The University of Birmingham, UK
The University of Birmingham, UK
Small and Medium-sized Enterprises (SMEs), as a major sector of the economy, have unique characteristics in terms of organisational and financial structures; reflecting the interest and strategy of the owner andfinanciers. With regard to the recent global financial crisis, the terminology ‘Credit Crunch ’ describes a shortage in financial funds and concerns most businesses as well as financiers. On the one hand, financiers (lenders) complain about weakfinancial structures (especially lack of equity) and high risks investments of innovations and on the other hand SMEs (borrowers) accusefinanciersfor a shortage offinancial funds or non-transparent and demanding credit conditions. This chapter describes various financing options and gives rationales for the credit rating process and credit conditions building the base for financing decisions. Furthermore, by discussing the topic of ‘Credit Rationing’, the authors demonstrate the impact of credit conditions on management decisions in order to justify the rationing of credits. This chapter also provides the necessary introduction and background to the understanding of the next chapter “Part II: Case Study of German SMEs in 2010”.
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This chapter introduces definitions and financing alternatives of ‘Small and Medium-Sized Enterprise’ (SME). A comparison and validation of different SME definitions is presented to demonstrate the complex categorisation of a heterogeneous set of firms. Finance as an ‘Organisations Creative Area’ supports innovation processes by overcoming barriers that exist especially for SMEs. These barriers are not just a lack of resources (especially financial resources), but also lack of expertise in fields outside the core competencies. For instance a manufacturer may have a lack of distribution knowledge and contacts. Therefore, a non-traditional financier (e. g. Venture Capitalist) may solve some of these problems and support innovation by delivering ‘Value-Added Services’ (e. g. contacts, experience and managerial competencies). Depending on the long-run targets a firm may not need the expertise of any Private Investor and may be able to be innovative with traditional financing (e. g. Proj ect-oriented bank loans). Therefore, choosing the right financing options, not just to optimize a firm’s financial structure, can have a synergetic effect on innovations. This chapter presents rather a theoretical background on financing SMEs, while the next chapter presents a closer focus on financing and its contribution to innovations in SMEs. In order to obtain a holistic view of what a credit crunch is and how it is caused, this chapter presents rationale of the credit market and a general description of the credit rating process. Additionally, non-traditional financing options are validated concerning the SME applicability.
In Europe, the degree of bank financing is high in comparison to financing through financial markets—especially compared to the USA. In the USA, bonds take an 80% share of debt financing and bank financing only 20%--while in Europe bank loans have an 80% share of debt financing (Schinkel, 2010). Therefore banks play a very important role in financing in Europe and it is worth it to have a closer look to the credit market and credit rationing. Due to the fact that most Small and Medium-Sized Enterprises (SMEs) are limited companies, rather than quoted companies, the access to financial markets is limited. Looking at the current financial crisis with a focus on the interplay of financiers and SMEs, companies are complaining about the so called Credit Crunch causing a shortage in funds. Financiers on the other hand complain about weak financial structures in terms of debt/equity ratios causing higher risks of losing loans. Non-traditional financing, with a potential to fill traditional financing gaps, offers especially to entrepreneurs an improved business framework; even though there are concerns about the dependence on financiers.
Structural and economic performance characteristics of Small and Medium-Sized Enterprises (SMEs) differ not only within different nations, but also within different industries. Therefore it is important to identify differentiation criteria (quantitative and qualitative) and to contrast definition approaches; addressing the question ‘which type of firm is included in the term SME?’ Sometimes the grouping structure of cooperating enterprises makes it complicated to distinguish between legally independent entities. While some organisation’s out-sourced departments and services appear to be independent, other business units corporate to an extend that contradicts to a quantitative separated definition. Most literature about small firms was originated from America
Table 1. Industry specific SME threshold criteria (Bolton, 1971, p.3)
before the Bolton Committee defined 1971 ‘model 1’ (Bolton Report) containing quantitative as well as qualitative criteria to define a SME (Stanworth, 1981, p.3). This model is based on the UK market. More recent, the Companies Act of 2006 (UK) and the European Commission defined quantitative criteria. Other qualitative models have been developed by the Committee for Economic Development (US) and IfM Bonn1 (Germany).
Depending on the type of industry, Bolton et al. (1971, p.3) defined quantitative threshold criteria which can be either the number of employees or the annual turnover. Further criteria (as shown in Table 1) are ‘percentage of all firms in industry’, the ratio of total employment to small firm’s employment and the ‘average employment per small firm’.
The Bolton Report model (1971, pp.1-2) defined besides quantitative criteria also qualitative characteristics. For instance the company should have a relatively small market share of its market, be managed in a personalised way (mostly by the owner), have no formal management structure and the principal decision-making-process shall not directly be externally influenced (e. g. not part of a large scale enterprise).
A broadly accepted and quoted UK-based definition of small companies is described in the Companies Act of2006 (chapter 46, part 15, sub-chapter 1, section 382). According to this act, a company qualifies as ‘small’ when it meets at least two of the following requirements (Table 2).
