ABSTRACT. This paper provides an overview of recent trendsin the financing of smaller businesses in the U.K. It refers inparticular to the findings of a major recent programme of workin this area funded by the Economic and Social ResearchCouncil, in which the author participated. This programmeincluded the first national survey to address these issues sincethe Bolton Report of 1971, as well as a range of projectscovering the finance of ethnic businesses and hi-tech firms aswell as the market for informal venture capital. On the basisof this work and of the results of more recent follow upsurveyors it is concluded that the evidence for general equityor debt gaps in the U.K. is weak. If anything SME fundingwas too easy in the boom of the late 1980s. It is argued thatconsideration could be given to the promotion throughseedcorn funding of SME co-operative or mutual guaranteeschemes to reduce information asymmetry in U.K. creditmarkets.

1. Introduction

The purpose of this paper is twofold. First to drawout some of the central findings of the ESRCSmall Business Research Programme on thefinancing of Smaller Businesses. Second todiscuss their implications for policy. I do notattempt to provide a general survey of all recentrelevant work on this issue. The background ofresearch papers and other material on which Idraw, however, does do this and the interestedreader can turn to the large number of workingpapers and publications arising from the ESRCResearch programme for a wider contextualanalysis.

What follows draws on material from twosources in particular. The first consists of workcarried out at the ESRC Centre for Business

Research (CBR) at the University of Cambridge(formerly the Small Business Research Centre(SBRC)). This includes the national SME surveysof over 2,000 firms carried out by the Cambridgeteam and published as

The State of BritishEnterprise: Growth Innovation and CompetitiveAdvance in Small and Medium Size Firms (SBRC,1992) and The Changing State of BritishEnterprise (Cosh and Hughes, 1996) as well as aseries of paper produced by them concerned withsmall business finance (Hughes (1994), Cosh andHughes (1994a), Cosh and Hughes (1994b),Moore (1994), Cosh and Hughes (1993), Cosh,Duncan and Hughes (1996)). The second is acollection of papers containing contributions fromeach ESRC programme team concerned princi-pally with financial issues (Hughes and Storey(1994)).

The idea that problems in the financing ofsmaller firms have significantly hindered the rolethey play in the overall performance of the U.K.economy is deeply rooted. Successive Committeesof Inquiry into Small Firms (The Bolton ReportH.M.S.O. (1971)), and into the Functioning ofFinancial Institutions (The Wilson ReportH.M.S.O. (1979)), identified problems for smalland medium-sized independent owner-controlledfirms employing less than 200, or 500 employees(SMEs). The Wilson Committee in its report onSME financing argued, for instance, that SMEswere relatively risky. They could therefore expectto face higher interest charges or more severesecurity conditions than larger firms. They con-cluded nevertheless that excessive bank cautionled to smaller, and especially newer, SMEs beingrationed in the market for loans and bank finance.They also pointed to a shortage of start-up capital,and of equity development capital for fully gearedestablished businesses wishing to expand. Thesereports led over the years to the introduction of a

Finance for SMEs: A U.K. Perspective Alan Hughes

Small Business Economics 9: 151166, 1997. 1997 Kluwer Academic Publishers. Printed in the Netherlands.

Final version accepted on November 13, 1996

ESRC Centre for Business ResearchDepartment of Applied EconomicsUniversity of CambridgeSidgwick Avenue, Cambridge CB3 9DE

variety of policy measures designed to tacklemarket failures in the supply of finance to SMEs,and particular sub-groups of them, such as hi-techfirms with a specific requirement for risk capital.For instance in the 1980s the Loan GuaranteeScheme (LGS) was introduced alongside theBusiness Expansion Scheme (BES). These weredesigned to tackle respectively the debt and equitysides of the SME financing problem. In thenineties the Loan Guarantee Scheme has beenaugmented and although the BES was wounddown other (very different) schemes such asSMART and SPUR were introduced to supportinvestment in hi-tech and innovative businesses,along with other developments such as theEnterprise Investment Scheme and Venture CapitalTrusts to boost finance for investment in SMEs.There was also a substantial increase in theavailability of private venture capital funding,although questions may be raised as to the extentto which this favoured lower risk managementbuyouts rather than high risk, high-tech, or inno-vative small business growth (Hughes (1994)).

The apparent resurgence, alongside thesechanges, of the SME sector in the 1980s, and theidentification of contemporary government fiscalpolicy, generally, with corporate and personal taxcuts to encourage an enterprise culture, mighthave been expected to reduce the intensity ofclaims that the SME sector in the U.K. remains ata disadvantage. Indeed one recent academic surveyconcluded that small firms in Great Britain cur-rently face few difficulties in raising finance fortheir innovation and investment proposals in theprivate sector (HMSO (1991), p. 17.) Thesubsequent report of the House of Commons Tradeand Industry Committee on the Competitivenessof U.K. Manufacturing industry also concludedthat

there is no evidence of a shortage of funds available forlending and investment (HMSO (1994), pp. 61, 28)

This is not, however, the end of the story. Thecombined impact of high interest rates and pro-longed recession in the early 1990s served tohighlight the extent to which SMEs continue torely heavily on short term finance from banks, tofinance their activities. It also revealed the wayin which, when times are hard, the smallest busi-nesses, which proliferated most rapidly during the

1980s, and are most dependent upon banks,protest vigorously about the apparently unsatis-factory nature of their relationship with them.(Binks et al. (1992), Cowling et al. (1991), Bankof England (1993)). Moreover, a recent study bythe Advisory Council on Science and Technologyof barriers to growth in small firms echoed theWilson and Bolton Reports concerns over equity,especially its absence in small amounts for riskyprojects, and those involving significant innova-tive components. In this connection it pointed tothe much better developed informal venture capitalmarket in the U.S. It also noted a number ofinstances in the case studies it conducted in theU.K. where financing difficulties had led to thesale of otherwise viable independent businesses tolarger concerns, with the implication that whereforeign purchasers were concerned an opportunityto develop an independent internationally com-petitive U.K. concern had been lost. (A.C.O.S.T.(1990)).

