The issue of “The funding gap” is frequently cited as a major challenge for startup and emerging small businesses. Is there any evidence to support this viewpoint, and what measures have relevant organizations taken to address the problem?
The purpose of this report is to analyze the external funding methods of young small businesses and start-up businesses. It focuses on three main aspects. Firstly, it explores the concept of the funding gap and provides evidence of its existence. Secondly, it examines the efforts made by organizations that provide funding for new and small businesses to address this issue. Lastly, it evaluates the effectiveness of these initiatives. The report follows a structured format.
- 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
Starting your own business comes with numerous challenges, with raising capital being just one of them. Throughout history, securing external funds has consistently proven to be a difficult undertaking. In fact, this issue is not a recent problem. The Macmillian Committee was the first to acknowledge this funding challenge, labeling it the Macmillian Gap back in 1931. Today, P Burns & J Dewhurst define the funding gap as the situation where a company’s funding needs exceed what can be provided by small-scale finance providers but are not significant enough to attract large equity providers.
The funding disparity is a common issue faced by startups and new companies. In fact, it is commonly acknowledged that it is more challenging to secure £50,000 for a new company with no track record or collateral compared to raising £5,000,000 for an established firm. The existence of information asymmetry is often attributed to the emergence of this funding gap. This occurs when the entrepreneur possesses superior information about the company’s performance as compared to the bank, leading to difficulties in decision-making.
Information asymetrics can result in two outcomes. The first is adverse selection, where banks struggle to differentiate between new firms with the highest returns and the level of risk they carry. This makes it difficult for banks to rely on the price mechanism to distinguish between the firms. The second outcome is moral hazard, which occurs when banks employ higher interest rates (due to lack of collateral) to compensate for risk. This gives loan-receiving firms an incentive to modify their behavior and pursue riskier projects.
Many face challenges in obtaining smaller funds compared to larger ones as banks typically require collateral, which can be difficult for new firms with limited funds but viable plans. This exclusion often leads to a funding gap for these firms. The main issue is that the information imbalance between banks and SMEs obstructs market clearance through price adjustments. As a result, banks are inclined to limit credit instead of increasing interest rates when there is a higher demand for loans.
The BOE report discusses the decrease in the funding gap and recognizes that 50% of start-ups fail within three years. It is worth noting that in 1999, there was a shift away from depending on debt for funding, which led to the emergence of alternative funding options. The chart below from source6 demonstrates this shift in funding sources.
Obtaining empirical evidence to support the presence of market imperfections is limited due to challenges in obtaining information about failed start-ups. Consequently, a comprehensive understanding of the situation based solely on data from successful businesses becomes difficult. The available evidence suggests that financially constrained companies are typically small, young, located in the manufacturing sector, and exhibit below average profitability.
Contrary to traditional beliefs, technology-driven companies like dot coms have witnessed a notable increase in funding followed by a subsequent decrease. This suggests that the funding gap is often influenced by unpredictable factors such as trends and optimism rather than moral hazards, information asymmetry, historical patterns, or collateral. Nonetheless, regardless of the underlying causes, it is clear that the gap has decreased recently.
Recent developments in the financing of small firms indicate a consistent enhancement in the provision of financial services for this market. Nonetheless, given the sustained economic expansion, distinguishing between improvements stemming from structural alterations in financing and those arising from more favorable trading conditions is challenging. The current deceleration in economic growth will serve as a test to determine the durability of these advancements.
Here, we review organizations that provide funding to SMEs and examine the measures they have taken to address the funding gap. The Bank of England (B.O.E.) has not directly assisted SMEs but has instead fulfilled its typical role of guiding the economy. However, it has produced reports on the sector from different perspectives, benefiting both lenders and borrowers.
The Department of Trade and Industry, a government entity, supervises different support mechanisms. One such mechanism is the Small Business Services group (SBS), which will commence operations in November 2000 in collaboration with regional development agencies. The government has specifically directed its policies towards addressing the requirements of small and medium-sized enterprises (SMEs). Funding has been allocated primarily to technology-based and other high-growth industries, aiming to foster a favorable business environment. These companies typically heavily depend on knowledge as their main asset, making them challenging to measure.
In 1981, the DTI created a scheme with the objective of improving debt finance accessibility for viable firms. These firms face difficulties obtaining conventional finance due to a lack of history, collateral, or both. During 1998/99, the scheme guaranteed a total of £189 million through 4,482 loans. Established businesses can receive up to £250,000 in loans while start-ups can access up to £100,000.
The act, set to take effect in November 2000, permits companies to request interest from both small businesses and larger firms/public sector. Presently, numerous companies exercise their ability to impose interest charges, and this pattern is expected to persist after November 2000. The act holds importance in the process of credit management.
The article discussed the changes in small firms’ financing patterns over the last decade. It was observed that small businesses are now financed in a more suitable manner compared to the early 1990s. They rely more on internal sources of finance, with many small businesses actually having more funds in the banking sector than they borrow. Additionally, businesses that do need external financing now utilize a broader array of financial products. However, it is worth mentioning that traditional bank finance still remains the primary external source of funding.
Market competition plays a crucial role in creating and sustaining the drive for improvement in the finance sector for small businesses. While the industry of bank finance for small firms is concentrated, advancements in technology are leading to increased competition. However, one area that lacks improvement in terms of financial support is the availability of risk capital for small firms specializing in technology.
Challenges arise during the initial stage of a business, as there is a lack of funding in the form of seed capital and early-stage equity finance. Most formal venture capital firms do not invest small enough amounts to support these companies, and the informal venture capital market, such as business angels, is still not well-established in comparison.