The turnover values refer to the company’s financial year and any occurring maximum figures have to be adjusted proportionately. The balance sheet total is the aggregated amount of assets from the company’s balance sheet and the number of employees is calculated by the average ‘persons employed under contracts of service ’ per financial year. Furthermore, a company is excluded from the “small companies regime” if during the financial year the company is either a public company, an authorised insurance company, a banking company, an e-money issuer, an ISD2 investment firm, an UCITS3 management company, or a member of a group that does not comply with required criteria (Companies Act 2006, chapter 46, part 15, sub-chapter 1, section 384).
Table 2. UK threshold criteria according to the Companies Act 2006 (chapter 46, part 15, subchapter 1, section 382.3)
According to the American Committee for Economic Development (CED), a small business has to meet at least two of the following for requirements (Recklies, 2001, p.2):
a. Since the manager usually owns the business, the management has to be independent
b. The ownership is held by one individual or a few individuals which supply the capital
c. The operating area is mainly (but not necessarily) local
d. The SME has to be smaller than large competitors in its industry
Table 3. SME threshold criteria of the EU Commission (c. f. Official Journal of the European Union, L124/36, 2003, Annex, Title1, Article 2.1-2.3)
In accordance with the latest publication of the European Commission4, micro, small and medium - sized enterprises include all together firms that employ less than 250 employees, have a annual turnover of less than 50 million and an annual balance sheet total of less than 43 million (Official Journal of the European Union, L 124/36, 2003, Annex, Title 1, Article 2.1). Table 3 provides quantitative threshold criteria for a closer differentiation of the three categories:
The so called ‘staff headcount criterion’ (employees) takes, as the main criterion, different structures and characteristics of different branches into consideration. For example manufacturing firms usually have more employees with a certain turnover compared to firms working in the distribution or logistic sector (Official Journal of the European Union, L 124/36, 2003, p. 1, paragraph 4). The turnover threshold values are being adapted to changes in price and productivity. Furthermore, the so called turnover ceilings can be regarded as a statistical ratio between the balance sheet total and staff headcount. (Official Journal of the European Union, L 124/36, 2003, p.2, paragraph 6). According to the EU Commission, another criterion for an enterprise to be regarded as a SME is the relative share of external shareholder; not more than 25% of shares should be owned by another external company.
Hauser5 (2005, p.3) points out that SMEs are limited to a size in which owners can manage to have a rather holistic control of the business—in contrast to Large Scale Enterprises (LSE). Due to the fact that the relative share and ‘weight of decision’ of private investors (like share holders) usually decreases with the size of enterprise, the incentive to get detailed information and the commitment decreases as well.
Besides these limiting figures, the IfM and the OECD Statistics Directorate published a meeting document about “a qualitative definition of SMEs” (Hauser, 2005, p.2-3), in which three types of enterprises are differentiated (Table 4):
• Type 1 enterprise: An enterprise in which short - and long term decision are made by the manager who is the owner and a member of the family. The decisions are made only for the benefits and interests of the enterprise. The manager’s personal commitment and identification with the enterprise is very high.
• Type 2 enterprise: An enterprise in which the manager is only authorized to make short-term strategic decisions, but prepares long-term decision for the board of owners. The board of owners can also consist of private investors. Interests are to maximise their profits and profits of enterprise.
Table 5. Average annual turnover and employment of German enterprises as legal units
• Type 3 enterprise: An enterprise that is part of a group. Strategic decisions are made in favour of the group rather than the enterprise. The decision making process is influenced by the structure and interaction of group members. The affiliation can have legal, financial and knowledge advantages. The enterprise as a member of
Table 4. SME threshold criteria ofthe IfMBonn (In - stitutfur Mittelstandsforschung (IfM), 17.07.2010)
the group may have different characteristics than SMEs according to quantitative definitions (e. g. annual turnover, number of employees).
A validation ofthe EU Commission’s proposal of SME classification has been conducted by the IfM to check the applicability to German SMEs - as a key player of the European Union. The following table (Table 5) shows the average annual turnover and average amount of employees in each size - group. The survey was conducted with German Manufacturing enterprises; employing at least 20 people. Hauser (2005, p.9) states that distortion of empirical data occurs by taking corporate enterprises (being incorporated into a group) into consideration. These enterprises act therefore in the group’s interests rather than own interests. To solve this issue, the IfM statistics look at legal units, which are clearly independent businesses, rather than incorporated group members.
Comparing Table 5 with Table 3 shows that the threshold criteria of the EU Commission are suitable for instance for SMEs (as legal units) in the Manufacturing sector in Germany.
