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The Finance Gap 15/12/2007 Is it being plugged? Is the Finance Gap being plugged?

Major changes to the Small Firms Loan Guarantee, and the introduction of Enterprise Capital Funds, are just around the corner, and there are encouraging results from investment readiness pilot schemes.

by Jerry Davison, The Mill Consultancy

As most advisers will be aware, the government has been quite active in trying to plug the ‘finance gap’, the band from £250,000 to £2 million, within which it is very difficult to raise money for growth companies. If the venture capital community is favouring later stage, lower risk companies, who is going to fund the early stage companies that will survive and grow to become mature companies? The DTI has sought to encourage the supply of funding into the gap range through a number of initiatives. Government policy is to stimulate and not displace private activity, so the initiatives are designed around this basic principle.

The ‘finance gap’ is associated with both equity and debt. Many commentators discuss an ‘equity gap’ only, but the accessibility of both sources of funds is very important.  Most early stage or expanding companies require a funding structure that is typically a mix of equity, loans, overdraft and asset finance such as leases. Friends, family and business angels can provide equity, although it can be difficult to find angels if you don’t have the contacts. The accessibility of debt funding is of course highly restricted if there is no available security for bank loans and overdrafts, and banks are wary of young companies with little track record.

Some industry experts dispute the existence of a gap, citing lack of investable propositions as the real hole. I would contend that there is definitely an apparent gap, in that the relative availability of funding within the range is certainly lower than that in the £2 million plus level, and that this shortage is caused by market forces reacting to higher risk levels. There is no doubt that some very good propositions are failing to get financed, so the government is aiming to plug the gap by addressing both the demand side (investment readiness) and the supply side (funding initiatives), as follows -
  •          Small Firms Loan Guarantee (SFLG) scheme
  •          Regional Venture Capital Funds – providing equity up to £500,000 or more
  •          National and regional business angel networks, such as SWAIN, to build contacts between angels and investee companies
  •          Tax incentives – the Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCTs); tax reliefs were improved in the 2004 budget
  •          Enterprise Capital Funds (ECFs) – likely to be introduced in 2005, a private/public vehicle to provide funding between £0.25m to £2m
  •          Investment Readiness training and awareness

In the past few months, we have seen a thorough review of SFLG, the issue of guidance for establishing ECFs, and feedback from a number of pilot investment readiness schemes. Generally, the news is encouraging, but I have some caveats.
The SFLG scheme was reviewed by an independent committee and its report was issued in October. The government has accepted every recommendation, although the date of implementation has not been published. As a reminder, the SFLG enables loans to qualifying companies who have a good business proposition, but no collateral for the debt.  The Government guarantees 75% of the debt and the lender risks the other 25%. Loan periods are two to ten years, and repayment holidays are possible. The maximum loan is £250,000 (or £100,000 for companies trading less than two years).  There is evidence that the SFLG is not used consistently by banks, and any SME seeking such a loan should certainly try more than one bank.

Key recommendations –
  •          All businesses should be entitled to the £250,000 maximum loan
  •          Maximum qualifying turnover £5.6 million for all companies
  •          The SBS no longer needs to authorise every loan – this is left to the lender only, as a commercial decision
  •          The introduction of a limit of five years trading, beyond which the business is ineligible for SFLG
  •          A reduction in the red tape involved in applications
  •          The limit on lending to any one individual over a ten year period is removed, as this was discouraging serial entrepreneurs
  •          No limits on repayment holidays
I take issue with two of the recommendations in the review. First, the restriction on the age of the business to less than five years is misguided. The SFLG should be aimed at growth enterprises, not just at start-ups and early stage as the report suggests. Many good, expanding companies which have ploughed much of their profit back into the business over the early years, but which do not have much ‘traditional’ collateral built up either in the business itself or personally by the entrepreneur, may have a very good proposition for an investment which requires funding and for which a loan rather than equity is appropriate. This investment would fund a step change improvement in the business, and probably generate more jobs. However, under the new rules, any business over five years old would be discriminated against.

Second, there is an undercurrent in the report that suggests that many applications for SFLG are not in the spirit of the scheme and should instead be funded by equity or by normal commercial loans. The report goes on to say that SFLG should only be available to businesses that genuinely do not have the collateral to support lending, but which do have a viable proposition, and that lenders should make a decision on SFLG in the light of other financing options. It concludes that ‘a widespread publicity drive for SFLG aimed at borrowers and business advisers’ would therefore be unadvisable!
SFLG is not an easy option for a banker, and the lenders are subject to audit by the DTI. While it’s true that a few companies in the past may have obtained SFLG rather than equity, and that occasionally entrepreneurs have protected their own assets from being used as security, this is hardly widespread and it should be down to the banks to enforce the rules. Surely the SFLG should be given as high a profile as possible. In my experience, many good small businesses have been completely unaware of the scheme, so recommending against more publicity seems rather perverse.
Turning to ECFs, the government is establishing a funding model very similar to the Small Business Investment Company (SBIC) in the US. The privately run ECFs will use government loans to leverage private capital, from high net worth investors and institutions. Essentially, government loans (of up to £25 million per ECF) will finance up to two thirds of an ECF’s investment fund, which must be used to invest in SMEs requiring up to £2 million of equity and/or debt. While the government stands to make a good profit from successful outcomes, private investors should see a better return, based on the planned structure.

Draft guidance notes were issued recently to assist people interested in launching a pathfinder ECF. The DTI is awaiting state aid clearance from the EU, which should be forthcoming in early 2005, and then three or four vanguard ECFs will be set up. The results of the pathfinder round will be used to establish long term goals and structures for the ECF model. There are no tax breaks for investing in ECFs. The key attraction for private investors is that the government loans will help to reduce the overall risk of the venture, in the sense that funding is largely underwritten. It will be possible for business angel syndicates to establish their own ECF.

Finally, the results of a number of investment readiness demonstration projects have been evaluated by the SBS. In order to successfully raise funding, whether equity, loans, grants or other forms of finance, a company must be in good shape and sufficiently attractive to the providers of funds. A company with higher investability, that makes funders ‘feel right’, will have a greater chance of getting finance and will secure it both quicker and cheaper. This is investment readiness, and is in my opinion the key to success.

Six demo projects were established around the UK in 2002 and ran until early this year. Most of them met or exceeded their targets. The key findings were very supportive of formal investment readiness programmes, and in particular it was found that –
  •          The initiatives require long term commitment and continuous awareness raising among SMEs
  •          Individual delivery (one to one mentoring) is the most effective method
  •          Lack of awareness of different types of finance, their benefits and downsides, particularly equity, was widespread
  •          Main improvements among the SMEs in the projects included fundamentally refined business plans and better understanding of investor expectations and the varying nature and sources of finance
  •          The deliverers must have appropriate experience
The last point is paralleled by the recommendation in the September 2004 DTI report ‘Facilitating Finance’ that the designation of accredited ‘SME Funding Adviser’ should be introduced, to allow SMEs and funding providers to more easil y identify properly qualified and experienced advisers.

© The Mill Consultancy 2004 



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