Other developments in the 1980s led to theemergence of new questions in the debate oversmall business finance. One of these was thegrowth of ethnic businesses, in particular thoseowned and run by members of the Asian commu-nity. Here the debate focused on their particularstrengths and weaknesses in raising finance in theface of cultural stereotyping, lack of establishedtrack records, and racial discrimination on the onehand, and strong informal financial networks onthe other (Deakin et al. (1992), Ward (1991). Atthe same time the unprecedented rate of companyformation in the 1980s was associated with adebate about the relatively high cost of compli-ance with company audit and disclosure require-ments for small firms compared with their largercounterparts, and the widespread use by the formerof the dispensation to submit brief modifiedaccounts granted under the Companies Act of1981. It also led to a debate about whether thebenefits of limited liability were worth the costsincurred for smaller companies in a world inwhich the pursuit of collateral by banks effectivelyundermined it, and in which the supposed benefitof company status in gaining access to capitalcould rarely be taken advantage of because of theequity capital market failures noted above. TheESRC Small Business Research Programme hassomething to say on each of these issues.

152 Alan Hughes

2. The comparative financial structure andprofitability of large and small companies

Table I and the figures derived from it present asummary analysis of the balance sheet structure,

gearing, and profitability of large and small U.K.non-financial companies in the U.K. in the period198789. Large companies are those ranked inthe top 2,000 in terms of capital employed in theU.K. non-financial corporate sector. They are

Financing for SMEs: A U.K. Perspective 153

TABLE IThe balance sheet structure, gearing, and profitability of large and small U.K. companies in the manufacturing and

non-manufacturing industries (excluding oil) in the period 198789

Manufacturing companies Non-manufacturing companies

Small Large Large Small(Average % 198789)

1. Fixed assetsNet tangible assets 030.2 034.2 026.4 052.4Intangibles 000.4 003.3 000.9 003.4Investments 000.9 007.0 003.5 003.4

Total net fixed assets 031.5 044.4 030.9 059.2

2. Current assetsStock and work in progress 019.6 019.8 025.0 014.0Trade and other debtors 037.9 023.6 036.0 019.3Investments 001.0 002.8 000.6 001.7Cash and short term deposits 009.9 009.3 007.9 005.8

Total current assets 068.5 055.6 069.1 040.8Total current and fixed assets 100.0 100.0 100.0 100.0

3. Current liabilitiesBank overdrafts and loans 011.3 006.1 011.0 004.4Directors short term loans 000.5 000.0 002.7 000.0Other short term loans 000.3 001.1 001.1 001.3Trade and other creditors 035.3 023.6 041.9 021.9Dividends and interest due 000.3 001.7 001.3 001.5Current taxation 007.1 004.8 004.4 003.9

Total current liabilities 055.0 037.3 062.4 033.1Net current assets 013.5 018.3 006.8 008.3Total net assets 045.0 062.7 037.6 067.5

4. Long term liabilitiesShareholders Interestsa 036.1 042.0 026.8 047.4Minority interests and provisions 002.3 006.5 001.1 002.8Loansb 003.2 011.5 006.3 015.4Other creditors and accruals 003.4 002.7 003.5 001.9

Total capital and reserves 045.0 062.7 037.6 067.5Total capital and liabilities 100.0 100.0 100.0 100.0

5. All loans as % total assets 015.3 018.7 021.1 021.1All loans as % shareholders interest 042.4 044.3 078.7 044.5Long term loans as % all loans 020.5 061.7 029.4 072.9Interest expense as % earnings before tax 015.4 012.4 021.4 014.7

6. Pre tax return on net assets 015.9 019.6 019.1 014.4Pre tax return on total assets 012.4 014.3 013.0 017.6Pre tax return on equity 010.4 019.1 018.8 013.3

a Ordinary, plus preference plus capital and revenue reserves.b Directors loans, bank loans, convertible and debenture loans, all of which have a duration of over one year.Source: Business Monitor MA3 Company Finance: Various Issues.

primarily quoted companies. Small companiesare a 1 in 300 sample of the remainder of thecorporate sector stratified by size of capitalemployed. Averages for these two groups mayobviously conceal wide variations within them,and may also reflect the effects of aggregationacross industries characterised to different degreesby the presence of large and small firms. As arough check on the latter effect a breakdown ofthe sample is provided into manufacturing andnon-manufacturing industries. The data are thebest available official statistics for the purpose inhand and may be compared with similar analysesspecially carried out in the Bolton and WilsonReports. It is worth emphasising, however, that inthe course of the 1980s increasing numbers ofsmall companies took advantage of the dispensa-tion to submit modified accounts in their returnsto Companies House. This has led to an increasein the estimation involved in producing the datawhich is reported here. It is ironical that at a timewhen information on small company performanceis of growing interest it is becoming increasinglydifficult to obtain it in a useful form. Consequentlywhen I try to probe beyond these aggregate figuresI use a specially constructed panel sample for anearlier period 197783 (Cosh and Hughes, 1994),which pre-dates the extensive use of modifiedaccounts, and for later years the results of theESRC Centre for Business Research SME surveys(SBRC (1992), Cosh and Hughes (1996)). Bothof these sources cover samples of over 2,000firms.