The three types of enterprises described in the section “SME definition according to the IfM” have all pros and cons depending on the resources they require in operation. The most flexible enterprise category is type I due to the fact that decisions do not have to be co-ordinated to large extend and can be quickly executed through the owner/manager. On the other hand the risk ofwrong decisions and prioritising can rise without the co-ordination
of decisions. Modularization and the principle agent problem rise with the size of company and when grouping enterprises6 because one business unit may act on behalf of its own interests rather than the whole firm’s interests; furthermore this problem is related to Asymmetric Information. Concerning the availability and maximisation of resource capacities, the type III enterprise has an advantage over the other two types due to the fact that group members can shift their resources to each other. Therefore the assessment of financial and productivity performances is rather difficult when looking at type III enterprises. Type I and type II enterprises have less complex allocation of resources - which makes it easier to assess SMEs quantitative. Qualitative characteristics are very difficult to unify, categorize and access for externals. Therefore different definitions have been developed applicable for different nations.
The more detailed contribution of the IfM (Hauser, 2005) contrasts structural aspects of organisations and demonstrates that enterprises, interacting in a group, are difficult to assess. Furthermore, SME threshold criteria based on statistical data need to be adopted according to legal units rather than single companies; that appear to be independent. An example related to the work of Hauser (2005, p. 4-9) is a company that has outsourced its Research and Development (R&D) and dispatch department (for taxation- or cost saving reasons). Looking at the single performance of all three business units (production department as a residual department and the two new independent business units) will show that one will generate most likely a profit and the other will reveal a very low operating profit. These three independent enterprises would contribute equally to a statistical result of a SME survey looking at each of them as a single entity; because interrelations are difficult to detect for externals. Therefore the relation between employment, machine capacities and financial ratios of different entities can be misleading regarding unifying definitions. Furthermore, it is difficult to define
SMEs as enterprises in which the owner has the overall control of the business. When looking at companies with more than 100 employees it is very likely to find assistant managers in several departments with certain competencies and room for manoeuvre.
The terminology SMEs is often wrongly associated with entrepreneurial businesses. Due to the fact that most businesses started out small, some can be in the position of an innovative-, entrepreneurial - or start-up business. While the aim of most entrepreneurial businesses is to grow, to gain market share and to maximise profits; some SMEs follow the strategy of staying in a niche market and maintain their size. Nevertheless, Bridge (2003) describes a classification of innovative businesses in relation to the growth of business. One class of business are the ‘lifestyle’ businesses that have “...no-growth aspiration”; “...often home-based, sole trader operations employing no more than one additional person...” (Bridge, 2003. pp. 276-277). Furthermore, he states that a remarkable number of entrepreneurs aim at moderate growth due to the fact that in a firm with an arithmetical growth, the occurring problems grow geometrically. In addition, owner of SMEs may prefer a smaller size because of a less aggressive competitive environment and more stable economic development following personal management goals.
Concerning technological innovations, small enterprises have most likely an increased flexibility to adopt the product or service faster than LSE due to their key account management and dependence on their customer. Furthermore the management structure and decision making process as well as customer relationship management differ significantly from LSE that started out as an entrepreneurial business. While an entrepreneurial business is expected to have an early return, covering research and development cost and serve share holders, an aim of a small business might rather be a stable business basis that is capable to be managed by a single person or in a partnership. A major advantage that small firms have is the ability to be innovative and to take up new technologies within a short time (further details in the next chapter). As there is now need to wait for the decision making process involving several people within the management structure. Due to the fact that a SME is able to react flexible to changes and opportunities, the customer relationship can be defined as much closer, personal and supporting.
Alambritis (2010) who is a member of Britain’s Federation of Small Businesses states that “Small businesses are the lifeblood of the economy...”. General speaking SMEs can be regarded as a key player in each nation’s economy; especially in terms of GDP - and employment contribution. According to the European Commission, SMEs represent 99% of all enterprises and provide 75 million jobs in Europe. The “.. .support for SMEs is one of the European Commission’s priorities for economic growth, job creation and economic and social cohesion” (European Commission, 2003, p.5). The global financial crisis has proved that SMEs can absorb economic shocks better than LSE and have a stabilising function in the economy (Borger, Kiener-Stuck, 2010, 1-27). “Cutting off their credit poses a very real threat to the economic recovery” (Alambritis, 2010).
Due to their management structure with a high grade of personal commitment and responsibility as well as flexibility in the decision making process, SMEs generally have the ability to provide stable employment conditions and stable tax payments. Besides assistance programmes of governments and private investors, a group of SMEs is less likely to get as much governmental help as a LSE being in the centre of public attention - even though a group of SMEs together are more resistant to economic recession and provide more stable jobs and tax payments than a single LSE. To cover own costs and finance innovations, SMEs often form collective group agreements to profit for instance from large-orders discounts. Smaller scale organisations often offer the opportunity to the management to resolve employment related problems on an individual base rather than being confronted with a strong labour union and are less likely be confronted with labour strikes. On the one hand LSEs are more likely confronted by the ‘monopolies and mergers commission’, but on the other hand they can deal easier with environmental and social and governmental requirements due to their organizational structure. In order to survive in a general competitive environment, SMEs marketing strategies are often focused on an innovative, customer oriented and high quality product rather than low price products.
