FREE ESSAY ON SMALL BUSINESS FUNDING GAP

SMALL BUSINESS FUNDING GAP

"The Funding Gap"
Due Date: Wednesday November 1st, 2000
The question
"The funding gap" is always quoted as a major issue for dstart up and developingh small
businesses. What evidence is there to support this view and what measures have relevant
organisations taken to overcome the problem?
Executive Summary
This report critically examine concerned with how young small businesses and start up
business fund themselves externally. Firstly we look at the funding ga,p what it is and
evidence of its existence. Secondly, how organisations that fund new and small
usinesses have done to help this problem and finally a reivew of their usefulness. This
is done in a report style
Abbreviation list
BOE; Bank of England
SME; Meaning small - medium enterprise. For the sake of this report it is taken here to
mean both business that are new or business that are still in the developing stage.
DTI: Department of Trade and Industry
Part 1
SME's are an important contributro to the economy, defined by the Bank of England as 49
employees or fewer1. In 1997 SME's accounted for over 40% of the economy's turnover and
45% of total employment in the United Kingdom 2 The chart below reveals a b
akdown of industry where sme are located including area as well. Source; bvca.co.uk
Starting your own busines rasises many difficulties and raising the capital is just one
of them, listed below are the main problems encountered. Throughout history, seeking
external funds has remained one of the most difficult. Indeed this is not a ne
problem The Macmillian Committee first regcognised the funding issue dubbing it the
macmillian Gap in 1931. Today the funding gap can be defined by P Burns & J Dewhurst3
as:
"where the funding requirements of a company are greater than those that can be met by
the small scale providers of finance, but not substantail enough to be considered by the
large equity providers".
Source; Small Business Finance Report BOE Oct 2000
Evidence of the Funding Gap
The funding gap is prevelant with start ups and new firms. Indeed it is often known that
is harder to raise ?50,000 for a new firm with no history or collertaal than it is to
raise ?5,000,000 for a established firm. 
Information asymmetrics is often blamed for creating the funidng gap. This is when the
entreprenurer generally holds better information regarding the firms performace than the
bank for making decisions. 
Information asymetrics can lead to two developments. Firstly, adverse selection, The
banks cannot distinguish which new firm has the highest returns relative to the degree of
risk, they have trouble adopting the price mechanism to help distingusih be
een firms . Secondly, moral harzard, where (in the absence of collertal) use of higher
interest rates by banks to offset risk would give firms receiving loans an incentive to
alter their behaviour to adopt risker projects. 
These two reason reveal why it is harder to obtain smaller rather than larger funds.
Banks requuire collertal in responce to these problems. However this often excludes new
firms who lack funds despite viable plans. Therefore many fall into the fundi
gap. The central hypothesis is that the market is not cleared through the price
adjustments because of the asymetry of information between banks and SME's. So banks have
an incentive to respond to an increased demand for loans by rationing credit fur
er rather than by raising intereset rates.
Also with new start ups having a 50% failure rate4 with the first three years funders can
be generally reluctant to fiance such a propsotion.
The funding gap questioned.
The BOE report5 however states that there has been a decline in recent years of the
funding gap. 1999 saw a trend away from debt reliance as new source of funding appeared.
Below is a chart from6 showing the change of funding sources.
Source: Bank of England see footnote 6.
Empirically their is little evidence for the existence of such market imperfections.
However this is only based on partial facts because it is difficult to obtain information
on failed start ups . Therefore with information from only surviving firms 
is not easy to determine the full picture. 
What evidence their is suggests that the most finance constrained businesses are
relatively small young located in the manufacturing sector and of below average
profitability. This does sound risky and hence it is unclear whether the terms attached
to s
h lending are unreaosinable in relation to the extra risk.
On the other hand, technology driven firms such as dot coms have seen a dramatic increase
in available funding only to has this fall again. Therefore 
it could be that the funding gap is often related to fickle resaons like fashion and
optisism rather than jsut moral hazards, information asymmetrics, history or collertral.
However regardless of why the gap has appeared it is apparent that the gap has declined
in recent years.
More recent trends in small firms financing suggest that there has been a steady
improvement in how finance providers service the market. However, against a background of
sustained economic growth, it is difficult to distinguish improvements resulting 
om structural changes in the financing of these firms from those resulting from better
trading conditions. The recent slowdown in the growth of economic activity will test the
robustness of the improvements.
Source: DTI Website Oct 2000
Part 2
Organisations that fund SME's are now reviewed here. In particular what steps they have
taken to helkp close the funding gap?
Bank of England
The B.O.E. has not played a direct hand in helping SME's but instead taken its usual role
in sterring the econmony accordingly. 
