Small SMEs in Business

1. Introduction:

It is well known that a Small-medium enterprise (SMEs) plays a very important role in the UK economy. It is boosting productivity, increasing competition and innovation, creating employment and prosperity and revitalising communities. According to the statistical press release by The Department for Business, Enterprise and Regulatory Reform (BERR), there were an estimated 4.5 million business enterprises in the UK, which contributed 2,600 billion combined annual turnovers and 22.4 million employments (58.9 per cent) in the UK. At the start of 2006, an increase of 125,000 (2.9 per cent) on the start of 2005, among them almost all of these enterprises (99.3 per cent) were small (0 to 49 employees) 27,000 (0.6 per cent) were medium-sized (50 to 249 employees) and 6,000 (0.1 per cent) were large (250 or more employees), (BERR, 2006).

Although the importance of SMEs to the UK economy continues to grow, unfortunately so does the barriers to finance at the start up and to grow and run the business and burden of regulation, imposes rules, and so on. Like any other business, small businesses need finance to start-up and to grow their business but SMEs are still facing various problems to raise the finance and to get access to various commercial finance. Bank is the only main external source the SMEs has been utilising so far but still SMEs cannot able to secure conventional commercial loans for various reasons. Consequently, there is also an increase interest in SMEs by the side range of sectors like financial markets for SMEs funding, government and policy makers. However, the access to finance often remains one of the main factors existing in SMEs, especially in start-up and developing stages. Currently there are a number of recent papers which have discussed the financial problems for large and public companies but seldom for SMEs. Therefore on my research, I will explore and investigate whether Small businesses face difficulties in gaining access to various types of finance and other alternatives and identify market failure as a barrier for SMEs. The proposal for this research process has been designed as illustrated, in chapter 2, we will be discussing about the critical evaluation of the literature review and chapter 3 describe proposal methodology.

2. Literature Review

2.2 Introduction

During the 1980s SMEs have dramatically increased in the UK, and internationally. Bolton Report in 1971 has suggested that SMEs are the independent which has got a simple management layout, manages in a personal manner and has a small share of the Market, (Bolton Report 1971). At least since 1931, the MacMillan Committee (1931) first rose the issues regarding SME's financial needs are not well served by existing financial institutions. MacMillan Committee reported that it was extremely difficult for SMEs to get less than 200,000 as long term capital; this funding problem is well known as 'MacMillan Gap', (Storey, 1994). Over the following sixty seven years, there has been a huge progress in the institutional framework for financing small firms.

This research will explore and investigate different kind of funding available to small business, and the circumstances under which these should be approached as well as we will recognize the financial problems that small business are likely to encounter. This research will also evaluate finance gap and equity gap act as a barrier to growth for small business and identify key financial issues facing the entrepreneurial small businesses.

2. 2 Sources of finance

2.2.1 Financial growth life cycle

According to Berger and Udell (1998), small medium firms might have gone through financial growth life cycle where financial needs and options change as the business grows, gains further experience, and becomes less informational opaque. Weston and Brigham had noted earlier in 1978 that the financial growth life cycle emphases the different sources of finance throughout various growth stages of the business. Since firm's inception, funds are primarily provided by founder, family and friends which referred to as the '3Fs' (Deakins and Freel, 2006). As businesses grow, they might gain access to intermediated finance on the equity side (venture capital) and on the debt side (banks, finance companies, etc). If the firms keep growing and expanding, the entrepreneurs may seek finance in public equity and debt markets (Berger and Udell, 1998). Berger and Udell also point out that this financial growth life cycle is not intended to fit all small businesses and that firm size, age and turnover.

2.2.2 Bank Finance

People start business with a motive to make money, but before the owners can start making money, they need to have enough cash to run the business. There are many sources of finance in the UK for SMEs and at the same time there are difficulties enterprenreneur may face in seeking finance to start and develop a business. I am introducing you the various kind of finances which are available to SMEs and key financial issues entrepreneurial are facing in their small businesses in the UK.