Financing of SMEs is major challenge due to limited financial-, personnel - and production resources. Due to the fact that most small firms exist in the legal form as limited companies (rather than public companies) access to new capital is limited. Furthermore owner/ manager of SMEs prefer to keep the overall control of their firms and therefore equity capital is not the most favourable financing option. According to Hauser (2000), small firms have more difficulties to cover temporary losses than larger firms - even though their turnover yield is larger. In addition small companies have a lower non-operational income and lower equity capitalization. Therefore it is particularly difficult to finance R&D as well as capacity related investments. Due to the fact that SMEs often employ temporary labour as well as leased equipment (sometimes even provided by the customer) and use single machines rather than complex production lines, the variable cost are compared to the fix costs relatively high. As a consequence the operation leverage tends to be lower which reduces the risk to pay back debts making SMEs more reliant and attractive to short term loans and overdrafts than to equity finance (Harrison, 1994). Investment loans are required by SMEs to renew work equipment and to expand the business. According to a study of SMEs in the financial crisis, the demand for investment loans decreased within an economic recession due to spare production capacities and a slow order situation (DSGV, 2010, p. 28). While the demand for investment loans decreases, the demand for working capital loans rises in a recession. This is due to the fact that SMEs need to cover raw material costs and some overheads by advance payments. Due to a low cash flow, the need for working capital loans rises.
Concerning the interests of SMEs, it can be stated that an owner who manages an enterprise identifies himself to a wide extend with the business and does not like to disclose business information. Therefore a confidential so-called ‘house-bank’7 with one assigned account manager is more favourable than different banks - all having the whole set of information. Especially in a financial crisis, it can be important to build on a long - term relationship with a bank to “soften budget constraints” (Revest, 2010, p.6). In general, managers of SMEs have a good knowledge and experience about their new investment’s potential, whereas bankers might not be specialist in this particular field; making it more difficult for bankers to assess an investment’s risk.
There is a trade-off between the tax payment and credit rating. While taxes might be reduced through the transformation of profit into so called inventory provisions and accruals, the bank/ financier cannot assess the value of these positions and therefore the credit rating downgrades as well. According to the opinion of an executive of a leading German bank, foreign banks entered loan markets of other countries during the last years and tried to gain market share by employing competitive bidding strategies. This led for instance in Germany to relatively low interest rates. While the industry was used to relatively favourable loan conditions, the banks struggle to justify higher cost for similar services. Due to the fact that the latest economic crisis and recession affected the whole world, financiers had to raise the risk premium and formal requirements, which make the money cost rise as well; impaired by a low equity ratio of SMEs. In a financial crisis, equity equals safety. In Germany the average equity ratio of SMEs in the trading sector was 2008 12.6% and in the producing sector 19.7% (DSGV, 2010, appendix p. 8-9). Medium-size enterprises8 are known to have higher equity ratios and higher inflexible overheads.
SMEs are often incorporated into a network with other SMEs and LSE causing not only dependencies, but also profits (e. g. higher purchasing power). The higher the dependency on one major customer, the more similar is their economic development and the higher the necessity to adopt capacity utilisation. Especially in manufacturing firms, the need for flexible and capable technology (often CNC-machines, measuring equipment) can cause the necessity not only to monitor costs, but also financial reorganisation. Older technology with lower fix costs (e. g. costs for maintenance, electricity and tools) and higher variable costs/ unit costs need to be replaced by costly new technology with higher fix costs and lower unit costs. To comply with capacity and flexibility requirements the firm has not only to invest into new technology but also cover higher fix costs/ overheads—requiring a sufficient cash flow. In times of an economic recession solutions like credit factoring, diversified investments and additional private capital can be very useful. According to Schneider (2004, p.8), most SMEs have “.low company capital [which] influences the credibility towards banks.” and investors. In case of Entrepreneurs the uncertainty about future development of innovations makes the financing unattractive to private investors According to Moore (1993), financial constraints are the most significant barrier to growth.
Traditional Financiers may vary within different nations. In Scandinavian countries, Germany, France and Japan especially bank financing represents traditional financing. Especially innovation - financing dependents on the financial system in a certain country (further reading in Revest, 2010, Financing technology-based small firms in Europe: what do we know? Pp.2). In order to focus on Europe, banks are regarded as traditional financiers. Banks are often defined as institutions that have the permission to carry out regulated and controlled activities of accepting deposits and executing loan transactions. They play an essential role in the economic cycle: Collecting and administer money (deposit business) to invest it in other businesses (lending business); for the original purpose of a macroeconomic profit maximisation as well as an achievement of own profit (depending on the purpose and type of bank institution). In addition, they provide payment services like money changing and support of monetary transactions. Another service banks provide is transforming assets in corporation with firms and investors acting as financial intermediary (FI). General speaking, this works through the aggregation and change on the asset side to create a new product on the liability side9. Other key functions are managing risks (e. g. loan-, liquidity - and interest rate risks) and associated monitoring of borrowers; as well as the information processing. There are different types of financiers competing with each other. One example are the so called ‘invoice finance and asset based lenders’, which provide services like factoring to firms in order to support their maintenance of cash flow. These institutions, working as non-traditional financiers, take over gradually market share from the banks.
