conditions.
The stock exchange is the biggest source of external equity capital where large and established companies are concerned. By contrast, smaller and newer enterprises tend to rely on venture capitalists and/or secondary or unlisted market sources for equity funding. In Britain, there was a boom in private equity financed company purchases in the early 2000s. However, prior to this, the UK venture capital market was only worth some £2-3 billions annually – of which about three-quarters was invested in just 1000 firms.
Historically, a major alternative to both long-term bank borrowing and share issues has been the sale of interest-paying corporate bonds.
Nowadays, there is substantial product diversity in the corporate bonds market. Some corporate bonds (e.g. those issued by newer and smaller companies and for leveraged take-over purposes generally) have risk-and-reward characteristics little different from those of shares. Conversely, the bonds issued by large established blue-chip corporations may be closely akin to government gilts.
After a long period of decline, there was a significant revival of the corporate bonds market in late 20th century Britain. Factors behind this revival included:
     ·  the comparatively high costs and/or limited availability of traditional long-term bank loans and share capital;
     ·  significant secular reductions in inflation and interest rates – which reduced the costs and risks of longer-term lending and borrowing generally;
     ·  strong business demand for new sources of large-scale long-term capital to fund company growth, takeovers, and investments and developments in emerging industries (etc.); and
     ·  the introduction of new special tax reliefs on corporate bond investment purchases and rewards.
Finally, asset-based financing in the form of factoring and invoice discounting became major and growing means of raising finance against the trade debts of companies in the late 20th century.
In Britain, factoring took-off rapidly in the 1980s – when it grew by some 20% a year on average.Major attractions of factoring have tended to be the flexibility and benefits to cash flows and the speed with which individual factors are able to convert most of the face value of invoices into cash. In addition, factors may provide useful and staff-saving associated services – such as debt collection, general credit management/protection, and sales ledger administration.
Ordinary trade debts or delays in payment for purchases of goods and services are effectively a kind of informal borrowing or extension of credit to customers by the sellers.There is substantial similarity and substitutability between trade credit, factoring and invoice discounting, and overdrafts as instruments of business financing. All are used mainly to provide short-term flexible working capital. But in practice, all may develop into means of directly or indirectly financing long-term fixed capital investment and business growth.
As far as large-scale long-term investing for business growth is concerned, finance may be required for (e.g.):
     1. acquisitions of production plant and machinery;
     2.  acquisitions of office equipment;
     3.  hiring and training new staff;
     4.  building or refurbishing premises; or
     5.  financing mergers and acquisitions.
In the case of big complex projects, mixed packages of different funding for different purposes are commonplace. The sources of the finance for such projects also often vary. Management buy-outs of companies are often funded by a combination of equity and mezzanine finance from venture capitalists, senior debt and overdraft facilities supplied by banks, and contributions of equity finance from management buy-out teams themselves.
Such complementarities in funding mean that an increase in demand for one kind of funding will often result in an increase in demand for another, related kind.(2)
3. Influences on the demand for business finance
In the business finance as in other markets, supply and demand is largely a function of price. Other factors being equal, the lower that interest rates and other costs are, the greater will be the demand for business finance.
Such products as term loans, overdrafts, and asset-based finance are significantly substitutable and in competition with each other. However, there is a high level of heterogeneity in business finance products and the market overall. Structural differences in forms of business finance are largely related to the differences in functions performed by the finance. Different types of business often have substantially different uses for finance. The funding requirements of individual firms also vary over time, and there tend to be considerable differences in the size and nature of the demand for external finance between different industries and broad sectors of the economy.
In the case of any particular form of finance, whether or not it is selected will often depend on the size, ownership, degree of riskiness, and other characteristics of the business/project concerned – as well as the total amount of funding required and over what time-scale and the comparative costs/benefits of the finance.
On this last score, the costs of finance to businesses include not just the interest rates, dividends, and additional fees payable but also the costs of security requirements and the time and effort involved in arranging the funding. Businesses may be deterred by specific restrictive terms and conditions or limits on managerial autonomy attached to funding. On the other hand, they may be attracted by various ancillary benefits offered by large bank lenders or by the capacity of venture capital partners to bring in new financial-managerial skills and/or reduce principals' risks and gearing levels.
There tend to be substantial differences in the overall business financing requirements and arrangements of large international firms, medium-sized quoted and unquoted companies, and small owner-managed firms.
Most small businesses largely depend on banks for external finance. By contrast, large international firms with high credit ratings will often tap wide and diverse sources of finance worldwide. For example, in addition to making use of regular bank funding they might issue commercial paper on domestic and foreign stock markets, use brokers to arrange large bilateral or syndicated loans, and utilize various kinds of specialized funding products and facilities supplied by non-financial as well as financial institutions. In addition to having a wider choice of finance products, they also tend to enjoy greater flexibility, higher levels of renewability/continuity, and more repayment options in their arrangements with particular financial suppliers.
As far as medium-sized companies are concerned, a major variable affecting external financing is the ownership-management structure. Most obviously, while public limited corporations can tap the stock market for external finance medium-sized unquoted companies tend to be highly reliant on banks and/or private equity financiers.
The type of industry is another major variable affecting business financing. The ISR report The Business Finance Market: A Survey examines various special features and variations in financing/investment between firms in engineering, building, mortgage financing, and other industries.(3)
In addition, the manufacturing sector as a whole tends to have significantly different financing requirements from the primary producing and services sectors.In manufacturing companies generally, large-scale long-term capital investment is often required to (e.g.) enlarge and improve buildings, plant, machinery, and other fixed assets; develop products, markets, and marketing/distribution capabilities; or finance takeovers and mergers. The benefits to firms from such investments may be:
     1.  increased productivity or production and distribution capacities, resulting in higher output/turnover/sales;
     2.  the realization of economies of scale in production, administration, and marketing and distribution (etc.);