The data in Table I, and the accompanyingFigures 1 and 2 derived from it, are presented asaverages over the three financial years 198789.Each balance sheet item is shown as a percentageof total assets/liabilities whilst rates of return areshown upon calculated total assets, net assets andequity (ROTA, RONA and ROE respectively). Inview of our interest in the role of debt and equityin financial structure several measures of gearingare calculated. First, a simple stock measureexpressing all loans as a percentage of total assets.Second, a ratio designed to capture the relativeimportance of short and long term gearing (longterm loans as a % of all loans). Third, a stockmeasure which relates all loans to shareholdersinterests and finally a flow measure showinginterest expense as a percentage of earnings before

tax. A number of conclusions may be drawn fromTable I, and Figures 1 and 2.

(a) Asset structure(1) Small companies have a relatively low ratio

of fixed to total assets. In the non-manufac-turing industries, for instance, small com-panies hold 30.9% of their total assets in theform of fixed assets. For large companies thefigure is 59.2%.

(2) Small companies have a relatively high pro-portion of Trade Debt in their asset structure.Thus in manufacturing Trade and otherDebtors comprise 37.9% of total assets. Forlarge manufacturing companies the figure is23.6%.

(b) Current liabilities(1) Current liabilities are a higher proportion of

total liabilities for small than for large com-panies especially in non-manufacturing, wherethe respective percentages were 33.1% and62.4%.

(2) Small companies are more reliant on short-term bank loans and overdrafts than largecompanies (4.4% and 11.0% of total assetsrespectively in the non-manufacturing sectorfor instance).

(3) Trade and other creditors are a higher pro-portion of liabilities for small than for largecompanies. In manufacturing Trade and otherCreditors were 35.3% of total liabilitiescompared to 23.6% for large companies. Incomparison with the Trade Debtor ratios wefind that the small manufacturing companieswere net receivers of credit. For large com-panies Debtors and Creditors cancel out.

(c) Long term liabilities(1) Small companies are less reliant on share-

holders interests to finance their assets. Inmanufacturing for instance these accountedfor 36.1% of total small firm liabilitiescompared to 42.0% for large companies.

(2) In non-manufacturing, gearing, (as measuredby the stock ratio of total loans to shareholdersinterest, or by the flow measure of interestexpense as a percentage of earnings before

154 Alan Hughes

Financing for SMEs: A U.K. Perspective 155

Fig. 2. Selected Financial Ratios II: U.K. SMEs 198789.

Fig. 1. Selected Financial Ratios I: U.K. SMEs 198789.

interest and taxes) is higher for small com-panies than for larger companies.

(3) In manufacturing small companies are slightlymore highly geared on the flow measure butslightly less highly geared than larger com-panies on the stock measure.

(4) If we compare the ratio of total loans to totalassets, however, there is very little to choosebetween large and small companies in non-manufacturing. In manufacturing the largerfirms are more highly leveraged using thismeasure.

(5) In both manufacturing and non-manufacturingsmall firms are much more reliant on shortterm loans. Thus in manufacturing long termloans are only 20.5% of all loans for smallfirms, but 61.7% of all loans for large firms.

Thus in manufacturing we find little differencein overall gearing but within the overall level ofgearing a greater emphasis in small firms is placedon short term loans. The high reliance on shortterm finance provided by banks, and the relativelylow proportions of assets financed by shareholdersinterests are clearly long run persistent featuresof small business finance. The same is true of therelative importance of trade debt, and trade creditand the relative unimportance of fixed assets intheir balance sheet structure. Thus our resultsmatch the results of previous investigations for the1960s and 1970s for the U.K. It does appear,however, that the extent of reliance on short termloans and overdrafts has if anything increasedsince the Bolton and Wilson reports where thedifferences reported between larger and smallfirms were somewhat less than those shown inTable I.

(d) ProfitabilityThe implied relatively high reliance on internalfunds makes assessment of profitability importantin determining the growth potential of smallerfirms. Table I shows that;(1) The profitability of small manufacturing com-

panies is below that of large manufacturingcompanies on each of the three measuresshown. Thus for example the rate of returnon total assets (ROTA) was 12.4% for small,and 14.3% for large, companies.

(2) The profitability of small non-manufacturingcompanies was above that for larger compa-nies when measured as the return on net assets(RONA) or equities (ROE), but below that forlarger companies on a ROTA basis. Theyearned a ROTA of 13.0% compared to the17.6% ROTA of larger companies.

(3) Profitability estimates based on ROTA arerelatively low for small firms because of theirmuch higher reliance on short term liabilitiesin the form of trade credit. Netting out shortterm liabilities to calculate returns on netassets inevitably raises estimated small com-pany profitability compared to large com-panies.

These results imply that the relative prof-itability of large and small firms has been reversedsince the Bolton Report.

The Bolton Report provided estimates ofROTA, RONA and ROE for small and large busi-nesses in 1968, whilst estimates of RONA for197375 were prepared for the Wilson Committee.These estimates showed that small firm prof-itability was between 8% and 30% higher thanlarger company profitability, depending on themeasure and time period. This superiority was alsorecorded in a number of other studies surveyedby the Bolton research team for the period195868. It is apparent, however, that over theyears shown the gap was narrowing, and that, aswe have seen, it was reversed by the late 1980s.

We can probe a little further behind theseprofitability figures by making use of a specifi-cally constructed panel data set covering the years197783 which in part fills the gap in timebetween the profitability results of Table I and theWilson and Bolton Reports (Cosh and Hughes,1994). This data set has a number of advantages.First, it allows us to distinguish between differenttime periods, 197779 and 198082, so as to pickup any greater volatility in small business prof-itability in the face of recession in the early 1980s,and, secondly, it allows us to disaggregate by awider range of sizes.

For the sake of brevity discussion is confinedto one measure of profitability, the ratio of profitto net assets; (RONA); Figure 3 shows medianvalues of RONA averaged over the years 197779for 1,191 continuing companies ranging in size

156 Alan Hughes

from 30,000 to 12.5 billion in terms of totalassets in 1976 and for 1,185 companies in theperiod 198082. Once again smaller firms appearin general less profitable than larger ones but thereis a non-linear relationship between size andprofits. Thus the smallest 3 size classes show alower RONA than the top 3 but the difference isonly statistically significant (on either the mean ormedian measure) when sizes 1, 2 and 3 arecompared with size class 4. Thereafter averageRONA declines insignificantly with size.