Central Bank Authorities are responsible for macroeconomic services (monetary policy) as well as microeconomic services (support and control of financial market). Examples of Central Bank Authorities are European Central Bank (EU), Federal Reserve System (USA), Bank of China (China), Bank of Japan (Japan) and Bank of England (UK). Not all Central Bank Authorities are dependent on governmental decision.
The banking system needs regulation due to many different reasons. One important reason is the existing ‘systemic risk’ (c. f. Thompson, 2004, p. 339) which can arise when a bank has liquidity problems (like it happened to many banks in different nations in the financial crisis in 2009). A structural key problem of banks is their balance between liabilities and assets. Bank’s liabilities are liquid and their assets are not liquid due to problematic repayments at short notice. In case a depositor get informed about an economic crisis of the bank institution or market, it is likely that he will withdraw his deposit at short notice, assuming it is safer not keeping it in the bank. This applies not only to one particular bank which is in trouble, but also to other banks—as most depositors cannot differentiate between bank institutions and their economic wealth. This can lead to liquidity problems of banks and a systemic collapse, because even banks will refuse to lend money to each other. Therefore national laws define the bank legislation and policies for banking operations in each constitutional state. To mention some of them: “Banking Act” (UK) and “Kreditwesengesetz” (Germany). These laws are being continuously revised by governmental institutions. A maj or aspect of banking regulations is the ratio of which loans are backed-up with equity (e. g. Basel I-III10).
Since a credit is a non-uniform product, the demand and supply relationship is very complex - and so is the relationship of lender and borrower. According to Freixas (1997), instead of a graphical analysis looking at demand and supply, a new equilibrium concept is required to describe the output of a competitive credit market; since the demand and supply curve simple will not intersect with high-level interest rates. Furthermore, the level of interest rate is limited according to a bank’s interests (see section “Types and phenomena of Credit Rationing”). Assuming a borrower is offered a loan to a given interest rate, he cannot just extent the amount of the loan in order to optimize his marginal cost—because the lender’s risk of losing money rises with the amount lent. Therefore “the equilibrium interest rate may be a nonlinear function of the loan size.” (Freixas, 1997, p. 138). The discussed influence of the interest rate on the demand of loans is called ‘price factor’. In addition, there are non-price factors, like collateral requirements, influencing the likelihood of getting a loan granted. Credit rationing (CR) is a phenomenon that occurs “...if in equilibrium the demand for loans exceeds the supply at the ruling price (interest rate).” (Voordeckers and Steijvers, 2005, p.2). In the literature the term CR is not used in a consistent way. CR is referred to describe the rationing of loans when looking at the inter-banking-relationship as well as bank - customer relationship. Nevertheless, it has been proven that CR has an impact on SME’s financing opportunities (Voordeckers and Steijvers, 2005, p.2). In general it can be stated that the reduction of available loans reduces the availability of funds for potential projects of SMEs due to the fact that bank loan financing is still an important financing source (especially in Europe).
The characteristics of the credit market differ significantly from consumer market characteristics covered in microeconomics. In the usual consumer market (or perfect market), a monopolist seller can (simplified) sell as much products as required as long as he is willing to lower the product price. Simultaneously, a monopolist buyer can buy as many products as he wants as long as he is willing to pay the price. Clower (1995, p. 311) describes this as the ‘thick market hypothesis’ of the banking market. Depending on the pricing strategy of a company in the consumer market, the product price rises usually when the demand is high. In order to pursuit profit maximisation, chronic excess demand should be avoided (Gow - land, 2010, p.1). To put it in Keynesian terminology, which have nowadays perhaps even more general validity:
“Ifwe assume that the lending of money takes place according to the principles of a perfect market, it is evident that, given the demand schedule of borrowers, the effective bank rate and bond rate must uniquely determine the production of capital goods and hence, generally speaking, the volume of investment. So far, however, as bank loans are concerned, lending does not—in Great Britain at least—take place according to the principles of a perfect market. There is apt to be an unsatisfied fringe of borrowers, the size of which can be expanded or contracted, so that banks can influence the volume of investment by expanding or contracting the volume of their loans, without there being necessarily any change in the level of the bank rate, in the demand schedule of borrowers, or in the volume of lending otherwise than through the banks. This phenomenon is capable, when it exists, of having great practical importance.” (Keynes, 1930, vol.1, p.190)
In contrast to a “perfect market,” the credit market is called ‘thin market’, where the bank offers a “price-quantity-package on a leave-it or take-it basis...” (Gowland, 2010, p.1). There are several reasons that justify why loans for business customer are being rationed by a bank (three main reasons are described in paragraphs 6.2.3).
