Stuart Fraser Warwick Business School

stuart.fraser@warwick.ac.uk

Sumon Bhaumik Aston Business School

S.Bhaumik@aston.ac.uk

Mike Wright Imperial College Business School

mike.wright@imperial.ac.uk

What Do We Know About The

Relationship Between Entrepreneurial Finance and Growth?

The Issues

• Private sector firms should have adequate access to finance.

• Available data suggest significant decline in both debt and equity finance flows to SMEs.

• Widely held perception that funding gap yet to be bridged that builds on a very long-standing debate.

• Complex and nuanced issues not completely understood.

– low demand?

– contraction in supply?

• Policies targeting funding gaps to promote firm growth, require analysis of:

– factors that affect funding gaps and how they change over life-cycle.

– relationship between funding gaps and business growth.

19.3%

8.8%

10.0%

1.1% 1.0%

16.2%

6.8%

7.7%

1.0% 1.2%

13.1%

7.8%

6.7%

1.8%

0.1%0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Overdrafts Term loans Leasing and hire purchaseagreements

Invoice finance Equity finance

Application rates

2001-4 2005-8 2008-9

Decline in demand

Tightening supply

10.9%

5.4%

2.1%

8.6%

11.0%

7.2%

2.4%

5.3%

16.1%

14.1%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

Overdrafts Term loans Leasing and hire purchase agreements Invoice finance

Rejection rates

2001-4 2005-8 2008-9

VC rejection rates higher than for banks or angels

The Issues • Aims:

– Distinguish between issues well understood those less clear.

– Identify gaps in the academic literature to be addressed to better inform policy making.

– Recognise implications of greater heterogeneity than hitherto in both demand and supply side factors.

– Policy Implications.

– Research Implications.

Growth finance and market failure What do we know?

• Asymmetric information

• Failure in the market for finance can be alleviated by

– Firm’s ability to post collateral

– Firm’s access to trade credit

– Due diligence and monitoring

• Market and agency risk

• Contracts, staging, board seats

– Firm’s relationship with banks

• Monogamous vs. multiple banking relationships

• Facilitation of “arm’s length” banking by way of credit scoring

Heterogeneity • Demand side

– Entrepreneurial cognition

• Growth and control objectives

• Perceptions of supply (‘discouraged borrowers’)

– Type of firm ownership

– Stage of firm life-cycle

• Supply side

– Traditional debt and equity providers

– Financial and monitoring/added value support

– Emerging providers

⋮

Cognitive/financial

constraints

Sources of finance - Banks

- Angels

- VC

External finance

tendency

Internal finance

tendency

Discouraged

borrowers

Other internal

finance users

Demand

Supply

Demand

Supply

Perceptions

of supply

Entrepreneurial

cognition

Funding gaps

Funding gaps

Figure 1: Entrepreneurial Finance and Growth: An Integrated Framework

GROWTH

Cognitive/financial

constraints

Able to get some

external finance

Unable to get any

external finance

Growth/lifestyle

objectives

Lifecycle

stage

Reliant on

internal finance

Supply=Finance+

board service (VC)

Funding gaps, perceptions and growth

• Research for Breedon Review (Fraser, 2012) and by NIESR (2013) shows significant increases in funding gaps (rejection rates) following financial crisis.

– Overdraft rejection rates increased in relative terms by over 50% in 2009 (compared to 2004) and term loan rejection rates increased by 163%

• These analyses rigorously control for risk profiles (credit ratings, collateral, financial relationships and other business/owner characteristics) which impact access to finance

– So the findings suggest supply has tightened.

• Similarly rates of financial discouragement have increased (controlling for risk profiles) suggesting entrepreneurs’ perceptions of the supply of funding have deteriorated. – This is a key factor underlying the falling trend in finance demands.

When is a funding gap not a financial constraint?

• To move the policy debate forward, we need to look at the relationship between funding gaps and business performance.

• Funding gaps only negatively impact on business performance if finance providers are offering too little finance (i.e., financial constraints): – Conversely, no effect if entrepreneurs are seeking too

much finance (due e.g., to entrepreneurial ‘over-optimism’).

• Similarly discouragement will only negatively impact on business performance if it results in too little investment – Discouragement might be ‘good’ if unviable firms decide

not to apply for funding.

Initial findings

• Initial analysis using UKSMEF data for 2004-2009 finds significant negative effects of overdraft rejection on sales growth in 2007-8 and 2008-9 – For an average firm this means a reduction in sales from £3.2m in 2007 to

£2.1m in 2008 and from £3.3m in 2008 to just over £1m in 2009.

• Findings consistent with financial constraints due to insufficient working capital in the early stages of the financial crisis (2007-8) but with more severe constraints in 2008-9.

• However, no evidence of financial constraints prior to the financial crisis.

Initial findings

• Similarly, holding sales in 2007 constant, term loan discouragement is associated with a 57% reduction in sales by the end of 2008.

• These findings point to both financial and cognitive constraints on growth. – Specifically they are consistent with the widening of govt. assistance in

2009 to include support for working capital (under the EFG) and moves to promote ‘non-bank’ sources of finance (Breedon Review).

– They are also consistent with the commitments made by the Business Finance Taskforce (2010) to restore confidence in the lending process (including support for mentoring, the publishing of lending principles and the establishment of a transparent appeals process).

Non-bank finance • Equity gaps vary between sectors, regions and stages of

finance. • Questioning of spatial proximity arguments

– May be able to access VC if can signal quality – Angels invest cross-border

• Generally positive effect of VC & PE on growth even after controlling for (significant) selection effects – Importance of experience and specific expertise

• Affected by fund type – Independent (domestic) VCs have shorter term sales growth;

syndication important – experienced government backed less growth but greater

survival

Non-bank finance

• PE backed buyouts

– Evidence of growth on various dimensions

– Employment effect more controversial

– Again effect of experience and expertise

– Better than non-buyouts through recession

• Angels

– Fewer high growth cases but fewer failures

– More flexible involvement but less involvement when distress

Non-bank finance

• Alternative Investment Markets – Liquidity issues

– About half raise funding

– Share price performance generally weak

• Direct investment by pension funds and family offices – Emerging trend

– Recruiting investment bankers

– Questions over expertise to help portfolio companies but variety may emerge in this respect

Policy Implications • Credit market

– Potential for credit market intervention to make a difference in availability of finance and economic performance.

– Issues about take-up & delivery of assistance. • Awareness of policies to rebuild trust

– Promotion of greater sharing of credit information may help improve credit scoring models and reduce entry barriers for non-bank credit providers.

– Learn from other countries in terms of best practice in the design and delivery of support

– Address issue of potential drag from zombie companies

• Equity market – Stimulate cross-regional mobility of funding provision – Assess complementarity/substitutability of different types of equity

providers, business bank, etc.

• Competition – Effects of competition in both credit and equity markets not clear cut

in terms of availability and terms

Research Implications

• The role of finance and entrepreneurial cognition in explaining firm growth

• Understanding financing decisions

• Governance, finance and growth

• Involvement of financiers

• Modes and patterns of growth and finance

• Context, finance and growth

• Scaling-up and finance

• Entrepreneurs, finance and growth

Thank you!

Questions?

For more information about this White Paper contact us on:

stuart.fraser@warwick.ac.uk

S.Bhaumik@aston.ac.uk

mike.wright@imperial.ac.uk