The most important source of start-up capital comes from entrepreneurs and owner-managers themselves as their own retained profits, savings, remortgages, or perhaps money raised from the 3 Fs' family, friends and fools, (Deakins and Freel, 2006). The research done by Harding (2002) shows that businesses in the UK receive 20,000 in start-up finance, 10,000 from personal investment; 5000 from family and friends; the remainder are from external sources. External finance can be drawn from number of sources when internal finances are no longer sufficient.

Bank lending is one of the primary external sources. Entrepreneur can get lending through high-street bank branches that provide short-term debt finance and overdrafts. It might be easy to get a bank credit for consumer goods such as car, home appliances, but it is still not the case for SMEs. Many SMEs that need credit to expand businesses come to a dead-end when the owners of the businesses have to fulfil various requirements. Bank ensures whether the owner has a good personality, his business condition, and capability to run the business, and most importantly whether they have enough collateral to cover the loans.

SME's in UK find their main source of external finance mainly through bank. Even though bank finance leads an important role, there's always a regular lack of reluctance to lend money. It comes through high bank charges and poor service. This confirms more from the statistics gain by the survey federation of small businesses in 2000. It contains 22000 of UK members and 70% were already disappoint with the charges levied by banks. Previously in 2000, the Cruickshank Report (Cruickshank, 2000) has discovered, more than a million of small businesses were being overpriced by their own banks and figures recognise up to 550 million a year. However the clash between banks in UK is still high. In fact 5% of customers each year change banks. It is because they do not identify, the other bank is any better than the bank, they actually on. Perhaps of the high switch costs related with changing banks.

On the other hand, before bank makes any decision about granting any loans, they need to get the financial information and personal interviews of SME owners. Those are the most significant basis of information they need to check before granting any loan.

According to the ACCA research report ...... , the latest results from the Bank of England proves, Nowadays access to debt finance is not that hard. Members of UK small business organisations are not worry about the entry to bank finance. The Small Business Research Centre's European Survey for Lloyds TSB found that access to finance was a constraint on growth for only around 1% of businesses. Since the SFLG has established in 1981, ACCA decides the finance market for SMEs has become more vibrant.

2.2.3 Small Firm Loan Guarantee (SFLG) scheme

Successive governments have acted to help the funding of small businesses of several schemes. Along with is the Small Firm Loan Guarantee scheme. One of their main responsibilities is to assist tackle the financial barriers SMEs face when starting their businesses. SFLG was launched by the government in 1981. It helps small firms who cannot provide required security for their debt or does not have the track record to convince the bank to lend. The SFLG covers 75 per cent of the lender's exposure, with the borrower paying two per cent premium to the government. According to Stokes and Wilson 2006, since 1981 approximately 92,000 loans have specified over 88,000 businesses. The government agrees to guarantee a bank loan, in return for which the borrowing firm has to pay a very high interest rate. The terms and condition have varied considerably over the years. Loans are available in the period of between two to ten years on a sums from 5000 to 100,000 (250,000 if the business has traded more than ten years) SFLG guarantee 75 per cent of the loan and in return, the borrower pays DTI presently BERR, premium of two per cent over the commercial terms of the loan. To entitle for a SFLG, SME should be an UK company with an annual turnover of no more than 3 million and 5 million if the company is a manufacturing company.

However SFLG is a very reliable government scheme, it is still facing criticism. Banks are reluctant to use the scheme, because it is extremely bureaucratic and expensive to administer. So as the interest rate it highly premium.

Recently the scheme has reviewed and where approvals are published in September 2004 (Graham, 2004). The scheme will now be focus when the beginning of the business and young businesses. Between these two groups it is identified, who is unable to raise money due to lack of collateral assets and the business track records. In future lender will make a lending decision without any approval from the small business service.

2.2.4 Leasing and Hire Purchase

A more flexible alternative for borrowing is to use hire purchase (HP). After bank loan and over draft, the leasing and HP represent the second most important source of finance.