As Pawlowska (1997, p. 1-8) points out, there are different types of influences shaping the loan contract: Interest price terms, non-interest price terms and non-price terms. Interest price terms are defined by the interest rate. Non-interest price terms contain collateral, compensation balances, equity requirements and commitment fees. The third type of influence on the loan contract deals with standards of creditworthiness, long-term customer relationship, borrower’s intended loan use and restrictive covenants. Varying the interplay of influencing aspects leads to two different categories of CR: The so called “weak - or non-interest - price CR” appears when the interest rate is kept constant but the non-interest price terms increase. The other category of CR is “Strict - or non-price CR” which is based on the idea that interest rate and non-interest price terms are kept constant while non-price terms increase. Gowland (2010) suggest more general to differentiate between two additional types of CR: Type I rationing occurs if a bank grants a customer just a proportion of the requested loan. Whereas type II rationing occurs when a banks refuses to grant a loan to a customer at all; even when the customer has apparently the same profile like another customer who has been granted a loan.
The so-called Asymmetric Information (AI) problem occurs between the customer and supplier of financial services (Canals, 2002, p. 307). The bank acting as a lender might not know the real risk when it grants a loan to its customer and a depositor might not be fully informed about the real risk of losing deposited money. In both cases there have been solutions developed to solve or to downsize the insecurity. First for the lenders (bank) security, CR standards (Basel I - III10) and continuous analysis of balance sheets have been developed in order to collect, compare and categorize companies. Concerning the other aspect of the phenomenon, there are institutions that carry out standardised test (e. g. Stress Test of European Banks in 2010) and define rules for banks to achieve transparency for the customers. The Bank for International Settlements (BIS) and the Committee of European Banking Supervision (CEBS) have achieved indicators for a bank’s financial health. One example is the rules on the minimum value of a bank’s capital (Canals, 2002, p.307).
Another problem related to AI is the so called Moral Hazard (MH) problem. It can be explained as the consequential choice of a higher risk project with higher expected payoffs. Most textbooks (e. g. Mullineux, 1992, p. 71-72) explain the MH problem with the underlying assumption that a borrower can go bankrupt in case of project failure. Thus the borrower will at most pay back a proportion of the loan (depending on the limited liability). This assumption might be applicable to very large projects requiring a large loan. Due to the fact that the long term relationship with a bank (especially house-bank relationship) and a borrower’s credit history are important aspects for the availability of reasonably priced loans in the future, it should not be the original aim for a borrower to use loans with higher cost for higher risk projects. Furthermore, SMEs often have multiple small projects that do not lead to a bankruptcy on its own and therefore the borrower (SME) will still have to pay back high cost loans accepted for higher risk projects. Nevertheless, a start-up company financing an innovative idea by the means of a higher cost loan, the assumption that the borrower will go bankrupt might be applicable, supposing the bank grants at all a loan to a new high risk project.
The problem with rising interest rates above the bank-optimal interest rate (where the bank’s average return is the highest) is the attraction of higher risk borrowers (Adverse Selection effect). According to Voordeckers and Steijvers (2005, p.2) borrowers that know their limit of capital costs will reject loans with higher interest rates, but entrepreneurial SMEs or established companies with higher risk investments are attracted. This effect leads to a lower average return for the lender and makes the lending business less attractive.
The risk assessment and risk management is very important when it comes to financing innovations. To assess the risk taking behaviour of entrepreneurs (Pawlowska, 1997) it is important to relate it to the offered loan conditions. As Pawlowska points out, loans offered to higher interest rates are more frequently accepted by enterprises that are funding higher risk innovations and providing lower assets than the inverse. Established enterprises with higher assets and innovations of lower risk are more likely to avoid high interest rates. Furthermore, the risk premium naturally rises within a financial crisis. The banks need to have their own rating system in order to judge investments. In this example, lending money to a SME can be seen as the investment. Therefore the bank rates the lender’s ability to pay back the borrowed money including a provision. Every bank has its own rating system, criteria as well as grade system. According to an in-depth interview with Starke (2010)11, rating systems are concerned with loan behaviour, account behaviour, financial analysis, master data, external data and qualitative factors (grouping). However, a more detailed description of the credit rating process is described later on.
Credit rating agencies (CRAs) are profit-oriented private companies offering financial services. The main service is the assessment of companies from different industries as well as states to assess its financial situation and creditworthiness. The service helps investors and financiers to obtain an impartial impression of the likelihood that an investment succeeds with a profit. Nowadays ratings are a substantial subject to finance - and banking regulations. There are just a number of CRA which are allocated by financial institutions like banking supervisions.
In the inter-banking businesses CRAs play an important role, whereas in the bank-consumer (private and business) businesses this third-party- service is not as important, due to the fact that banks have their own credit rating processes.
The so called ‘credit crunch’ is a phenomenon describing a situation where hardly any loan (investment loan and working capital loan) are available to enterprises. According to the DSGV12 (2010, p. 28), the rising risk premium proofs that the credit market works efficiently concerning risk differentiation. Furthermore, the existence of difficulties to obtain a loan in single cases has been confirmed, but a general credit crunch had not taken place—according to Starke
(2009) . Due to the fact that the real economy and financial markets have international crosslink, the recession was imported even to countries with a healthy, stabilizing financial market structure, according to DSGV. Such a credit crisis is a stress test for the lender-borrower relationship (e. g. with house-banks), proving the dependence on a healthy relationship. Sometimes even a company’s survival can depend on the house-bank relationship, because the banks has detailed information as well as experiences about the potentials and weaknesses ofthe business and might be the only available financier.
