“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?
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
- 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 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”.
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 been 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 furer 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 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.
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.
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 resultingom 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.
Organisations that fund SME’s are now reviewed here. In particular what steps they have taken to helkp close the funding gap? 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.
The government’s own Department of Trade and Industry is an umbrella for a whole range of support mechanisms.Some are listed below. 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.
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 taling £189 million. Here the maximun loan is up to 250 ,000 for established business and for start ups 1000,000 .
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 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
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 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