The years 197779 were relatively buoyantcompared with 198083. The results of an analysisof RONA for these latter years is also shown inFigure 3. The impact of the recession is dramatic.Whereas RONA falls from 9.9% to 4.7% for allcompanies, by far the most dramatic falls occurin the smaller size ranges, with size class 1 fallingfor example from 8.7% to 1.8%. The result is thatsize classes 1 and 2, with an upper limit total assetsize of 500,000 in 1976, now have a significantlyworse profit performance than size classes 4, 5 and6, where the lower cut off point is 2.5 million.Size class 3 also has a substantially lower RONA

than the large size classes but the wide dispersionof returns prevents this from being statistically sig-nificant.

From the point of view of the finance ofcompany growth these findings highlight therelative financial volatility of small firms to thetrade cycle (a volatility which is reinforced byan analysis of company failure in this data set(Cosh and Hughes, 1993)). They also confirm therelative riskiness of this sector.

3. Profits retentions and finance for expansionSmall firms are heavily reliant on retentions tofund investment flows. The relatively low level ofprofitability which we find for the small firmsector is coupled with an absence of dividendpayment by them and hence a policy of maximumretention for growth and replacement investment.Thus the median company in the Cambridge panelwith total assets of less than 2.5 million paid nodividends at all in the period 197779.

We can gain a further insight into fundingpatterns by switching from an analysis of company

Financing for SMEs: A U.K. Perspective 157

Fig. 3. Median profit rates by size of company.

accounts to the results of the Cambridge SMESurveys (SBRC (1992), Cosh and Hughes (1996)).Sixty-five percent of the 1991 Cambridge surveysample of over 2,000 firms had sought externalfinance in the three years 198790. The propor-tion in the Bolton sample was 26% but in thatsurvey the question related to the previous twoyears. However, if we adjust the Bolton figure to39% in order to make it comparable to the laterfinding, we can see a marked increase in the pro-portion seeking external finance. It is not possibleon the basis of our study to say whether this is atrend or cyclical difference. Moreover the Dunand Bradstreet sampling frame on which theCambridge surveys are based is biased towardsfirms seeking finance since it is a credit ratingdatabase. What is striking, however, is that of the65% which sought finance in the period 198790,only a small number (25) failed to obtain some.This may reflect a reluctance to admit havingsought finance and failed to get any or relativelyeasy financial conditions in the period 19871990.The Cambridge Survey of 1995, however, revealssimilarly high success rates in the periods 199193and 199395 in rather different financial condi-tions (Cosh, Duncan and Hughes (1996)) Taken asa whole these results contrast with earlier findingsfor the U.K. Thus in the Bolton sample about athird of those seeking finance failed to obtain anyat all and so in that sense there may have beensome closing of the small firms finance gap sincethen.

A comparison of the proportion seeking addi-tional finance across various groups of firms in theCambridge survey covering the years 198790showed that there was little difference betweenmanufacturing and services, whereas the Boltonsurvey found that manufacturing firms were farmore likely (32% in the previous two years) tohave sought additional finance than service firms(20% in previous two years). On the other hand,and like the Bolton survey, the Cambridge datashow that larger companies and faster growthcompanies are more likely to have recently soughtadditional finance. In addition, a higher propor-tion of newer companies seek external funding.

Cambridge survey firms who had obtainedexternal finance were asked to indicate the pro-portion obtained from different sources. This givesa clear picture of the relative importance of

different sources of finance. The responses forthe period 198790 are shown in Table II andFigure 4. Table II shows that banks are by far themost significant providers of finance to the smallfirm sector. The banks provided some finance to84% of those who had raised finance, and aseparate analysis shows that they accounted formore than half of the additional finance raised for65% of the sample. Loans were dominant as thefirst source of finance sought after internal cashflow. The next most important source was hirepurchase or leasing which was a source of financeto 45% of the sample firms which had raised newfinance, and accounted for over half the additionalfinance in 14% of the cases. This has clearlygrown in importance as a significant alternative tofurther borrowing since the Bolton Report andfrom the point of view of the contracting partiessolves several moral hazard and default problemswhich would be present if assets were bought onthe basis of debt finance. The Cambridge SMESurveys of 1993 and 1995 reveal a further shiftin this direction (Cosh, Duncan and Hughes(1995), Cosh, Duncan and Hughes (1996)). Theonly other important source is partners or workingshareholders who were identified as a source offinance in 19.5% of the firms in 198790. TableII and Figure 4 also show what proportion of thefunds raised in the period 198790 came fromthese various sources. Banks accounted for 60%of total funds raised and hire purchase for 16%.Partners and Working Shareholders put up another7.6%. Much further behind come venture capital-ists (2.9%) and private individuals (1.7%). By1995 the mean share of funding raised from bankshad fallen to 50% and the mean share of hp/leasingrisen to 31%, with only minor changes occurringin the importance of the other sources (Cosh,Duncan and Hughes (1996)).

When the 198790 Cambridge sample isdivided into the different groups of firms the broadpicture already identified is maintained, but thereis some difference in emphasis across the groups.Newer firms raised a lower proportion of theiradditional finance from banks and hire purchaseor leasing; consequentially, they were more relianton other sources, particularly private shareholders(both working and other). This reflects the heavyreliance on this sort of finance in the start upphase. In a similar way service firms were less

158 Alan Hughes

dependent on these two main sources and far morereliant on partners and working shareholders.