Expanding firms (especially entrepreneurial businesses) are likely to utilise non-traditional financing means after the personal resources, such as partner’s share, friends and family credits (“cradle equity”), are utilized (Benjamin, 2005). Figure 1 presents an overview of the major financiers for SMEs. Some of the non-traditional finance options are equity financing through Venture Capital firms, Business Angels13 and governmental loan guarantees. As Benjamin points out, “...early - stage ventures have the best chance for funding, survival, retention of a larger share of venture ownership and control, and long-term success by developing an efficient capitalization strategy to find and approach Angel Investors.” (Benjamin, 2005, P. XXXVIII). According to Metrick (2010, p. 4-7), so called Business Angels use their own capital and tend to focus on younger companies in an earlier stage with smaller investments. Venture Capital firms on the other hand, tend to focus on larger firms that are easier to exit and to take over some control (usually taking over 1 board member position). Both financiers can help to boost product innovations or existing businesses by providing ‘Value-Added Services’ like using their contacts and experience in development, managerial control and distribution.
A major issue for both groups (Venture Capital firms and Business Angels) are information barriers (Mason, 1992). The firm’s owner needs information about the expertise, experience and contacts ofthe future shareholder and the Business Angel needs to assess the risk of investment. According to Goff and Cohen (2010) companies even use other (non-traditional) funding channels to refinance bank loans. Due to a higher equity ratio, the financial structure and a firms Credit Ration is improved.
“Thus, venture capital investment provides the cash to drive innovation forward within small companies at a faster rate than would ordinarily be possible and it provides a rigorous and ongoing monitoring process that responds by killing failure
Figure 1. Major financiers of SMEs
early.” (Barnes, S. in Tidd, J. and Bessant, J. (2009)
Managing Innovation: Integrating Technological, Market and Organizational Change, pp. 446-447)
In order to stabilize a business and make it economically sustainable, the equity ratio is an important ratio. A major factor, influencing the ability to get funds (through an improved credit rating) and overcome a credit crunch, is an equity buffer. The equity ratio is also an indicator showing that a business grows naturally by its own funds. A simplistic definition of private equity as providing “...long-term, committed share capital, to help unquoted companies grow and succeed” is given by Cumming (2010, p. 54). Nevertheless, in the literature the range of application for the term private equity is however much wider than covered by this given definition. Fraser-Sampson
(2009) points out the problematic use of using the term ‘equity’ and ‘unquoted company’ by asking the following questions: “What about investments which are structured as convertible debts... [and]... What about companies which are publicly listed but are taken private?” (Fraser-Sampson, 2010, p.2). These questions lead to the following categorisation of private equity according to Wickel (2010, p. 20): The first category is “direct investing,” which occurs either by an increase of capital or acquisition of shares. The second category is Mezzanine capital occurring by a ‘typical’ or ‘atypical’ silent partnership, subordinated loan or profit-sharing rights. Direct investing offers long - run equity from a determined partnership with a financial partner14. In contrast to bank financing with debt capital, there are no securities required and the financial partner will not just share profits, but also losses. The financial partner has the right to a say in monitoring-, supervisory - and affirmative - matters - depending on the negotiated terms of contract. When the predetermined target is reached, the financial partner has the option to sell its shares to the original owner or other investors (exit strategy). Mezzanine capital is generally speaking a mix of equity and debt, therefore Mezzanine equity and Mezzanine debt can be legally differentiated. When capital is regarded as equity rather than debt the interest rates are higher, but the credit rating improves. In a silent partnership the interest rate and the degree of transparency offered by the firm’s management are relatively high. To sum up, Mezzanine capital is a financing tool that can improve a firm’s capital structure by the right balance of debt and equity; depending on the financial partner’s preferences for risk and control.
New types of short-term SME financing are direct loans from online marketplaces or ‘online social lending communities’. One example of such an online marketplace for businesses in the UK is ‘Funding Circle’ which has been launched in August 2010 (Financial Times, Companies - UK, 13.08.2010, p. 14). This platform offers 1-3 year loans from £5,000 up to £50,000 for expected interest rates of 6-9% (Fundingcircle. com15, 14.08.2010). With lower total cost of finance (annual review fees, monitoring fees and security fees) banks can be undercut (Funding Circle, 14.08.2010). Nevertheless, only borrowing companies that pass the initial accreditation assessment can participate; which make this service appear in a similar light to the lending service of banks. The default rates are expected to be only between 0.6% and 1.5% according to Funding Circle. Furthermore, they are classified in risk categories (‘C, B, A,A+’). The base ofinformation about companies is according to Funding Circle similar to the ones that banks use (e. g. ‘Experian’). Private lenders, as the source of financial funds, cannot just choose the sectors they want to invest in, but also diversify their investment to reduce the overall risk.