Also it has published reports on the sector from varying angles hence helping both
borrower and borrowee.
Government Support
The government's own Department of Trade and Industry is an umbrella for a whole range of
support mechanisms.Some are listed below 
Small Business Services 
The Small Business Services group or SBS set to start in November 2000 working with
regional development agencies. Here government policy has focused on the needs of the sme
sector. Special attention has been given to funding technology based and oth
high growth industries with a strong emphasis on businesss culture. These firms in the
past have liitle collertol reling on knowledge as their main asset and hence diffcult to
quantifly. 
Small Firms Loan Guarantee Scheme (SFLGS)
This scheme extablished in 1981 by the DTI has aimed to improve access to debt finance
for viable firms unable to able for conventional finance due to lack of history or
collateral or both. During 1998/99 4,482 loans were guaranteed under the scheme t
aling ?189 million. Here the maximun loan is up to 250 ,000 for established business and
for start ups 1000,000 .
Source: Federation of Small Business " SME's and the Economy 1998.
Late Payment of Commerical Debts Act 1998.
To be implemented in November 2000. This act will able firms to claim interest from other
small business, rather than only larger firms and the public sector. Many firms now
excersie their right to charge interest and many more are likley to do so from
ovember 2000 onwards. The act plays a important role in the credit management process.
The Alternative Investment market
The Alternative Investment market raised ? 933 million with the goviernment keen to
encourage entrereprenship in this area. This investment is usually only viable for hi
tech firms that are faily established.However the rise and fall of dot coms has l
t this market over valued currently.
Forums
In recent years there has been a increased interested in forums being held. Recently the
Ethnic Miniority Business Forum7 was held in July 2000 and the Connecting Creativity with
Capital 8held in November 1999. These forums spondered by various public
nd some private sources allow information and funds to be shared.
Equity finance 9
Accounting for just 3% of external finance for sme's between 1995 -1997, venture capital
is a small player. The formal venture sector invested nearly ?5 billion in over 1300
firms during 1998. But only 288 went to start ups and early stage develeoment. 
e mainly to the level of available agggregate returns, high transactionss costs
associated with making an investment and the subsequent monitoring costs. Despite issues
of liquidity, depth of markets and vaulations theis type of funding is geared towar
high tech firms such as dot coms.
Business angels 
More prevalent in the USA than in the UK. These business angels are specific individuals
who wish to become involved in the financing of higher risk projects. They are usually
motivaed by a desire for some form of control and profit in return for fin
cing the firm. It is bellieved their are 18,000 business angels in the uk offering 500
million annunally.10
Banks 
Debt finance is the traditional route for sme of external finance with overdrafts and
loans as their main tools. Despite their decline in recent years the still play the
largest role. The banks characteristics have changed considerably in the 1990's. K
changes include shift towards technology orientated banking delivery systems ie internet
and phone banking. Trade credit, asset based and receivables finance play an big role.
Factoring has doubled between 1991 -1999.11
The structure of bank lending has also shifted, away from short-term variable-rate
lending and towards more term finance. The ratio of overdraft to term lending has fallen
significantly, from 49:51 in 1992 to 31:69 in 1998, and fixed-rate lending has ri
n from 28% to 33% of term lending since 1996. See chart below. This has addressed one of
the problems highlighted by the early 1990s recession -small firms' over-reliance on the
overdraft facility to finance anything from working capital to long-term in
stment projects-and has reduced the vulnerability of small firms to the economic cycle.
Banking and Finance Issues
Source: DTI Website
Biliography
Books
Small Business Guide Lloyods Bank By Sara Williams. 1996 Edition, Penguin Books. Chapter
5 Financial Preparation And Control. pages 268 - 334.
Innovation and Entrepreneurship by Peter Drucker Butterworth-Heinemann. 1995 Chapter 15
The New Venture, pages 172 - 191 & Chapter 16, Fustest with the Mostest
pages 193 - 203. 
An Introduction to Strategic Financial Management by David Allen. Kogan Page Publishing.
1997 Chapter 2 Finanical management pages 27 -38.
Paths of Enterprise - The future of Small Business By J Curran & R Blackman. Routledge
Publishing. 1991
Chapter 8 - Small businesses and thier banks in the year 2000 pages 149 - 163.
Small Business and Entrepreneurship, Second Edition by P Burns & J Dewhurst. Macmillian
Press. 1996. Chapters 7 Venture Capital pages 131 -166. Chapter 8 Franishing pages 166 -
180.
Handbook of Entrepreneurship Edited by D. Sexton & H. Landstrom. Blackwell Press. 2000.
Part 111 Financing Growth, pages 195 - 283.