     3.  cost/price reductions as a result oflabour and energy savings, reduced scrap or wastage, savings on product inspection and other quality control and assurance procedures, greater speed and flexibility in production allowing for the maintenance of smaller inventories, product-design simplifications, fewer plant and machinery breakdowns and reduced maintenance/servicing requirements, and lower staff turnover because of job dissatisfaction (etc.);
     4.  extensions of facilities, product ranges, and markets served – and thus larger and/or more stable earnings; and/or
     5.  higher margins and increased sales through the production of better quality products which command higher prices.(4)
In manufacturing, investment finance often has to cover various indirect or ancillary costs as well as the direct costs of fixed capital and other projects. The same batch of capital may have to cover everything from decommissioning old plant and equipment, through training staff to operate new machinery, to expanding storage and working capital requirements in order to cope with higher production volumes.
Finally, the characteristics of individual banks and other finance suppliers affect the demand for their products. Apart from prices or direct cost competitiveness, business clients will often be attracted to particular suppliers by:
     ·  perceived reliability, knowledge and experience, and personal friendliness;
     ·  geographical convenience/access; and
     ·  offers of useful ancillary products and services – for example, full current account banking, business financial information and advice, specialist export-financing services,and factoring/leasing with debt collection and equipment repair-and-maintenance (etc.) thrown in.
However, while different firms, industries, and funding requirement (etc.) are often best served by different forms of finance, it should be reiterated that in the majority of established businesses of all kinds it is internal funds (and especially retained profits) and not external capital that is the single most important source of finance. In a survey of 501 medium-sized British companies in 23 industry sectors, it was found that retained profits amounted to 43% of the total finance used in private companies and 38% in stock market listed. This survey also found while less than one-quarter of companies had experienced significant problems in raising medium- and long-term external finance, just over one-third had experienced significant problems of late payments of invoices by their customers.(5)
4. Bank finance
Commercial banks are the main formal suppliers of external finance to small-and medium-sized businesses.
Large numbers of firms nowadays use non-bank institutions as well as or instead of banks for equipment loans, other forms of credit, and savings and investment accounts. Non-bank institutions either dominate or have substantial portions of such major specialist business-financial markets as financial leasing, motor vehicle loans, and brokerage services.In these and other financing areas, comparatively low-cost high-technology centralized suppliers have exploited the benefits of specialization and economies of scale – often with the backing of strong parent organizations and advanced marketing and distribution systems – to take business away from the banks.
However, in Britain in the early 1990s there were nearly three million separate businesses – virtually all of which had bank accounts and were potentially in the market for bank loans and other financial products and services.Well over half of UK firms were at any particular time users of bank overdrafts, term loans, leasing facilities for the acquisition of assets, or other sources of external finance. In addition, well over half of firms used such basic business banking facilities as commercial savings deposits and drafts, giros, credit cards or other non-cheque means of money transmission.(6)
As far as small businesses were concerned, about 50% had at one time or another borrowed from banks. However, own resources were the commonest source of finance.Most small business start-ups were largely funded by their owners out of their own savings, redundancy cheques, money from families, friends, or private investors, and second mortgages on houses (etc.). Less than one-quarter of new small firms received significant start-up funding from banks. Once established, some four out of five small firms then preferred retained profits to overdrafts, loans, or venture capital sources of funding. In the event of outside borrowing, short-term facilities were substantially more popular with small firms and their banks than long-term debt.(7)
With regards to UK medium-sized company financing, one survey found that total borrowings (overdraft finance and loans together) amounted to 30% of the funds used by private companies and 22% of those used by listed. Within this total, bank overdrafts were a more important source of finance than term loans in both private and listed companies. Overdrafts amounted to 16% of finance in private companies and 14% in listed, while term loans amounted to 14% of finance in private companies and 9% in listed. The smallest companies were generally the most reliant on overdrafts as sources of finance, while the largest companies (those with turnovers of between £201-500 million) were the least reliant. Medium- and long-term bank loans accounted for 60% and 73% respectively of private and listed companies' term loan finance.By contrast, factoring and invoice discounting were of fairly minor importance: only 17% of companies in the sample raised finance through such means (amounting to 3% of finance in total). Finally, only 14% of companies (99% of which had turnovers of less than £50 million) used venture capital financing.(8)
Business financing in the United States is even more highly securitized and diverse than in Britain. Nonetheless, a US survey found that nationally 94% of small- and medium-sized businesses used commercial banks for financial products and services while only 35.5% used non-bank institutions. Banks' provision of checking facilities and their geographical locational convenience were found to be their main competitive advantages. Less than 8% of the businesses in the survey used non-bank institutions as their primary financial institutions. The study also found that less than 10% of businesses used commercial banks located more than 30 miles away, and that they purchased on average 2.4 financial products and services from their primary provider. Businesses on average purchased only 1.08 products from institutions that did not supply checking facilities. In addition to checking accounts and credit lines, other valued and widely used business banking products and services were:
     ·  transactions services (including credit card processing, currency and coin, and night depository services);
     ·  cash management services (including wire transfers and lock-boxes); and
     ·  pensions/trust services.
However, the survey found that with increasing size (as measured by the number of employees), small and medium-sized firms made increasing use of external credit by volume and also a wider range of bank and non-bank financial products and services. In the survey, as many as 45% of the smallest businesses (employing 4 employees or less) had no borrowings and a further 50% used only one or two of five main types of loan finance listed (i.e., lines of credit, mortgage loans, motor vehicle loans, equipment, and other loans). By contrast, some 90% of businesses employing between 100-500 persons had outside borrowings and 65% used two or more types of loan finance.(9).
Regarding financing in Britain, there have been a number of public criticisms of the business banking industry over the years. Business owner-managers and others have complained about (e.g.):
     1.  short-term profits rather than long-term investment orientations on the part of banks;
     2.  inabilities on the part of banks to make funding decision locally; and
     3.  bank staffs' inadequate understanding of businesses and/or uncooperative attitudes.
