The 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 SMEs are an important contributro to the economy, defined by the Bank of England as 49 employees or fewer1.

In 1997 SMEs accounted for over 40% of the economys 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.

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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 SMEs. 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 SMEs 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 SMEs 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 governments 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 ” SMEs 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 smes 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 Mo …

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