Articles
The Finance Gap
15/12/2007
Fact or fiction?
The Finance Gap - Fact or Fiction? by Jerry Davison, The Mill Consultancy
The Government believes that there is a shortage of funding for start-ups and small companies in the range up to £1 million. Some people say that most venture capitalists won\'t get out of bed for an investment of less than £5 - 10 million. However a lot of corporate finance specialists believe firmly that there is always money available for a good proposition. What is the truth?
If you’re a growth company requiring £500,000 to take you to the next level – perhaps you need larger premises, more staff, more marketing, better equipment – where do you find it? Indeed, can you find it?
According to the DTI – and this a view supported by many organisations including the CBI - there is a ‘finance gap’ which ranges from £250,000 to £1 million (many commentators say up to £2 million or even more), within which it is very difficult to raise money for business propositions. The many reasons are discussed below. The key problem is that the majority of growing small and medium enterprises (SMEs) require funding amounts in precisely this range.
However a number of industry experts dispute the existence of such a gap, and state that there is plenty of money available for good, robust and credible ventures. For example, to quote the British Venture Capital Association, the major problem is actually ‘a shortage of suitable commercially attractive propositions’.
Nobody is saying that it is impossible to raise £500,000. Essentially, the debate is about the level of difficulty. The alternative sources of funding are debt and equity. Typically the solution could be a mix of these two. In some cases, grants could be available but they’re not covered in this article and there are actually very few grants that would help much towards this level of funding anyway.
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 needs to be examined. Unless a company has some assets which it can put up as security (often including a director’s own house) the availability of bank loans or overdrafts is highly restricted. High Street and other commercial banks will never normally lend money to a company that cannot provide security for a debt.
A major exception is the Government’s Small Firms Loans Guarantee (SFLG) scheme, where loans can be advanced to qualifying companies who have a good business plan but no collateral for the debt. The Government guarantees 75% of the debt and the lender risks the other 25%. Therefore it is almost ‘quasi-equity’ in the sense that it is risk capital – except that the funding has to be repaid, whereas equity generally does not. The scheme has been quite successful but 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 or promoted consistently by banks, and any SME seeking such a loan should certainly try more than one bank.
The SFLG structure is currently being reviewed, and we may see some moderation of the rules and limits, and an uplift in the maximum loan level. This will not necessarily mean easier access to larger amounts. The commercial banks are nervous about even a 25% exposure to failure. Bear in mind that banks make a low margin on loans, so the loss from just one failure could wipe out earnings on several loans in a banker’s portfolio.
It is important to appreciate the fundamental relationship between risk and reward, and where different types of funders sit on the matrix of this relationship. Generally, the higher the risk, the greater the reward expected, and therefore the higher the price for the money. Normal commercial loans, backed by security, may be priced at only 1-3% over base rate. SFLG loans will be at least 2% more. ‘Mezzanine’ debt, which like SFLG is quasi-equity in that no collateral is required, is available from a number of specialist finance houses, but can cost up to 20% per annum plus some share options. It’s called mezzanine because it sits on a floor between commercial bank lending and equity; loan amounts can reach quite substantial levels, but are generally only available for more established, cash-generative companies. Mezzanine is quite popular as a mechanism for management buy-outs.
So risk and reward have to be matched, and banks will tend to avoid early stage firms especially those which could struggle to service debt, i.e. meet the payments of capital and interest. Risk levels are higher at earlier stages of growth: there is a lack of track record and a start-up company could even be ‘pre-revenue’, meaning no sales yet and therefore no net cash generation from business operations.
The classic source of funding at higher risk levels is equity, where in return for a share of the company an investor puts in money which does not have to be repaid. Also, equity requires no security except for a share certificate. An external investor will usually want to see the entrepreneur investing some of his own cash in the venture to prove his confidence in it. Typically, equity is used to finance higher risk early stage companies or ‘second’ stage companies requiring funds for new product, market or technology development. There is potential for high growth but also a high risk of failure.
The cost of equity is not measured in absolute terms such as an interest rate, unless you’re looking at a publicly listed company, in which case its share price is fixed at any given time. For non-listed ‘entrepreneurial’ companies, equity is priced against the percentage of a business exchanged for a certain amount – but that depends on the valuation of the company, which can be quite subjective. The ‘price’ of equity to one entrepreneur may be a lot higher than for another who is more flexible in terms of ‘giving away’ part of his company in return for finance. While the price of equity may include giving up some element of control in the company, it is essential that an entrepreneur’s mindset appreciates that the money could help him realize his growth potential. This mindset is a significant factor in determining how well prepared a company is to take on external funding.