However, there is no evidence of any significant persisting structural barriers to the supply of bank finance to suitable applicants on mutually satisfactory terms and conditions in Britain. Independent analysts as well as the banks themselves have found the main obstacles to funding to be on the demand rather than the supply side of the market – especially in the form of:
     1.  lack of satisfactory business plans, accounting, and other information;
     2.  inadequate assets for use as security;
     3.  insufficiently high levels of business financial profitability;
     4.  current over-gearing; and
     5.  inadequate liquidity and stability on the part of funding applicants.(10)
5. Stock market finance
Major attractions to companies of stock market listing are the capacity to raise large amounts of risk capital to finance growth (etc.) and to avoid substantial debts and earnings-unrelated repayment obligations that could threaten their stability and survival.
On the other hand, significant obstacles to stock market listing on the part of companies are:
     1.  reluctance on the part of owner-managers to dilute their own equity holdings by sales of shares to third parties;
     2.  the involvement of outsiders in the ordering of firms' investment priorities, long-term strategies, and managerial decision-making generally; and
     3.  professional and administrative fees and legal-bureaucratic hassle.
For their part, stock market investors are often reluctant to buy shares in new small companies without track records, shares that are comparatively illiquid, or low growth/low earning shares.
In practice, most British medium-sized companies have remained private and been able to achieve satisfactory growth (etc.) without stock market financing.
6. Venture capital
Formal venture capital or private equity is available from a wide range of organizations and individuals in Britain – including:
     1.  specialist independent venture finance or private equity companies and investment and unit trusts;
     2.  ad hoc consortia, private individuals or business angels, and major manufacturing and other industrial-commercial companies with surplus funds for investment in new ventures; and
     3.  banks and subsidiaries of banks, insurance companies, and pension funds (etc.).
In the mid-1990s, the Coopers and Lybrand survey found that outside equity finance amounted to 18% in UK private companies and 36% in listed, with the London Stock Exchange being the main overall source of this finance. Only 16% of private companies and 12% of listed used venture capitalists for equity finance, with individual business angels supplying less than 1% of the total. Altogether, venture capital accounted for just 6% of private company equity and 1% of listed. Moreover, while venture capital shareholdings initially might range from 10-50% interest in the companies concerned, this interest then tended to decline and end altogether as the investors realized their investments on flotation.
Overall reliance on venture capital /private equity was anticipated to grow significantly in the future as a result of:
     ·  the introduction of tax breaks, and other positive supply-side changes;
     ·  company growth requiring new development finance on the demand-side; and
     ·  changes in the distribution of companies' existing shareholdings through sales of family and directors' equity.(11)
However, in the mid-1990s, the total amount of equity finance and/or long-term development loans obtained by businesses from all these formal venture capital sources still only amounted to less than £3 billion annually.
The total amount of risk capital invested in industry and commerce by specialist formal venture capitalists for all purposes is vastly outweighed by that invested by the public through the stock market. Most of the risk capital for business start-ups comes from entrepreneurs' own resources and/or family and relatives rather than outsiders.Meanwhile, external venture capital funding of technological development in industry is far outweighed by R&D spending by manufacturing firms out of their own resources.(12)
In practice, much mature situation and second- or third-stage financing by specialist venture capitalist organizations is little different from the kind of longer term/larger scale business development lending and equity financing that has traditionally been provided by clearing banks and other mainstream investment companies.
Nonetheless, there is a significant demand for formal venture capital/private equity from firms that are not able to acquire finance easily from the mainstream banking/financial market sources. Firms may require relatively large amounts of money for relatively risky long-term projects, but be already highly geared or unable to provide mainstream lenders and investors with adequate security. Many firms are too small or insufficiently well known to list on stock markets or issue their own bonds. Others simply lack adequate own resources in the form of retained profits, personal savings, property re-mortgages, or private borrowings from family and friends to finance investments.
Typically and traditionally in venture capital financed projects, risks have been shared and capital repayments linked to actual performance/revenue generation. Both sides have had a vested interest in making sure the ventures succeed.However, venture capital has tended to be comparatively expensive and entail significant reductions in managerial autonomy. On this last score, it has been common for venture capitalists to assume executive directorships in the companies they have financed.
But the nature and scale of venture capital/private equity financing changed considerably in the late 20th and early 21st centuries.
To begin with, various changes in the wider market-economic environment affected the overall supply, demand, and costs of that capital. At the beginning of the 1990s in Britain, there was a substantial aggregate surplus of formal-specialist venture capital over demand as a result of high and rising interest rates, general economic recession, and substantial downturns in particular key sectors. Amongst other things, recession in the housing market resulted in considerable deterioration in the business-financial positions of a number of major furniture and furnishing companies that had recently been bought-out by their managements using venture capital (such as MFI, Lowndes Queensway, and Magnet) and deterred more such deals.
The volume of smaller, more conservatively financed management buy-outs did not fall in the economic recession. Indeed, there was a significant increase in venture capital investments in:
     1.  early-stage and start-up projects in low-tech hotel and other businesses;
     2.  management buy-ins in which companies were being taken over by experienced outside teams of managers; and
     3.  deals abroad and in regions outside London and the South East.
However, larger and more speculative venture capital deals virtually disappeared for a while.
Subsequently, venture capital/private equity financing began rapidly expanding again as general economic conditions improved. By the late 1990s, growth was high, inflation was low, and long-term debt was cheap and readily available on high leverage multiples or debt-earnings ratios. In addition, there had been a significant shift out of the stock market by investors wanting better investment returns and a wider spread of their risks. The British and US regulatory authorities had encouraged this shift by insisting that pension companies place a minimum portion of their funds in non-stock market equity investments such as bonds and private equity and hedge funds.As pension funds put more money into supposedly lower-risk fixed interest investments, both share prices and interest rates were pushed down.
Simultaneously, stock market share investments became less attractive, listed companies became cheaper to buy, and the cost of financing investments by private equity deals became generally cheaper.
Globally, a major factor exerting downward pressure on interest rates on corporate debt (etc.) was the massive build-up in foreign exchange reserves in countries in Asia and the Middle East. By 2007, these reserves totalled well over $4 trillion. In keeping with the investment traditions of these countries, the bulk of the surplus funds tended to flow into bank deposits, bonds, and other interest-yielding assets rather than stock market equities.
