In reality, there are quite a few potential sources of finance for SMEs. However, many
of them have practical problems that may limit their usefulness. Some key sources
and their limitations are briefly described below.
OWNER, FAMILY AND FRIENDS
This is potentially a very good source of finance because these investors may be willing to accept a lower return than many other investors as their motivation to invest is not purely financial. The key limitation is that, for most of us, the finance that we can raise personally, and from friends and family, is somewhat limited.
THE BUSINESS ANGEL
A business angel is a wealthy individual willing to take the risk of investing in SMEs. One limitation is that these individuals are not common and are very often quite particular about what they are prepared to invest in. Once a business angel is interested, they can become very useful to the SME, as they will often have great business acumen themselves
and are likely to have many useful contacts.
SMEs, like any company, can take credit from their suppliers. However, this is only short-term and, indeed, if their suppliers are larger companies who have identified them as a potentially risky SME the ability to stretch the credit period may be limited.
FACTORING AND INVOICE DISCOUNTING
Both of these sources of finance effectively let a company raise finance against the security of their outstanding receivables. Again, this finance is only short-term and is often more expensive than an overdraft. However, one of the features of these sources of finance is that, as an SME grows, their outstanding receivables will grow and so the amount they can borrow from their factor or from invoice discounting will also grow. Hence, factoring and invoice discounting are two of the very limited number of finance sources which grow
automatically as the business grows.
Leasing assets rather than buying them is often very useful for an SME as it avoids the need to raise the capital cost. However, leasing is only really possible on tangible assets such as cars, machines, etc.
Banks may be willing to provide an overdraft of some sort and may be willing to lend in the long term where that lending can be secured on major assets such as land and buildings. However, raising medium-term finance to fund operations is often more difficult for SMEs as banks are traditionally rather conservative. This is understandable as the loss on one defaulted loan requires many good loans to recover that loss.
Hence, many SMEs end up financing medium-term, and potentially longer-term assets, with short-term finance such as an overdraft. This is poor matching and very much less than ideal. This issue is often known as the ‘maturity gap’ as there s a mismatch of the maturity of the assets andli abilities within the business.
Furthermore, banks will often require personal guarantees from the owner-manager of the SME, which means the owner-manager has to risk his personal wealth in order to fund the company.
THE VENTURE CAPITALIST
A venture capitalist company is very often a subsidiary of a company that has significant cash holdings that they need to invest. The venture capitalist subsidiary is a high-risk, potentially high-return part of their investment portfolio. Hence, many banks will have venture capitalist subsidiaries.
In order to attract venture capital funding an SME has to have a business idea that may create the high returns the venture capitalist is seeking. As such, for many SMEs, operating in regular business, venture capitalist financing may not be possible. Furthermore, a venture capitalist rarely wants to remain invested in the long term and, hence, any proposal to them must show how they will be able to ‘exit’ or release their value after a
number of years.
By achieving a listing on a stock exchange an SME would become a quoted company and,
hence, raising finance would become less of an issue. However, before a listing can be
considered the company must grow to such a size that a listing is feasible. Many SMEs can
never hope to achieve this.
SUPPLY CHAIN FINANCING
In supply chain financing (SCF) the finance follows the value as it moves through the supply chain. SCF is relatively new and is different to traditional working capital financing methods, such as factoring or offering settlement discounts, because it promotes collaboration between buyers and sellers in the supply chain.
Traditionally there was competition as the buyer wanted to take extended credit, and the
seller wanted quick payment. SCF works very well where the buyer has a better credit rating than the seller.
Technological solutions are used in order to efficiently link the buyer, the seller and the financial institution. These technological solutions effectively automate the business and
financial process from initiation to completion.
SCF can bring considerable benefit and can cover more than one step in the supply chain. It is perhaps of most benefit where considerable value is constantly moving through the supply chain. SCF is only currently used in a relatively small proportion of companies, but its use is expected to grow significantly. As with factoring and invoice discounting, this source of finance is only short term in nature.
Crowdfunding involves funding a venture by raising finance from a large number of people (the crowd) and is very often achieved over the Internet.
The Internet platforms are set up and run by moderating organisations who bring together the project initiator with the idea, and those organisations and individuals who are willing to support the idea. Different platforms have different policies with regard to assessing the ideas seeking support and checking those willing to provide the finance. Therefore, great care is needed when using these platforms.
Finance provided by crowdfunding may be invested in the debt or the equity of the ventures seeking the finance. Some crowdfunding is done on a ‘keep it all’ basis where any funds raised are kept by the recipient, whereas some is done on an ‘all or nothing basis’ where the recipient only receives the funds if the total required to fund the particular
project is raised within a given time frame. The crowdfunding platform takes a fee, which is often a percentage of the amount raised.
A feature of crowdfunding is that it lets people search for and invest in ideas and projects that they have an interest or a belief in. Hence, these investors are sometimes willing to take bigger risks and/or accept lower returns than would be usual. A further feature is that, just as in a real crowd, there is potential for interaction within the crowd, as such keen supporters of a particular idea will very often encourage others to participate.
Crowdfunding has the potential to be very beneficial to SMEs. It allows them to contact and appeal directly to investors, who may be willing to take the risk involved in funding the new technologies and innovations, which SMEs are often so good at producing.