As might be expected, the fast growth firmsappear to have drawn their new finance from awider variety of sources than slower growingfirms. Thus apart from factoring and customer/suppliers, both of which were of minor impor-tance, the fast growing group had a higher propor-tion from each of the other sources. But even thefast growth group was heavily dependent on bankfinance and obtained very little outside equity.

A comparison of size groups in 198790 showsthat larger firms had the highest proportion ofbank finance and that the micro firms were morereliant on private individuals, partners andworking shareholders. The results also suggestthat, whilst finance from venture capitalists isgenerally insignificant, its greatest impact wasamong medium-sized firms. Medium and LargerSMEs also have more term loans in the late

1980s. A further analysis of the interest paymentstructure of the surveyed firms as a whole alsosuggests some increase in the importance of termloans. Thus fixed interest payments as a per-centage of all interest payments increased inimportance between 1987 and 1990. Whereas 56%of firms had no fixed interest borrowings in 1987this proportion had fallen to 47% by 1990, and theproportion of firms with fixed interest paymentsproportions in the range 149% rose from 21 to28%. This trend has continued in the 1990s (Bankof England (1996)).

The analysis confirms the unimportance ofoutside equity as a source of new finance amongstsmall firms and even amongst those growingfastest; increasing debt, which in the period198790 was for small firms primarily short term,was the overwhelmingly most significant route,followed by raising additional insider equitycapital.

Financing for SMEs: A U.K. Perspective 159

TABLE IISources of additional finance for SMEs

Source of finance All Micro Small Medium Larger Older Newer Stable/ Medium Fast Mfg Servicesdeclining growth growth

% of respondents receiving additional finance from:Banks 83.7 80.5 84.1 85.7 90.1 85.4 81.8 82.4 84.7 87.4 85.6 81.6Venture capital 06.5 02.4 07.1 13.4 06.3 05.5 07.4 04.8 06.0 08.3 07.5 05.4Hire purchase/

leasing 44.6 33.3 50.3 46.2 41.4 50.3 38.8 38.1 51.0 47.8 48.3 40.4Factoring 06.0 03.7 07.3 07.6 03.6 04.1 07.4 07.3 04.5 05.4 06.2 05.8Customers/suppliers 08.5 09.8 07.7 07.6 09.9 08.2 08.7 11.7 07.4 08.3 08.9 08.1Partners/working

shareholders 19.5 24.6 17.4 25.2 13.5 15.3 23.7 15.4 18.4 23.7 15.0 24.5Other private

individuals 05.6 09.4 04.9 03.4 01.8 02.5 08.4 04.0 3.3 07.6 04.1 07.2Other sources 09.7 08.1 09.3 11.8 14.6 09.4 10.0 09.5 9.3 10.1 08.9 10.6

Mean % share by source of finance:Banks 60.6 60.8 59.1 60.1 68.9 64.6 56.6 63.5 62.1 58.5 62.5 58.4Venture capital 02.9 01.0 03.4 05.2 02.6 02.4 03.4 02.6 2.4 03.7 03.1 02.8Hire purchase/

leasing 16.0 13.9 18.3 12.6 12.7 17.5 14.6 13.4 18.1 16.8 18.2 13.4Factoring 03.5 02.2 04.1 04.2 02.4 02.2 04.5 03.9 2.7 03.1 03.3 03.7Customers/suppliers 02.2 02.6 02.0 01.9 01.8 01.9 02.5 03.2 1.9 02.3 01.9 02.6Partners/working

shareholders 7.6 11.8 06.7 07.2 03.6 05.5 09.9 07.1 7.0 08.1 04.6 11.1Other private

individuals 01.7 03.0 01.5 00.8 00.4 00.6 02.8 01.1 1.1 01.7 01.4 02.0Other sources 05.4 04.7 04.9 08.2 07.5 05.2 05.7 05.3 4.8 05.8 04.9 06.1

Total responses (no.) 1185 .297 .648 .119 .111 .561 .598 .273 .418 .278 .627 .554

Source: SBRC (1992).

This is consistent with a pecking order hypoth-esis of fund raising (Myers and Majluf (1984)).Funds are sought in an order which minimisesexternal interference and ownership dilution byleaving equity till last after retentions and debthave been exhausted. This also has positivesignalling qualities in so far as preferring debt toan early issue of equity implies confidence in highreturns and an unwillingness to share them withnew shareholders. The upshot is that small firmsare characterised by a relatively greater relianceon short term loans and overdrafts and a muchsmaller reliance on equity finance than are largerfirms. This structure, is as we have seen, of longstanding, as is the greater significance of tradedebt and trade credit in their balance sheets.During the long boom of the 1980s it wasassociated with a substantial increase in short termgearing as small companies found it possible togain access to bank finance on a large scale. Theimpact of high interest rates and recession weretherefore even more damaging than they mightotherwise have been when the long boom ended.For a sector dependent in the first instance onretained profits to finance growth the 1980s werenot historically a particularly auspicious period for

SMEs. Whereas in the 1960s and to a lesserextent the 1970s they had recorded somewhathigher returns than larger firms, by the 1980s theposition was reversed. Although the quality of thedata requires the exercise of some caution itappears that small firms suffered particularly badlyfrom the impact of the recession of the early1980s.