Low inflation and interest rates, cheap wholesale money market borrowing, and substantial inflows of new capital from pension and insurance companies and other investors provided venture capitalists/private equity funds with the financial resources for large-scale company acquisitions and mergers as well as business start-ups and new technology/production projects (etc.). Company buyouts boomed even more than they had in the late 1980s – when new issues of high-yield, high-risk debt instruments (popularly known as “junk bonds”) had often been used to fund them. Such was the scale of the finance available for buyouts that even the largest publicly quoted companies could now become takeover targets. Deals of $1 billion-plus became common on both sides of the Atlantic.
As said, the amount of money available to private equity investors had mushroomed at the same time that public companies had become cheaper to buy because of the regulatory cap on the amount of stock market equities that pension funds could hold as a percentage of their total assets. Other factors depressed the price of company shares, reduced the demand for stock market flotations, and resulted in already listed companies withdrawing from the market.
On this last score, a number of major British publicly quoted companies and their managements now sought outside private capital backing for taking their firms back into private ownership and control – in order to escape persistently low stock market valuations and/or the growing legal-regulatory burdens on PLC directors.
For their part, there were many private equity funds on the lookout for fundamentally under-valued companies and other established businesses experiencing growth and performance problems that could be overcome under new ownership and management.
Hostile private equity financed company takeovers often aroused opposition from trade unions, incumbent managements, and other vested interests. Private equity investors were often accused of asset stripping and causing unnecessary job losses. However, in reality numerous under-performing companies were rescued and revived through such takeovers. One survey of the effects of private equity takeovers on British companies found that on average over ten years the investors made profits 22% above the market index. Within the companies concerned, employment dipped by about 5% on average in the first year after a buyout but then rose by 21% after four years. Meanwhile, productivity almost doubled, product innovation and entrepreneurship increased, and employee wages and empowerment rose significantly.(13)
7. Efficiency and competition issues
As said, small and medium-sized enterprise financing overall in Britain is currently highly developed. Supplying debt and equity finance to firms is a major industry, and the general level of competition in the market is high. Over the years, strong market pressures on finance suppliers from both competitors and clients have tended to make for steadily increasing efficiency, innovation, and reduced costs in real terms.
However, there is and probably always will be significant scope for increased efficiency and competition in even the most advanced business finance industry and market.
Lenders and investors can never be perfectly informed about the characteristics of businesses, or always and everywhere able to distinguish good risks from bad.Lenders and investors cannot maintain infinitely long and broad relationships with clients or spend unlimited amounts of resources gathering business financial information for financing purposes.Thus there will always and inevitably be some businesses with sound propositions that are unable to access scarce or limited capital finance – or at least, have to pay above-market rates to obtain funding. However, professional business banking managers and equity investors make their living precisely from being able to quickly and efficiently assess business financial propositions, draw up contracts with appropriate repayment and other terms and conditions, and obtain satisfactory collateral and other guarantees from clients. In practice under normal market conditions, most viable financing propositions will eventually attract external funding on mutually satisfactory terms and conditions.
There has been a considerable amount of detailed research on factors affecting the profitability and overall performance of banks in managing business lending. Significant specific topics and issues in this field include:
     ·  the definition and measurement of performance in business lending and management, and the contributions of various major external and internal factors to that performance;
     ·  organizational aspects of the process: functional specialization and efficiency and the problems of effectively integrating business lending and related activities (etc.);
     ·  cultural and personnel aspects: the nature of modern business banking cultures and sub-cultures, and main factors affecting the productivity/performance of individual managers and lending officers;
     ·  technology and efficiency: the importance of technology in achieving and maintaining competitiveness and the market shares of banks, as well as the practical use of technology in lending operations and how new communications technology affects the location of functions;
     ·  economic aspects – especially, lending costs, risk levels, and loan pricing, the factors affecting the efficiency/productivity of lending resources, and possibilities for reducing lending costs and increasing efficiency;
     ·  lending risks and risk reduction: variations in levels of risk and risk-management techniques between different forms of business finance (etc.) and special risks in lending to new businesses, MBO teams and company purchasers generally, firms involved in highly speculative activities, and loss-making businesses;
     ·  the main positive influences on banks' credit-making decisions, and how banks seek to assess the quality of business-financial information, levels of risk, costs, and returns. (Given the riskiness of much business lending and thus the importance banks tend to attach to the values of business assets, security, and other loan guarantees and safeguards, there has been special focus on issues and problems of assessment/evaluation in these areas); and
     ·  the main types and sources of business-financial information used by banks for lending purposes and their specific advantages/limitations – and how banks' key information requirements tend to vary as between different types of loan, risk, and customer, and on the basis of other factors.
Inter alia, the ISR study The Management of Business Lending: A Survey examines new developments in business loan assessment, monitoring, and risk-management; effective pricing; and the nature and reliability of the major sources of business-financial information on which lending decisions are actually based.(14)
In the case of many relatively routine or conventional business credit applications, it is possible to rely on standardized quantitative credit scoring based on business-owner characteristics and recent cash flows (etc.) rather than the personal judgments of bank managers. Doing this can not only cut costs but also improve accuracy and fairness in the assessment process and enable banks to offer more loans and in larger amounts without excessive security. However, the intrinsically diverse and complex nature of much business lending limits the scope for applying computer-based scoring – especially by comparison with personal and residential mortgage lending. In business lending, extensive reliance is always likely to be placed on such things as documentary sources of information, interviews and visits, and the personal knowledge and expertise of bankers.