The dependence on short-term bank loans seems to be a major problem of SMEs especially in Europe. In a financial crisis, the credit conditions are being adopted for instance by the means of risk premium and collateral requirements. Other alternatives to bank lending should be taken into consideration to reduce this dependence. Nevertheless, bank financing tend to improve by a further developed rating system; looking at a single organisation rather than generalising it as part of a branch. Therefore SMEs with a unique selling point or product innovation are more likely to be granted a loan. However, there are alternatives like Direct Loan Markets and Equity and Mezzanine Financing. A main problem making financing of SMEs more difficult is the information barrier. With the tax - saving transformation of profits into inventory provisions and accruals, the assessment of these positions and a company’s credit rating is sometimes rather difficult. To improve a company’s bank lending, a reliable house-bank relationship, in which a borrower complies with the information assessment requirements, has to be established. Similar to bank financing, direct investments and equity financing require a management ofinformation and a transparent decision making structure to be attractive to investors. Once this information barrier is vanquished, the SME can profits from synergy and expertise to support its strategic development. The financial structure and credit rating can be improved by Equity - and Mezzanine Financing.
Future research should address the problem of achieving transparency of risks and opportunities related to innovations in the early stage. Furthermore transparency is needed in the financial structure and evaluation of inventory and accruals. A survey (e. g. an in-depth interviews with manager of SMEs) could help to clarify why traditional financing options are more employed than non-traditional; with a differentiation between European countries and the USA. In order to improve the accuracy and efficiency of governmental support programmes, new branch characteristics on the base of the Bolton Report should be defined.
This chapter presented various definitions of SMEs, with qualitative (personalised management, market share, independence of decision making) as well as quantitative (e. g. number of employees and turnover) characteristics. With a focus on various markets, different approaches to differentiate business types have been described. Different sectors do not only have different numbers of employees and turnover, but also differences in the management structure and decision making process. It can be concluded that the term SME is defining a diverse group of heterogeneous firms. Due to the fact that firms sometimes source-out departments or cooperate closely with legally independent units, a low level of differentiation can adulterate statistics about SMEs which are based on threshold criteria (like turnover and number of employees). Therefore it is important to look at legal units with a clearly defined structure; where allocation of resources and financial ratios are possible.
The major financiers of SMEs are Private Investors (e. g. Business Angels), Private Banks, Non-Profit Banks, Governmental organisations (Funds, Guarantees) as well as Asset and Invoice Financiers. Due to the fact that bank financing is still very common for European SMEs, the rationale of credit rationing in the credit market has been described. In contrast to the consumer market equilibrium, the credit market equilibrium is not defined by demand and supply. In order to maximise the profit from the lending business, a bank will define and adjust lending conditions. There are 3 major phenomena that occur in the credit market: Asymmetric Information, Moral Hazard, and Adverse selection. The Asymmetric Information problem occurs when the bank acting as a lender does not know the real risk of losing its deposited money when granting a loan. Therefore, Credit Rationing standards (e. g. Basel I-III 10) have been developed to reduce this risk. Another phenomenon is the so called Moral Hazard problem. A borrower will consequently choose the higher risk project with higher expected payoff when the loan costs are high as well. The assumption that a borrower is likely to take the risk of going bankrupt in case the project fails and will therefore not be able to payback the loan; is limited applicable. SMEs have to maintain a long run relationship with their so called ‘house-bank’ and have often multiple proj ects. However, for an entrepreneurial business the success of the first projects might be critical and therefore the Moral Hazard Problem is applicable. The third phenomenon is the Adverse Selection effect, which states that an established firm which is aware of its ‘ appropriate ’ capital costs will reject a loan if the lending conditions do not reflect the perceived project risk. Therefore only firms with higher risk investments are attracted.
The loan contract is influenced by: Interest price terms, non-interest price terms and nonprice terms. Interest price terms are defined by the interest rate. Non-interest price terms contain collateral, compensation balances, equity requirements and commitment fees. The third type of influence on the loan contract deals with standards of creditworthiness, long-term customer relationship, borrower’s intended loan use and restrictive covenants.
The credit rating of a firm is crucial because in some cases it can decide about the existence of the firm; due to the dependence on bank financing. The credit rating system of banks rates the lender’s ability to pay back the borrowed money including a provision. Even though rating - and grade systems differ from each other, most of the systems take loan behaviour, account behaviour, financial analysis, master data, external data and qualitative factors (a firm’s grouping) into consideration.
Non-traditional financing is especially attractive to expanding firms, but also firms with insufficient cash-flow. Some ofthe non-traditional finance options are equity financing through Venture Capital firms, Business Angels and governmental loan guarantees. However, the limited use of non-traditional financing can be explained by the organisational structure of a ‘one-man - show’ often to find in SMEs and a conservative attitude towards publishing confidential business information (information barrier). Further details about ‘SMEs and non-traditional financing’ are described in the next chapter.