Websites
www.venturesite.co.uk
www.bvca.co.uk
www.govgrants.com
www.otech.fi.incubator.html
wwwfinanceforbuisiness
www.venturesite.co.uk
www.entreprenuers.about.com
www.dti.gov.uk
www.bankofengland.com
Newspapers
Sunday Times 22nd October. Financial Section - Article 
Small Business suffers from red tape. page 3
Guardian Thursday 12 October Money Section - Interest rates affect business page 21
Reports
Bank of England Report on Financing for Small Firms year pages etc.
Barriers to growth
Section 3
This section looks at whether relevant organisations have been useful in reducning the
funding gap? In general SME's have become markedly become less dependent on external
finance. Recently published research has shown that only 39% of small businesse
sought external financing of any kind between 1995-97, compared with 65% between 1987-90.
12 Listed below are bullet points of the usefullness of the relevant organisations.
Business start-ups rose rapidly in the 1980s, as a result of a combination of government
schemes and deregulation of credit controls. Small businesses are now more appropriately
financed than in the 1980s, using a wider range of financing sources. Th
are no longer so dependent on overdraft financing, and rely more on committed funds, with
fixed repayments.
Individual small business banking codes of practice have lead to a open, two-way
relationship between banks and small businesses. This has benefited small
businesses-research by the Forum of Private Business13 shows that SMEs that had developed
a more 
ticipative relationship with banks were obtaining lower charges and collateral
requirements. 
Banks now have better warning systems in place to detect at an early stage whether
businesses are encountering trading difficulties. Small firms are more prepared to share
information with their banks. Better relations and a greater degree of co-operati
should help to avoid some of the strains of the previous recession, which contributed to
increased business failures and seriously affected the reputation of the banks.
Small firms are now assisted by a wider network of training and support agencies, such as
Business Links, TECs and Chambers of Commerce.
The providers of bank finance to small businesses operate in a concentrated industry. The
four main English clearing banks account for 84% of the market, with NatWest and Barclays
together accounting for 48% of the total (see Chart below). However, tho
h the overall market share of the Big Four has remained fairly stable, the market shares
of the individual clearing banks have changed significantly over the 1990s: NatWest and
Barclays have lost market share to Lloyds-TSB and, to a lesser extent, Midla
. This trend is even clearer in market shares of lending to finance start-ups. With
fierce competition for lending funds the customer ie the sme can only benefit . 
Source: Bank of England Website.
Venture capital looks set to remain stable with little growth. . Some recent research 14
suggests that UKentrepreneurs establish their own businesses partly because of a desire
for independence. This contrasts with a more overt wealth-creation motive i
he United States, and the desire for expansion in Europe. This attitude was highlighted
in a survey carried out by the British Chambers of Commerce, 15 which reported that only
one third of UK businesses were prepared even to consider using external eq
y finance. Research by Manchester Business School on private companies showed that the
desire to maintain ownership is particularly evident among family-owned businesses ( See
chart below) These figures provide some support to the 'pecking-order hypothe
s' of finance16 .According to this, equity finance tends only be sought when internal
resources and debt finance have been exhausted (perhaps leading to over-gearing). At this
point, businesses will decide whether they would rather remain at their curr
size and maintain complete ownership, or give up a degree of ownership in return for
further growth.
Source: The financial Affaiors of Private Companies, Manchester Business School 1998
Business angels are also failrly small scale in the UK. The main barrier to business
angel investment, which applies to all firms, is the lack of information on investment
opportunities. Business angels operate most effectively through local networks (
geographical considerations are important), and adopt a hands-on approach to their
investment, offering the benefit of their expertise as well as their financial
commitment. However, some locally based business angel networks cannot achieve sufficient

itical mass to become viable.
Conclusions
The article examined how the patterns of small firms
financing have changed over the past decade, . It
was noted that small businesses are now more appropriately
financed than in the early 1990s. They are more dependent
on internal sources of finance-with many of the smallest
businesses being net creditors to the banking sector-and
businesses that do require external finance now use a wider
range of finance products. Traditional bank finance does,
however, remain the most important source of external
finance for small businesses.
Market competition in the provision of finance to small
firms was identified as a means of facilitating and
maintaining the momentum for improvement. The
providers of bank finance to small businesses operate in a
concentrated industry, but the degree of competition in this
market is increasing, because of technological changes and
new entrants.
One area where improvement in the provision of finance is
less evident is in the supply of risk capital for
technology-based small firms. Problems appear to arise at
the start-up stage, where supplies of 'seedcorn' and
early-stage equity finance are limited. Many formal venture
capital firms tend not to invest in small enough amounts for
these companies, and the informal venture capital market
(business angels) is still underdeveloped compared with that
in the United States.