The effective assessment and monitoring of businesses' financial affairs and assets, trading performance, and lending risks is especially problematical in the case of relatively new and fast growing enterprises. However, even long-established and profitable SMBs with fundamentally sound propositions may be unable to access adequate amounts of external funding on satisfactory terms and conditions.
Governments may respond to allegations of inefficiency or gaps in provision in the business finance market by intervening in various ways.
In Britain over the years, governments have (e.g.) offered regional enterprise development subsidies, directly sponsored high-tech projects, provided small business loan guarantees, and offered special tax relief on venture capital investments. However, most good businesses have been able to obtain funding in the normal way through the market – and in practice, the amounts of capital supplied and the number of clients funded under government schemes have been small in absolute and relative terms.
There is no evidence of any significant persisting structural barriers to the supply of bank finance to suitable applicants on mutually satisfactory terms and conditions in Britain. The main obstacles to funding appear to be on the demand rather than the supply side of the market – and even here, surveys have found that accessing external finance is not a significant concern for most British businesses. In one survey, 71% of businesses did not think it was difficult to access finance.(15). In another survey, only 1% of small firms reported restricted access or high cost of finance as their main problem.(16)
A Small Business Omnibus Survey showed businesses reporting access to finance as a barrier to growth falling dramatically from 6% in the summer of 2001 to just 1% by the autumn of 2002.(17) This illustrated how quickly and significantly changes in the wider economic environment can affect the results of such surveys.
General economic conditions affect industrial-enterprise growth and profitability, the internal cash flows of businesses, their requirements for external finance in the first place – and loan and investment capital costs and availability in the business finance market as a whole.
In addition to more buoyant economic conditions and higher liquidity in financial markets, overall access to outside business capital is likely to be eased by such things as improvements in communications and trust between finance suppliers and business clients and the introduction of more effective methods of credit risk assessment.
So far as equity capital is concerned, most small and medium-sized businesses raise this from own resources and personal contacts rather than from professional venture capitalists. Surveys have found that many business entrepreneurs have a somewhat negative opinion of formal venture capital. The latter is often regarded as comparatively expensive, difficult to obtain, and reducing business managerial independence. However, as with bank loans, there does not seem to be any significant persisting structural barrier or gap in the supply of private venture capital to British businesses. One study found that that about two-thirds of applicants for private equity finance were successful – and that the main reason for rejection was simply because the applicant businesses concerned were unsuitable for such finance.(18)
Of late in Britain, the main focus of public criticism has tended to shift from alleged inefficiencies or structural supply gaps in SMB financing to alleged inadequate competition in the UK business banking industry as a whole.(19)
Regulatory bureaucracies such as the Competition Commission have claimed that UK businesses can have difficulties in comparing the prices of banking services and switching banks. In 2002, the Office of Fair Trading alleged that the four major clearing groups (Royal Bank of Scotland, Barclays, Lloyds TSB and HSBC) were making “excessive” profits from SMB banking services and obtained undertaking from the banks to pay interest on current accounts or waive charges on money transmission services.
Rates of switching banks amongst British businesses in general are low: currently, just 3-4% of businesses change banks per annum. However, high-growth businesses and firms with formally qualified financial managers tend to have significantly higher rates of switching. In any case, there is no evidence that switching banks is actually unduly difficult or significantly hinders access to finance/raises borrowing costs.(20)
There has been a substantial overall increase in competition in the UK business finance industry and market over recent years. Many new foreign as well as domestic institutions have entered the market. In addition, long-distance telephone and internet banking services have expanded and innovative asset-based and equity finance (etc.) products have been developed as an alternative to traditional bank credit.
External business capital is nowadays available from a wide range of institutional and private sources. However, the banks continue to enjoy a number of significant advantages in competing with non-bank organizations to supply SMB finance. In Britain, over 80% of the business customers of the commercial banks are small businesses. The latter still mainly rely on traditional bank overdrafts and small loans for external financing and have tended to stick with banks as suppliers because of such things as the provision of current accounts and other related products and services as well as comparatively low cost and competitive terms and conditions for finance.
Like the clearing banks, many of the large mortgage banks and building societies have extensive branch networks – plus in some cases, better reputations for reliability and customer care/service than the clearing banks. They have long had comparatively speedy and efficient technology-based processing, administration, and tele-banking and other communications/delivery capabilities in place in their specialist fields of mortgage lending and personal savings and loans generally.However, these institutions do not have the customer bases and knowledge and expertise of the clearing banks in the business finance field.
As actual or potential competition from non-bank suppliers and non-loan forms of business finance has increased over the years, the banks have tended to respond positively. They have taken various steps to increase efficiency, reduce costs/charges, and innovate and diversify in order to maintain their share of the SMB finance market.(21)
8. The political-legal environment
Government and the law have a major impact on small and medium-sized business financing.
To begin with, the political-legal environment affects industrial-economic growth and performance overall.
Excessive government spending and borrowing tend to result in higher inflation and interest rates – and then in generally higher costs of finance to business. High inflation and interest rates tend to have an especially adverse effect on long-term financing. In general, they tend to curtail longer-term fixed-rate lending and the corporate bonds market in favour of short-term variable rate loans and equity financing. They also tend to increase the cash-flow problems of many businesses, erode the real value of the cash resources of savers, investors, and consumers, and disrupt long-term business planning and decision-making capacities.
The taxation system also has a major direct and indirect impact on business financing.
In general, taxation affects the capacities of individuals and firms to set up in business in the first place, to finance the running of firms, and to expand businesses on the basis of own or borrowed financial resources. It affects overall flows of capital to industry and commerce as well as the particular financing decisions of individual investors and companies, and economic activities generally. High levels of business taxation tend to hamper the building-up of internal financial investment resources by firms – and reduce the real net returns from industrial-commercial borrowing and investment.