The leasing allows SMEs to acquire the relevant equipment, machinery and transport without possessing them. The ownership is hold by the l easing company, however in many cases there is a purchasing option during the leasing period. The finance lease is a financing agreement whilst an operating lease is a rental agreement. In operating lease, the lessee hires the assets for a period of time which is considerably shorter than the actual life of the assets. Hence the ownership of the asset is remains with the lessor. Extensively in Finance lease transfers all the risks and the rewards of an asset to the lessee.

HP lets the purchaser, to start using the asset once the instalment has paid. After the payment of agreed number of instalments with the interest charge, the ownership will be transferred.

2.2.5 Alternative Investment Market (AIM)

AIM was established in 1995. Its objective is to open the doors for SMEs to get access to a secondary equity market in the London Stock Exchange (LSE). In this way, SMEs are capable of admission to the market in a primary stage in order to achieve its experience as a public company , however the rule of listing are difficult therefore less expensive.

2.2.3 Reasons why SMEs financing different from large enterprise

There are distinct differences between the financing of small firms and of large quoted companies

2.2.4 The Pecking Order Theory

Pecking order theory suggests that external funds are only necessary when internal funds are no longer adequate. Myers and Majluf (1984) argued that the information asymmetry that exists between a firm's manager and the finance market results in pecking order when choosing among the available sources of funds. According to pecking order theory, as developed by Myers, firstly small firms prefer their investment with funds internally generated, namely retained profit, depreciation expenses or even can get an internal financial support from family, friends and fools. Secondly firms base the dividend payout ratios on the future investment opportunity set and their expected cash flows; thirdly payout ratios tend to be sticky in the short term, so in some years internally generated flows will be enough for financing company needs and in some years not; fourthly funds obtained in years of financial surpluses, after payment of dividends and financing, are directed to finance short-term financial investments or to reduce debt. When there is a financial deficit, firms will seek external finance: first debt, then hybrid securities like convertible bonds, and finally equity issues.

3 capital market

In a perfect capital market, sufficient capital is always available for businesses that require funds for growth and expansion. Small Business Services states that, the UK has well-developed and dynamic financial markets that are argued to be amongst the most efficient in the world (SBS, 2004, p1). However, the fact that some small businesses find it difficulties or problems experienced by the small business owner and entrepreneurs in accessing finance is the concept of market failure, (Stokes & Wilson, 2006). It is increasingly recognized that SMEs access to finance are hampered by a number of market failure. Market failure has been explained predominately in terms information gap along with its adverse selection and moral hazard effect (Storey, 1994). Stokes & Wilson, (2006) have mentioned two main types of market failure in the literature on SMEs finance they are illustrate below.

3.1 Finance Gap

Historicity, it was first bought to wide attention by the MacMillan Committee report on finance and industry in 1931. Finance gap does exist because demand for the small business is higher than the keenness of various financial and commercial institutions to supply the finance at the current market conditions.

3.2 Equity Gap

3.4 The Government Role

According to annual report of BERR published in 2006-07, there are 4.3 million SMEs in the UK and Government has important role to help tackle the barriers enterprises face in the starting of the business as well as in the growth of the business. Successive Governments have acted to assist the funding for a growth and development small businesses by creating and supporting various financing scheme. According to the press notice published HM Treasury, Government budget 2008 introduces a package of measures to support small businesses access the finance and resources they need to start up and grow, responding to business needs.

For example, the small firm loan guarantee scheme was introduced in 1981 to help small businesses to seeking finance with a viable business proposal but unqualified fro bank debt on commercial terms. Recently, the UK government temporary has increase of 20% in the amount of finance available through the SFLG scheme, and relaxation of the restrictions on firm age to allow access to the scheme for a wider range of small firms.

A new capital fund primarily focused on businesses run by women.

3.4 Purpose of the study

By analysing literature of SMEs finance, it is concluded that small businesses are still facing number of financial constraints, especially in seeking external finance by comparing with large companies. Because of information asymmetry, newly born and growth firms facing difficulties in rising various finance for the business. Because of lack o assets to put as a collaterals and lack of track record, SMEs are having difficulties from various finance providers. Small firms cannot raise capital on a stock exchange because majority of are sole trading, partnership or private limited entities, (Collis and Hussey, 2007), which is drawback to SMEs and well knows as finance gap or market failure. In recent years, most governments are playing active part in to get rid of finance gap by introducing various programs and schemes.