One important conclusion to emerge from thisanalysis is that the financial structure of SMEsmay reflect well the wishes and strategies of theirowners as much as constraints placed upon themby suppliers of finance. It is therefore necessaryto probe qualitatively beyond the financial struc-ture itself to address issues of financial constraintsmore directly. Here case study evidence (ACOST(1990)) supports theoretical arguments for somemarket failures on the loan and equity fronts forrapidly expanding or innovative firms, as well asthe relative paucity of informal venture capital inthe U.K. In the latter case in particular theCambridge survey data supports case studymaterial. Informal funds (i.e. supplied by privateindividuals who were not working partners orowner-directors1) amounted, as we have seen, onaverage to only 1.7% of total new funds raised by

160 Alan Hughes

Fig. 4. Shares of amount of additional funding obtained by source.

the Cambridge sample of around 2,000 SMEs inthe period 198790, whilst formal venture capitalaveraged around 2.9% with little further changeby the mid 1990s (SBRC (1992), Cosh, Duncanand Hughes (1996)). This is also confirmed usingwider sources of data for the 1990s (Bank ofEngland (1996), Buckland and Davis (1996)). Thecontrast with the United States is striking. In thatcountry informal venture capital is twice asimportant in quantitative terms as institutionalisedventure capital, (Wetzel (1987)). However, theCambridge Survey also revealed that informalcapital was at its most significant amongst micro-firms employing less than 10 people. In thosefirms it accounted for 3% of new funds comparedwith 1.0% from formal venture sources.

The nature of this type of informal finance isexplored in the ESRC funded work by Mason andHarrison (1994). One of their main contributions,in the first systematic attempt to survey this sectorin the U.K., is to identify the characteristics ofU.K. informal investors, (business angels) andtheir investment practices. The problems of sur-veying this sector are formidable and are well setout in their work, one part of which reports theresults of a postal questionnaire sample of 78 firmssupported by 8 face to face interviews. The smallsample sizes reflect the paucity of systematicinformation to serve as a sampling frame as wellas the reticence of angels (shown to be predom-inantly middle-aged businessmen with a contin-uing interest in other business(es) they havefounded) to reveal themselves to public gaze.Mason and Harrisons analysis confirms the roleplayed by business angels in supplying relativelysmall sums (median value of around 22,000) tosmaller businesses that is suggested by theCambridge Survey results. Their detailed analysisshows that this reflects the relatively modestincomes of business angels (only 16% reportedearnings above 100,000), their small individualinvestment portfolios (75% had invested under50,000 in total in the previous three years, withonly 12% of individual investments in amountsover 50,000), and their reluctance to take part insyndicated deals (66% always or usually actedindependently). Nevertheless, the highly skewednature of both income and wealth in the Masonand Harrison sample meant that in total their86 respondents had available investible funds

amounting to nearly 10 million.2 In addition totheir potential and actual role as financiers, thestrong entrepreneurial and managerial backgroundof the typical investor in their sample meant thatthey typically played a hands-on role as minorityshareholders, joining the board in around 27% ofcases, and playing a purely passive role in only20%. Whilst this may be beneficial in cases whereinjections of both expertise and finance arerequired it may have costs in terms of conflictsover strategy and control where they are not(Harrison and Mason (1992)). Moreover, giventhat over 50% of the sample expected to exitfrom their investment within 35 years, theimplications from the point of view of growingmedium-sized independent companies are notnecessarily promising. Indeed, as Mason andHarrison note, U.K angels are less patient thantheir U.S. counterparts, and more likely to sell tooutsiders via merger or stock market flotationthan to sell their shares to insiders. From a policypoint of view, what emerges most strongly is thatif this sector of the financial market is to play amore significant role a greater degree of informa-tion exchange about potential investors and invest-ment opportunities is required. Thus Harrison andMason show the essentially ad-hoc nature of muchbusiness angel search and referral activity. Theessentially individualistic nature of the informalinvestment activity which their survey revealsleads the authors to conclude that one possibleavenue for policy intervention is to be found in thepromotion, especially at a local and regional levelof information brokerage, either through the TECsystem or the Business Link one-stop shopsintroduced by the DTI.3 The informal investorsinvestigated by Mason and Harrison are primarilyinterested in high growth potential businesses,many but not all of which are to found in sectorswhere innovation intensive activity offers theprospects of spectacular breakthroughs. The finan-cial problems facing these New TechnologyBased Firms (NTBFs) has been of particularpolicy concern, not least because findings such asthose of Pavitt et al. (1987) have suggested thatthe share of innovations accounted for by smallerfirms since the 1950s in the U.K. has outstrippedthe contribution which might have been expectedgiven their shares of output or employment. It hasbeen suggested in the reviews by Barber et al.

Financing for SMEs: A U.K. Perspective 161

(1989) and by ACOST (1990) that, althoughNTBFs play a crucial role in the economy, theyfind it disproportionately difficult to obtainappropriate financing from the institutions. This isbecause such firms are perceived to be particularlyrisky for several reasons. The first is they arefrequently attempting to introduce products andprocesses which are new to, and untested in, themarket. Secondly the firms are often in industrieswhere rapid developments make existing tech-nology obsolete and thirdly they are often in busi-nesses which have only a single product. Finallythe businesses are often owned and managed byindividuals with stronger technical than businessskills. For all these reasons it is not surprising thatstudies such as those by Oakey (1984) suggestedthat bank finance is significantly less importantat start up for NTBFs than is the case for con-ventional small businesses. Even so, these resultscontrast with those of Monck et al. (1988) whichindicate little difference in the ways in which hightechnology firms are initially funded, comparedwith small businesses as a whole.

Moore (1994) provides a detailed analysis ofthe issue. He takes 292 high technology smallcompanies and compares them with more than1,700 smaller companies which are not in the hightechnology sector. Both groups are asked the samequestions about the extent to which a range offactors have constrained the growth of theirbusiness. For both high technology and conven-tional firms, finance constraints are seen to be themost important. In a multiple regression analysisMoore demonstrates that the businesses which aremost likely to report financial constraints are thosewhich are young, in the manufacturing sector,have below average profitability and are smaller.Holding these and other variables constant, Moorecan find little evidence that the high technologybusiness is more likely to experience difficultiesin obtaining finance than its counterpart in theconventional sectors. Indeed it appears to be thecase that the small high technology firm is, ifanything, more likely to be in receipt of venturecapital and support from private individuals(Angels) than is the case for the conventional firm.It is the youth and lack of track record of thesefirms rather than their hi-tech nature as such whichappears to constrain their access to funding. Sincethey are relatively young and small their plight is

however a specific reflection of several problemsfacing the SME sector.