The tax system may also be biased in favour of debt finance and against equity – by (e.g.) treating interest payments as allowable expenses but not dividend payments. Some corporation tax regimes tax company profits and distributions separately with no interconnection. Others give shareholders credit for tax paid at the corporate level. The former kind of tax system will favour debt (bank loans, corporate bonds) over equity as a source of business finance.
Governments have often encouraged firms to purchase new machinery, plant, and buildings by means of generous tax allowances on capital investments. Various other types of investment and saving have also been tax-favoured by government.
For many years in Britain, the business capital allowance system stimulated investment in manufacturing production rather than in services, commercial buildings, or inventories. Until 1984, the corporation tax system allowed 100% immediate relief on capital investments – i.e., the entire writing-off of spending on plant and machinery in the first year for tax purposes. In the 1980s, the Tory government phased out the 100% initial tax allowance for plant, machinery, and industrial buildings and replaced it with a writing-down allowance of 25% a year.Writing-down at this capped annual rate for several years was obviously less generous than the previous relief system. However, there was fiscal compensation for businesses as a whole in the form of a series of significant reduction in the standard rate of corporation tax and the extension of capital investment tax relief to other, non-manufacturing sectors of industry and commerce.
Indirectly, the taxation of personal savings and investments also tends to have a major impact on the supply, demand, and costs of business finance.
Until the 1980s and 1990s in Britain, a generous system of tax relief or exemption for pension and life insurance payments and mortgage-financed property investments channelled personal funds into these areas rather than the stock market (equities).However, the advantage began to shift in the other direction as a result of steady reductions in the value of mortgage interest tax relief coupled with the development of tax-exempt Personal Equity Plans and the flotation of state companies on the stock market. Private equity investment was also stimulated by reductions in the rate of direct taxation and the launching of official enterprise investment incentive schemes like the Business Expansion Scheme (offering income and capital gains tax exemptions to investors in small businesses), the Enterprise Investment Scheme, and Venture Capital Trusts.
Over the years, various proposals for further stimulating business finance and investment via the tax system in Britain have been put forward. They include:
     1.  extending the scope of tax exempt personal equity plans to include investments in secondary market or unquoted companies;
     2.  abolishing capital gains taxes on shares in growing businesses after they have been held a certain number of years;
     3.  removing tax code bias in favour of debt as opposed to equity capital investment by limiting the tax deductability of business interest payments;
     4.  changing tax regulations to make it more advantageous to retain profits within companies – perhaps even introducing tax-exempt savings accounts for small firms to encourage the retention of profits for long-term capital investment, research and development, or training (etc.);
     5.  removing tax incentives that tend to channel personal savings into property, government securities, and/or large firms rather than small businesses;
     6.  reducing the overall level of business taxation, including:
          ·  lowering corporation tax rates;
          ·  exempting small firms and self-employed persons from value added tax (which may be chargeable even though the latter have lower net incomes than their employed professional and executive counterparts);
          ·  tapering capital gains tax to encourage individual entrepreneurs to build-up and retain wealth in businesses;
          ·  removing corporation tax penalties on fast-growing companies by extending initial tax allowances for plant, machinery, and building investments;
          ·  allowingcompanies to decide for themselves at what rate to depreciate fixed capital assets and thus gain tax reliefs or writing-down allowances on investments; and
          ·  reducing or abolishing quasi-taxes such as the compulsory provision of health, welfare, and educational/training benefits to employees by businesses – replacing the latter with government and/or self-financed personal provision; and
     7.  simplifying business tax accounting, administration and collection – e.g. abolishingrequirements for small company accounts audits, replacing complicated value added taxation by simple traditional sales (etc.) taxation, and amalgamating income tax and compulsory national insurance/social security contributions.
However, business-economic growth and performance tend to be facilitated by universalism rather than particularism in taxation systems – i.e., by the application of more or less the same taxes and reliefs to all kinds of business-economic activities (products, services) rather than by official discrimination.
Granting special tax favours to particular types of business-economic activity tends to have various dysfunctional consequences.
The overall tax burden is not relieved by such official fiscal privileges or exemptions: the burden is merely transferred to other sectors of industry and commerce. Even standard rate business tax reductions and/or the more favourable tax treatment of capital investments overall are of no use to firms without current profits. Over the years in Britain and elsewhere, accelerated depreciation allowances for business investments in new plant and equipment have resulted in some manufacturing firms receiving substantial tax breaks that are the equivalent of subsidies – while other firms (e.g. service firms, low technology manufacturers, and firms at different stages of the growth and investment cycle) have received little or no benefit.
More generally, reductions in write-off periods and other fixed asset investment tax breaks have tended to favour capital over labour as a factor of production. They have also tended to encourage businesses as a whole to invest in new technology and abandon older plant, subsidiaries, and product/production lines for tax purposes rather than basic commercial reasons.
Apart from special grants for technical R&D or setting-up operations in Development Areas, the British government nowadays supplies very little direct financial aid to industry. However, it continues to try to stimulate certain kinds of economic (etc.) activities and discourage others via the tax/relief system.
Like the American and many other governments, the British government also operates a small business bank loan guarantee scheme.
Such schemes generally aim to encourage banks to make loans to entrepreneurs who might otherwise not qualify and/or to charge less for relatively high-risk loans. Politicians may thereby hope to raise the overall level of business start-ups or self-employment in the country.However, small business loan guarantees cover only a very small portion of total commercial lending in the economy. The rules governing the schemes also usually cap the amount of money that can be borrowed at a relatively low level – and guarantee not the whole but only part of the loan. Thus, would-be entrepreneurs still often have to re-mortgage their homes and/or put up other sizeable assets as security for loans. Meanwhile, small businesses in mainstream sectors such as retailing may be statutorily ineligible for help altogether (e.g. so as not to distort competition).
In practice, rather than lowering the costs of borrowing official loan guarantee scheme can actually raise it. On top of regular borrowing charges, small business and other borrowers may now have to pay extra to compensate banks for the additional administrative costs and risks involved in operating the schemes.
Other, more fundamental economic criticisms have been made of official small business loan guarantee schemes – and of state financial aids to industry and commerce in general.