The main sources of external risk equity are as follows –
• ‘Business angels’ (usually wealthy individuals who have enjoyed entrepreneurial success) who can as a group invest hundreds of thousands but the average individual investment is under £50,000. The lower end of the gap is set at the limit to which most angel investment syndicates will fund - £250,000.
• Venture capitalists (VCs) and private equity houses who invest institutional and other funds. VC investments are usually less than £10 million and may be invested in earlier stage companies. Private equity fundings are normally £10 million+ and invested in more mature propositions such as MBOs. The higher end of the gap is set at the perceived bottom limit for VC investment - £1 million.
Before we consider the arguments for and against the gap, it is useful to look at some statistics –
• Only 5% of SMEs need finance for growth
• Only 4% of SMEs demonstrate a greater than 20% p.a. growth rate – the sort of growth at which real investor interest is sparked
• Only 35% of SMEs have any type of external finance…of which only 8% is equity, the remaining 92% being bank loans, overdrafts, leasing and HP
• In 2002, only 6% of private equity was invested in start-up or early stage businesses
• The only fall in VC investment between 1997 and 2001 was in the £500,000 to £1 million bracket
• Success rates for funding applications are 1-2% with VCs and 7-10% with business angels
One could infer from these numbers that very few SMEs need external equity finance, that the majority of them are well served by commercial lines of credit such as leasing and perhaps that most of those who need risk funding can probably find it. However, there are nearly three million SMEs in the UK, so there are thousands of companies seeking funding for growth – and most of this funding will have to be equity, given the risk/return dynamic. Moreover, because the definition of an SME covers companies with staff levels between 1 and 250 people, the statistics can distort the real picture concerning earlier stage companies. One of the patterns over the last few years has been an increasing skew among VCs towards funding later stage, more mature enterprises. Similarly, a number of start-ups which initially managed to attracted early stage funding are now finding it difficult to obtain second round, or ‘follow on’ funding.
These last points are typical of the arguments for the existence of the finance gap. A general defining characteristic of the gap is that a viable business proposition is unable to attract equity investment. As we shall see however, this does beg the question of what is really ‘viable’ – it could be a great business idea, but if the management is average, will the idea be properly executed?
Arguments for the gap
There is a mix of factors, some of which are a ‘permanent’ feature of fund raising at this level and some which have appeared more recently and are perhaps more cyclical in nature.
Conventional reasons cited for existence of the gap –
• High transaction costs – the accounting and legal costs of a deal, mainly for due diligence purposes, can be as high for a smaller transaction as for a larger one, because most of the work requirements are the same, therefore many smaller deals can be uneconomic
• Higher risks of earlier stage – companies are too new or too small
• Portfolio running costs – the question of economies of scale again prejudices smaller deals; monitoring a venture capital fund with a portfolio of ten £2m investments is far more cost efficient than managing one with forty £0.5m investments
• Lack of exit options and liquidity – all investors will expect to realise their investment at some stage, so every business must provide a realistic prospect for exiting, either a listing, trade sale or perhaps an MBO. Institutional interest in smaller quoted companies on the London stock exchanges has declined significantly, which has reduced the chances for exits through flotation
• Regulatory hurdles – some commentators believe that the complex red tape introduced by the Financial Services Authority, such as the FSMA 2000 regulations and the Financial Promotion Order, have alienated a lot of investors, particularly potential business angels
• Lack of ‘investment readiness’ (i.e. providing sufficient information, credibility and trust to an investor to motivate him to invest in a proposition). For example -
o Poor business plans
o Lack of awareness of funding sources or approaching inappropriate sources
o Insufficient management experience or skill
o Fear of interference and loss of control
o Lack of independent advice taken
• Incomplete information and asymmetry of information – sometimes called the information gap, and refers to the problems faced by investors and bankers in obtaining a full understanding of a business. For example, many SMEs simply do not have the systems to retain, analyse and report much of the business critical information that is normally available from a larger enterprise. Asymmetry refers to the fact that the information is very one-sided, and much of it may well only reside in the entrepreneur’s head!