The second special case is the financing ofethnic or non-white businesses. The central issuehere is whether there is evidence of the ownersof these businesses being denied access to loan orequity capital on racial grounds and whether themode of financing influences the performance ofthe ethnic business sector.

The major research finding on this topic in theUnited States has been provided by Bates (1991).Bates work finds that in the United States startup businesses established by blacks tended toreceive smaller loans from banks than whiteowned start ups. Secondly he found that black-owned firms were under-capitalised, comparedwith white owned firms.

Bates hypotheses that commercial banks aremore likely to lend to individuals with morehuman capital, more equity and with demographictraits that are associated positively with businessviability. In this context human capital is likelyto be reflected in the level of education of theindividuals, their age, whether or not they haveprevious managerial experience and family smallbusiness background. The first key result whichBates generates is that, even when these factorsare taken into account, it is still the case that theloans made to white business start ups exceedthose made to black business start ups.

Bates then shows that it is lower levels ofcapitalization which are associated with higherrisk of business failure. From this he infers thatat least part of the observed higher failure rate ofblack owned firms reflects this lower capitaliza-tion and that, most significantly, their failure rateswould be no different from white-owned start upsif they received a similar level of external loan.

Research on the financing of ethnic businessesin the United Kingdom in the ESRC programmehas not made use of the huge databases or thestatistically sophisticated techniques which areemployed by Bates. Nevertheless the ESRCfunded work by Jones, McEvoy and Barrett (1994)provides helpful insights. They review thefinancing of both white and non-white businesses.They show that the most striking differencebetween ethnic groups, in terms of mode offinancing, is not between white and non-whites,but between Asians and Afro-Caribbeans. They

162 Alan Hughes

show that Afro-Caribbeans are perhaps twice aslikely to experience problems obtaining bank loansas white applicants. Secondly they show that theAsian business is significantly more likely to havebeen established using loans from family orfriends than is the case either for white or Afro-Caribbean businesses. Thirdly they point to recent,but highly significant, changes in the ways inwhich Asian businesses are being financed. Theysuggest that, if anything, U.K. banks now lookmore favourably upon the Asian business owner,than upon the white business owner. However, ina very interesting analysis of those businessesestablished by Asians which have been funded100% by the bank, the authors show these aremuch more likely to have been started by British-born Asians than those born overseas, and morelikely to have been established by Asians withhigher educational qualifications.

In their comments upon how matters are likelyto change that the authors offer important policyperspectives. Although there is now clearly amuch greater willingness of banks to supportAsian owned businesses, the evidence is that banksupport is more difficult to obtain for businessesin the non traditional areas such as manufac-turing than in the traditional areas of foodretailing and confectionery, tobacconists andnewsagents (CTNs). Thus they point to thechanging character of the Asian entrepreneur inthe 1990s, as being more likely to be British bornand educated to a high level, more likely to beseeking finance for a business outside the tradi-tional areas and less likely to either wish to, orbe able to, rely upon finance from family sources.It is unclear whether the banks are yet targeting,or even aware of, this type of shift.

To summarise, there does appear to be clearevidence of market imperfections in the financingof black businesses in the United States. Fullycomparable work has not been conducted in theUnited Kingdom but, that which has, does notsuggest any clear market failure in the financingof Asian businesses. The only major reservationis whether banks are sufficiently aware of thenew type of entrepreneur emerging from theAsian community. So far as Afro-Caribbeanbusinesses are concerned, these are clearly verydifferent from Asian businesses and do experiencesignificantly greater problems in both raising

finance, and in their relationships with the banks.Whether this constitutes an illustration of a marketfailure, or whether it merely illustrates the higherrisk associated with these types of businesses isnot clear from the research conducted so far.

4. The implications

To what extent does the evidence presented heresupport, or undermine, the view that access tofinance has inhibited the contribution which smallfirms make to the U.K. economy? Do the papersprovide further evidence of gaps or marketfailure? If so, what should be done to rectifythese matters?

The evidence in support of the existence ofgaps is provided mainly by Mason and Harrisonin their analysis of Business Angels. They suggestthat many such individuals are seeking to makefurther investments in appropriate smaller com-panies, but are unable to obtain a sufficient flowof suitable proposals. Mason and Harrison alsosuggest there are business owners, whose firms areconstrained in their growth by a shortage ofequity, and who would be prepared to share thatequity with informal investors. The clear impli-cation of their research is that information barriersexist between the two groups, and that it would bebeneficial to the economy as a whole if thesebarriers were overcome.4

However, little further evidence emerged fromthe ESRC research programme or the subsequentCambridge surveys of 1993 and 1995 to suggestthat general gaps exist in the financing of smallfirms, although it must be noted throughout thatinvariably such evidence arises from the analysisof surviving firms and severe financial constraintscould have produced failure or takeover (Cosh andHughes (1994) and Cosh, Duncan and Hughes(1996)). Bearing this in mind financial constraintsdid not appear in areas where they might beexpected. For example, Jones, McEvoy and Errettin their paper on the financing of White and EthnicBusinesses find no difference in this respectbetween Asian and White Businesses. They dopoint to problems experienced by Afro-Caribbeanbusiness owners, but these may reflect both thesectoral composition and poorer performance ofbusinesses established by these groups. The factthat they find that discrimination occurs does not,

Financing for SMEs: A U.K. Perspective 163

in itself, imply a market failure without furtherwork on the relative characteristics of thesebusinesses.