In a functioning free market economy, such subsidies are basically unnecessary because businesses and projects that are fundamentally sound and profitable will tend automatically to attract commercial investment funding. Meanwhile, selective subsidies tend to handicap competitors not in receipt of government money, transfer limited capital resources from ventures that would make better use of them, and generally raise the costs of business finance.
To the extent that indigenous business subsidies operate as de facto international trade protectionist measures, they tend to reduce industrial-commercial cost-efficiency and innovation generally.
Finally, schemes often encourage fraud as well as bad commercial decision-making. Bankruptcy for profit tends to be higher when governments guarantee the debt obligations of banks and business borrowers.
Perhaps the most useful things that governments can do to increase efficiency and competition in the business finance industry and market are to ensure sound money, protect against fraud and other criminal actions, uphold contracts, and remove existing illiberal and dysfunctional regulations.
On this last score, liberalization or deregulation had substantial beneficial effects on SMB and general business financing in Britain in the 1980s.
Amongst other things, firms could now freely tap foreign markets and suppliers if they found they could not obtain funding on satisfactory terms and conditions in the UK. Increased competition also raised cost efficiency all round, boosted medium- and longer-term bank lending, and encouraged the emergence of a much wider range of business financing techniques.
Financial market liberalization in general stimulated the emergence of a wide range of new more sophisticated risk hedging instruments and swap facilities. The abolition of exchange controls boosted direct foreign corporate investment – and also effectively undermined the system of fixed exchange rates established at the end of the Second World War. British industry and commerce as a whole benefited considerably from the greater economic stability that came about as stop-go monetary policies designed to artificially fix currency exchange rates were abandoned.
9. SMB finance in less developed countries
Small and medium-sized business financing in less developed countries is not intrinsically different from that in advanced industrial economies.
In most African, Asian, and Latin American countries nowadays, there is substantial conventional collateral-based lending to businesses by banks – and also various forms of asset-based, private equity, and stock market finance. Commercial banks in low-income countries tend to rely on formal business plans, conventional financial statements and related information, and standard credit scoring techniques as well as established customer relationships when making business lending decisions. Likewise, venture capitalists here as elsewhere tend to demand strong evidence of business-financial viability before investing in relatively risky projects.
However, by definition in a less developed/low-income economy, borrowers will often not be able to provide loan collateral of the scale or type conventionally required by banks in the West. Business-financial information will also often be deficient – on both sides of the market. These and other factors tend to limit the scope and usefulness of conventional financial statements, credit scoring, and the marketing and take-up of commercial capital.
In practice, even comparatively large and well-established enterprises may experience difficulties in obtaining adequate amounts of external finance on satisfactory terms and conditions in low-income countries. In an attempt to boost business financing and industrial-economic growth generally, governments in these countries may directly offer cheap loans or other subsidies to SMBs – or else legally require commercial banks to reserve a certain amount of their lending for poorer/indigenous/minority group entrepreneurs on especially favourable terms and conditions.
Beyond this, various non-profit charitable/voluntary organizations may be in operation providing investment finance in less developed countries. However, these organizations often specialize in aiding particular minorities or certain types of project and seek to generate wider social development objectives rather than simply provide regular SMB growth capital.
In low- as in high-income countries, ostensibly commercial business-financing schemes that are not operated in accordance with basic market-economic principles will tend to waste scarce capital resources that would be more productively employed elsewhere and be dysfunctional in other respects.
Reducing inadequacies and the costs of information will improve the assessment and managing of SMB bank lending in any country. Banks themselves often provide their business customers with free advice and information to reduce risk and improve the returns from lending on both sides. As already noted, there are well-established techniques for managing business lending, increasing the returns from traditional collateral based loans, and reducing the risk of private equity/venture capital investments. These techniques are more or less universally applicable. In recent years, technological and other developments have made business credit scoring and financial information processing in general easier, cheaper, and more accurate. However, SMB finance will still have to be structurally-functionally appropriate, tailored to the cash flows of businesses, and generate sufficient returns to cover both real and nominal costs if it is to be fundamentally viable and effective in the long term.
There is now a substantial amount of published research on finance and investment and its relationship to business-economic growth in less developed countries.(22) What is clear from this research is that official development aid programmes or financial subsidies have never produced a general transition from economic traditionality to modernity in societies.
To begin with, capital is only one of many major inputs into the development process. Even so far as the capital factor is concerned, industrial modernization and enterprise development requires not only access to loans on satisfactory terms and conditions but also the development of modern risk capital markets and institutions for equity financing, the commercial-professional ownership and management of major banks and other financial institu­tions, access to world financial credit markets, and openness to direct foreign industrial investment.
In practice, most business enterprises are substantially self-funded – and in financing and building themselves up, firms benefit far more from such things as monetary economic stability, low/flexible interest rates, generally favourable business tax regimes, and low or zero taxes on imports and exports than from special government financial subsidies or incentive schemes.
The importance of international openness and inflows of commercial capital from abroad for facilitating business-economic investment and growth is evident from the case of present-day East Asia and other high growth regions around the world. Foreign direct investors have been attracted to these places by (e.g.):
     1.  the availability generally of requisite factor supp­lies and market opportunities at satisfactory cost-prices;
     2.  low overall levels of taxation;
     3.  freedom from regulations;
     4.  lack of restrictions on the remittance of profits; and
     5.  low or zero duties on imports of plant, equipment, raw materials, components, and other items.
In some low-income countries, governments have created special economic zones in which direct foreign investment and business activities generally can take place free from the dysfunctional political-legal regulations and taxes (etc.) in operation elsewhere. However, such zones can have only limited developmental effects. They are not a viable and effective long-term substitute for general indigenous industrial-commercial liberalization, the right and freedom of all enterprises to transfer their investments and operations elsewhere, and business-economic growth across the country as a whole.(23)