Cyclical factors –
In its 1999 report on the equity gap, the DTI suggested the gap’s range was £100,000 to £500,000. As noted earlier, this range has moved upwards to £250,000 to £1 million+. The increasing skew towards funding later stage, more mature enterprises and the difficulty in obtaining follow on funding are symptoms of a shift in risk tolerance. The huge growth in MBO/MBI deals and the allegation that VCs look only at larger, proven businesses also offer evidence.
Certainly, the IT/internet bubble of 1997/2000 caused significant damage in the investment community, and investors are more risk averse following the meltdown in company valuations and the losses triggered. However, it could be argued that the bubble period behaviour was atypical and investors have now returned to the normal, diligent and demanding procedures that were always in place before the bubble, with substantial examination of management strength, intellectual property rights and the market opportunity in particular. Try funding a flakey dotcom in 2004!
Arguments against the gap
Many industry insiders would contend that the gap is definitely more apparent than real, and that the problem is exaggerated. The appearance of the gap is exacerbated by such factors as deal lead time – equity investments can take six to nine months to finalise, and this increases the apprehension of an apparent scarcity of funding – and the volume of business plans that are rejected.
It is impossible to calculate real unmet demand, but any professional investor will tell you that if he finds a great proposition, and it’s in his sector, he will want to invest in it. It is said that the real problem is that there are not enough good proposals. John Moulton, of the VC Alchemy Partners, says that it is an equity hole: 'The real problem is the inadequate supply of good companies, with good management teams, in decent markets, that can grow sufficiently in value to support the proposition of equity investment.'
Lack of investment readiness is also cited as a major problem on the anti-gap side. Many business plans may have inherent merit, but are either insufficiently developed or are inappropriately structured. Very often, the approach to investors is badly handled, e.g. plans being emailed to a VC without even bothering to identify the appropriate addressee. This all reflects badly on the entrepreneur’s ability. Many VCs do not even look at unsolicited business plans – unless a plan has been referred by a trusted source, they go in the bin. This is only because most VCs just do not have the time to read the hundreds of propositions they receive, so there has to be a filter mechanism. Very often, plans are simply sent to the wrong type of VC; it’s no good sending a software proposition requiring £1 million to a VC who doesn’t touch IT and only does deals over £5 million.
The contention is that if more companies were properly prepared, then far more would be successful in attracting investment and the apparent gap would fade away…‘Good proposals will always find money’. Apart from the thousands of business angels, there are over two hundred VCs in the UK, and many more in the US and in Europe. There are several VCs who will look at funding requirements well below £1 million.
Government initiatives
The DTI has been convinced of the finance gap’s existence for some time, and has sought to stimulate supply of funding into the gap range through a number of initiatives. The Government is concerned that whatever the arguments on each side, it is essential that the best entrepreneurs should have easier access to funding. Ultimately, future growth in the UK is based on constant birth and nurturing of new and innovative businesses. If the investment community is favouring later stage companies, who is going to fund the early stage companies that will survive and grow to become mature companies?
Government initiatives include the following –
• SFLG scheme, as outlined earlier
• Regional Venture Capital Funds – providing equity up to £500,000 or more
• National and regional business angel networks, to promote visibility of and access to angels and investee companies
• Tax incentives – the Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCTs) allow income and capital gains tax relief on certain investments
• Enterprise Capital Funds – likely to be introduced in 2005, a private/public vehicle to provide funding between £0.25m to £2m
Government policy is to stimulate and not displace private activity, so initiatives are designed around this basic principle. Some of the schemes have been quite successful in helping to fill the apparent gap, while avoiding the obvious trap of providing taxpayer funding for lame ducks.
Conclusion
I believe that while there is a lot of evidence for the existence of a gap, especially in the current more risk averse cycle, that in fact the gap is more apparent than real. The relative availability and capacity of funds in the gap’s range is lower than that outside of the range, for a number of reasons, but there is not an absolute scarcity of funding in the range by any means. The reality is that market forces are operating, they have to deal with risk, and the strongest ideas will be selected and financed. There is still a good number of VCs who will finance early stage investments under £1 million, very often co-funding with business angels.
The main reason for lack of funding of companies is repeated time after time – the quality of the team. And the best people will ensure that they are as well prepared as they can be for the investment process, and that they seek out the most appropriate funding partners.
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 the providers ‘feel right’ about advancing funding, and that has knowledge of the diverse sources of finance 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.
The good news is that many investors believe that a return to early stage investments is imminent.
© The Mill Consultancy 2004
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