The same principles apply to the findings byMoore. He shows that the businesses which aremost constrained are those which are young andsmall and therefore likely to appear most risky and manufacturing businesses where the amountborrowed is likely to be higher than for servicesector businesses. What Moore does not find,although he explicitly tests for it, is evidence thatwhen age, size and sector are taken into account,businesses in the high technology sector are morelikely to be finance constrained than thoseoperating in the more conventional sectors.Although he does report that both groups claimfinancial constraints to be their most significantbarrier to growth. What this points to is specialcare in dealing with young and small firms, NTBF,and manufacturing firms. Distinguishing betweenthose who want to grow and have the non-finan-cial capacity to do so and those who dont, anddealing with the specific risk assessments ofhigh-tech firms, remain major challenges forlenders.

So, what should be done? One role for gov-ernment is that of encouraging the sharing of boththe risks and returns of business ownershipbetween the providers of finance and the entre-preneurs. One illustration of moving policy in thisdirection would be to specify, a substantialminimum share capital for those wishing to estab-lish limited companies and gain the benefits oflimited liability whilst leaving businesses withlittle aptitude for growth to remain unincorporated.

The provision of equity funding more generallywill always be problematic for smaller firms giventhe internal pressures to maintain independenceand the signalling problems associated withissuing equity. Entrepreneurs totally convincedthat their business proposition will be hugelysuccessful, is very unlikely to be willing to sharethe fruits of that success. As the NationalWestminster Bank put it to the House of CommonsSelect Committee:

where the businesses had real confidence in themselvesor their products or their customers, they would not giveup that equity. Conversely, where we found businesses thatlacked direction very badly and where the managementwas extremely weak and did not have much faith in their

product, in those situations they will give up equity(HMSO (1994) pp. 107, 287).On this basis many proposals which are put to

venture capital organisations or individuals arelikely to include a high proportion of cases whichshould not be supported and the challenge is to siftthese out on other criteria. The development ofclearing house schemes to encourage investmentangels is worth pursuing here. So too is theconsideration of schemes to encourage ploughback by the owners of SMEs either by tax breaksfor retentions used to fund certain types ofqualifying investments, or more general differ-ential taxation of retained profits. The fate of theBES suggests that technical progress in taxavoidance may subvert even the best intentionedof schemes but that should not stop the search foran effective one.

On the loans front smaller business may havea role to play independent of government iftogether with, or independently from, banks theycould form consortia to underwrite their own loanapplications. This would capitalise on informationheld by the firms themselves and solve some ofthe information asymmetry problems whichbedevil the lending market. The development ofMutual Guarantee Schemes along these lines iscommon in Europe. There is a seedcorn role forGovernment here in overcoming public goodproblems in setting them up though not necessarilyin maintaining them where they are in operation(see Hughes (1992)).

There is a case too for a public goods rolefor state or region backed development financebanks for smaller firms. The prime nationalexample of this sort of institution is theKreditanstalt fur Wiederaufbau (KfW) inGermany. Its quasi-government status and longterm performance has given it high credit ratingsin its pursuit of international and national fundswhich it uses to refinance private sector commer-cial long term loans to SMEs. SMEs benefit bylower interest rates than would otherwise beavailable, and more generous phasing of repay-ments than would otherwise be the case. Therecent Trade and Industry Committees recom-mendation that a loan funding scheme along theselines be investigated should be followed up. Theimportance of both the mutual guarantee approachand the KfW development bank approach is that

164 Alan Hughes

there is explicit recognition of a public goodproblem is SME financing but the commercialbanks are not asked to solve it. They makecommercial lending decisions in circumstances inwhich either consortia of borrowing companiesoffer guarantees against cost of default or statebacked (but not state funded) refinancing arrange-ments are available.

Developments of this kind should, however,enable banks to shift emphasis away from collat-eral backed short term lending and towardslonger term lending based on human capital andbusiness prospects rather than carcase valuation.Cosh and Hughes (1994) note that the latter hashappened to some degree but it needs to go further.One way in which banks can build a longer termand more fruitful relationship with their client baseis to build upon and strengthen decentralisedlending decisions based in turn upon more stableregional career patterns. Lending decisions couldthen be more satisfactorily based on informationgleaned from a longer-term association of indi-vidual bankers with a given regional or localcommunity. This would also stimulate and developan information framework to bring togetherinformal investors and entrepreneurs as recom-mended by Mason and Harrison. Whether thisdecentralised relationship banking is compatiblewith cost effectiveness for the Banks is a mootpoint. An alternative way forward may well, onthe contrary, turn out to be standardised creditscoring for the smallest borrowers and a moreresource intensive but cost effective relationshipwith companies with sufficient scale, and growthpotential to be future candidates for stock marketflotation.

Acknowledgements

This paper summarises results arising fromresearch conducted under the ESRC Small FirmsResearch Programme and at the ESRC Centre forBusiness Research at the University of Cambridge,funded by contributions from the ESRC, BarclaysBank, Commission of the European Communities(DG XXIII), Department of Employment and theRural Development Commission. This support isgratefully acknowledged. None of the authorscited are responsible for the interpretations of theirwork reported here or for the policy implications

drawn. The paper draws upon joint work withDavid Storey published as the introduction toHughes, A. and Storey, D. J. (eds) Finance andthe Small Firm, Routledge, 1994. An earlierversion was presented to the ESRC Small FirmsInitiative Conference in London in June 1994.

Notes1 Some businesses angels could be classified aspartners/working shareholders, so that a wider definition of!informal funds might increase its apparent importancesomewhat.2 This amount comprises both investments in the previousthree years plus amounts available for investment.3 Some TECs have already operationalised this matchmaking function.4 Harrison and Mason also imply that latent demand forequity finance would be realised if angels were seen to bemore accessible. They regard the key step to be a demonstra-tion to business owners such as angels exist and are preparedto make small investments.

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