1. The Business Finance Market: A Survey, Industrial Systems Research, Manchester UK, 2011. The Management of Business Lending: A Survey, Industrial Systems Research, Manchester UK, 2011.


2. Stuart Fraser, Finance for Small and Medium-Sized Enterprises: A Report on the 2004 UK Survey of SME Finances, Centre for Small and Medium-Sized Enterprises, Warwick Business School, University of Warwick, 2005.


3. The Business Finance Market: A Survey, op. cit. Chapter 5: “Business Financing Requirements in Different Industries”.


4. Manufacturing in Britain: a Survey of Factors Affecting Growth and Performance, Industrial Systems Research, Manchester UK, 2011. Chapter 9: “Capital Investment and the Growth and Performance of Firms”. Manufacturing and Investment around the World: an International Survey of Factors Affecting Growth and Performance, Industrial Systems Research, Manchester UK, 2011. Chapter 6: “Finance and Investment in Manufacturing”.


5. Made in the UK: The Middle Market Survey, Coopers and Lybrand, 1994.


6. The Business Finance Market: A Survey, op. cit. Chapter 4: “The Financing Requirements of Different Types of Firm".


7. The Business Finance Market: A Survey, op. cit. Chapter 4: “The Financing Requirements of Different Types of Firm”.


8. Made in the UK: The Middle Market Survey, Coopers and Lybrand, op. cit.


9. National Survey of Small Business Finance, USA Small Business Administration and FRB, 1990.


10. The Business Finance Market: A Survey, op. cit. Chapter 4: “The Financing Requirements of Different Types of Firm”.


11. Made in the UK: The Middle Market Survey, Coopers and Lybrand, 1994.


12. Lewis F. Abbott, Technological Development in Industry: A Business-Economic Survey and Analysis, Industrial Systems Research, Manchester UK, 2011. Chapter 10: “Finance and Investment in New Technology”.


13. Centre for Private Equity Research, Nottingham University, 2007.


14. The Management of Business Lending: A Survey, Industrial Systems Research, Manchester UK, 2011.


15. Business Finance 2004, Institute of Directors, 2004.


16. Natwest Quarterly Survey of Small Business Customers, Small Business Research Trust, 2003.


17. Small Business Omnibus Survey, Small Business Service, 2001/2002.


18. Global Entrepreneurship Monitor, 2003.


19. Finance for Small and Medium-Sized Enterprises: A Report on the 2004 UK Survey of SME Finances, op. cit.


20. Finance for Small and Medium-Sized Enterprises: A Report on the 2004 UK Survey of SME Finances, op. cit.


21. The Business Finance Market: A Survey, op. cit. Chapter 2: “Banks and the supply of business finance”


22. Industry & Enterprise: An International Survey of Modernization and Development, Industrial Systems Research, Manchester UK, 2011. Chapter 16: “Finance, Investment, and Development”.


23. Industry & Enterprise: An International Survey of Modernization and Development, op. cit.




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