Why small innovative companies have the hardest time obtaining financing
When we talk to young, fast growing companies about their business, we are often struck by the amount of trouble they have to obtain external financing. Particularly companies that grow up based on digital business models appear to have a harder time than other young companies to get bank financing. Being built on software and intellectual property, something banks find problematic to use as security for loans, they often struggle to finance growth. Our conclusion is that the accelerating digitization trend is an important factor contributing to the SME funding gap. While this connection between digitization and the SME financing gap seems intuitive, we have struggled to find research that provides scientific evidence. For this reason, I was excited to see a mention of a piece of research from the UK that could shine some light on this topic in the latest OECD report on SME financing (“Financing SMEs and Entrepreneurs 2017 – an OECD Scoreboard”).
Development in the UK
Small and Medium-sized Enterprises (SMEs) – companies having less than 250 employees – constitute approx. 60% of private sector employment in the UK. Outstanding business loans to the UK SME sector peaked at GBP 119bn in 2008 and has declined every year since then to reach GBP 97bn in 2015, a decline by more than 18% in the period. A development which is very much in line with what has happened in many other European countries. The London School of Economics (LSE, Lee et al, “Access to finance for innovative SMEs since the financial crisis”, 2015) has looked at how the 2008-2009 financial crisis impacted SMEs access to finance. Based on information from about 10,000 SMEs gathered by the UK Small Business Survey, the LSE study had particular focus on innovative small firms since these companies are most likely to achieve rapid growth and help the economy recover.
In the LSE study, innovative companies are defined as companies that have developed entirely new products in the last 12 months, products that are not only new to the firm but also new to the market. While it is not known to what extent these innovative companies are built on digital business models, the report states that innovative firms are more reliant on intangible assets than other firms. The key findings of the LSE paper are, that small innovative firms have a bigger need of external financing than other firms, that they are more likely to be refused when applying for financing than other companies and that this has become much worse after the 2008-2009 financial crisis. Since access to finance restricts these companies’ ability to grow, this is a very serious issue impacting on the ability of the overall economy to grow.
Financing immaterial assets
The LSE paper goes on to analyse the reasons for this situation and points first to cyclical factors as a consequence of the financial crisis, which are well known. More importantly, they also refer to structural issues across the financial system, which is interesting since these are findings made within the context of innovative companies relying on intangible assets. LSE states that banks generally have difficulties to assess the risks related to the commercialization of new products and new business models as it involves a lot of uncertainty around the borrower’s ability to generate cash to repay the loan and accrued interest. As mentioned above, innovative firms are also more reliant on intangible assets and as banks find it difficult to value intangibles, they also are difficult to use as collateral for loans. Interestingly, LSE also found that there are “few substantive differences in the risk profile” between innovative companies and non-innovative ones, which is a clear indication that the difficulties faced by banks are related to a structural problem within the financial industry. Finally, LSE also found that there was a very clear link between company age and ability to obtain loans, younger companies are more likely to have problem getting financing than older companies, which is not surprising.
Revenue based financing – bridging the gap
While the LSE paper only covers the UK, I think these findings have broader implications. The SME financing situation in the UK is very similar to other European countries and I believe that the LSE’s findings very likely apply to large parts of the European market. In our conversations with young, fast growing companies, we see a clear link between digitization and the financing gap. New businesses built on intangible assets and digital business models are facing huge problems to raise bank financing, clearly due to the banks’ structural inability to deal with them within an SME financing context. At Round2 we are firmly convinced that new business models built on new technology will require new, alternative methods of financing. Revenue based financing is such an alternative to traditional bank financing, which is more suitable to the needs of companies growing up in the digital age.