With the help of literature review this research is going to investigate experiences on how SMEs actually finance and explore whether there is evidence to conform the theories related to SMEs finance.

◊ What are the different kind of funding available to small business, and the circumstances under which these should be approached as well as we will recognize the financial problems that small business are likely to encounter?

◊ What are the differences between theoretical and reality in access to finance for small business at its start-up, business growth and expansion?

◊ Should SMEs use 'Pecking Order Theory' to get access to external funds?

◊ Is the 'financial gap' truly appeared from the capital market failure that exists in the equity and debt markets?

Hence, the research objectives stated above will examine how well those theories explain the SMEs access to finance in the experiences.

4. Methodology

4.1 Introduction

This chapter provides a background on the research methodology with an overview of how the research will be conducted and the reasons why these techniques will be employed. The research questions for the proposed study will address are:

◊ What are the different kind of funding available to small business, and the circumstances under which these should be approached as well as we will recognize the financial problems that small business are likely to encounter?

◊ What are the differences between theoretical and reality in access to finance for small business at its start-up, business growth and expansion?

◊ Should SMEs use 'Pecking Order Theory' to get access to external funds?

◊ Is the 'financial gap' truly appeared from the capital market failure that exists in the equity and debt markets?

4.2 Research Methodology

The methodology for the research depends on the researcher's paradigm, whose terms refers to the progress of scientific practice based on people's philosophies and assumptions about the world and the nature of knowledge' and offer a framework comprising an accepted set of theories, methods and ways of defining data' (Collis and Hussey, 2003, p. 46). The design of the proposed study is based on a phenomenological paradigm. There are many methodologies identified for the phenomenological paradigm such as action research, case studies, ethnography, grounded theory, and so on. This research design is based on a case study. Case study is an 'extensive examination of a single instance of a phenomenon of interest' and is used in areas 'where there are theories or a deficient body of knowledge' (Collis and Hussey, 2003, p. 68). The purpose of the case study used in this research is to obtain data or information from entrepreneurs in the situations of access to finance. In this research, there sole traders or limited companies will be selected around the London city as the case study, located within a restaurant, motorcycle Ltd., and Gazette limited. These three cases represent different size, age and industry which makes sure the selective data will be more reliable.

4.3 Data Collection and Analysis

Data will be collected though a face to face interview with the owner of the SME. The interview will be semi-structured and will use 'open-ended' question with the laptop record to collect qualitative data. In addition, the personal interview is considered to be an appropriate method of collecting primary data. Therefore, enriched and extensive information and a detailed insight of entrepreneurs' experiences of raising finance could be obtained.

Critical incident technique will be used to collect data regarding the experienced from the owner of small business when assessing finance. It is 'a method of collecting data which focuses on gathering important facts concerning behaviour indentified situations' (Collis and Hussey, 2003, p.345). Once the data from interview is collected, it needs to be analysed for key themes or ideas related to the research objectives and the factors identified in

4.5 Appraisal of the research design

There are several pros and drawbacks in this research design. When using a case study approach, a thick description, including details in the contextual aspects, themes, and patterns, could be provided (Silverman, 1993). Zikmund (1997) also identified its primary advantages that the research problems can be investigated in depth and highly focused attention to detail. However, weaknesses exist in a case study approach. Collis and Hussey (2003) recognized that it is often difficult to negotiate with a suitable organisation and the process of the research can be very time consuming; it is also difficult to decide on the delimitation of the study. What is more, with whatever unit of analysis there will be a history and future which will influence the knowledge at present. As Collis and Hussey (2003) state 'you may find it difficult to understand the events in a particular period of time without knowledge of what went on before and what may follows' (Collis and Hussey, 2003, p. 70).


5 Research Finding and Analysis

5.1 Introduction

This chapter

5.2 Case study 1

The first small business interviewed, which is under the ownership and direction of a single owner has a limited liabilities legal status, and has been trading since beginning of 1980.

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