Bridging the Finance Gap: A Consultation on Improving Access to Growth Capital for Small Businesses.
Memorandum submitted in July 2003 by the Institute of Chartered Accountants in England and Wales (ICAEW) to the Small Business Service (SBS) of the Department of Trade and Industry (DTI) in response to the Consultative Document issued jointly by SBS and HM Treasury in April 2003
HM Treasury and SBS jointly issued a Consultative Document in April 2003 to seek the views of interested parties on 'what more could be done to ensure that entrepreneurs have access to the finance they need to turn their ideas into thriving businesses' Foreword to the Consultative Document. The Foreword was signed by both the Chancellor of the Exchequer and the Secretary of State for Trade and Industry. Written responses were requested by 25 July 2003.
The Executive Summary noted that there was an 'equity gap' in terms of an inability to find funding for businesses which required an injection of funds of amounts in the range £250,000 to £1 million.
'Many commercial venture capitalists are reluctant to invest in small amounts (a £1 million threshold is often cited) for a variety of reasons, principally high fixed transaction costs, shortage of available exit options, and a perceived greater risk in investing in early-stage companies. Although the UK has one of the most developed private equity markets in the world, it has increasingly focused on later-stage deals. While the overall number of private equity investments has increased by 17 per cent since 1997, the number in the £500,000 -£1 million range has declined by 10 per cent.'
Paragraph E.8 of the Consultative Document
We believe there is an equity gap but it is most acute in relation to early-stage companies.
In the case of established companies, where equity is required for expansion or for a buy-out, our experience is that there is much less of a 'gap' in practice. If the business is established, and can justify investment, the existing VCT funds and funds backed by high net worth individuals are interested in levels above about £500,000. There may be a case for addressing the range £250,000 to £500,000, although in certain regions of the UK the Regional Venture Capital Funds have been successful in addressing this market. The problem in those cases is primarily one of the relatively high up-front cost of due diligence and legal fees for an equity investment, rather than a problem of availability.
In order to overcome the latter problem the most effective remedy may be to raise the upper limit for Small Fund Loan Guarantee (SFLG) support.
In the case of early-stage companies, there is currently a clear problem at almost any size of equity investment. This problem arises from the high perceived risk (probably a more accurate assessment that that prevalent in the technology boom of 1998-2000) so it is not easily removed by the introduction of a new type of fund based on increased leverage, which further increases the level of risk of loss for private sector investors.
We note that in its 2003 report, published in mid July, the Small Business Council second Recommendation is 'that Treasury undertake and publish research into what measures are needed to improve the take-up of equity finance in small firms.' The report notes that the Government continues to concentrate on the supply of equity with too little attention to the take-up and delivery. The report also quotes the tenth report of the Bank of England on 'Finance for small firms', published in April 2003: this notes that although equity forms only a small part of the external finance sought by small businesses it is vital to those small firms with real growth potential.
If one is making comparisons between the UK and the US banking industries, insofar as they serve early-stage companies, then there are some interesting differences. In the US there is still an extremely healthy regional and local banking sector competing with the national giants. Local banks tend to specialise in serving smaller businesses in geographically focused areas, and we believe that this 'devolved' banking structure benefits emerging businesses in providing more focused, flexible and competitive services.
There is considerable evidence that SFLG scheme has been extremely successful.
Surveys of our members, in particular the 1999 SME Finance & Regulation Enterprise survey, indicate that members believe that the SFLG scheme is the most established and utilised source of government SME finance. At that time, in 1999, 66% of respondents wanted the terms of the SFLG scheme widened. This has now happened.
'On 1 April 2003, [the SFLG] was expanded to a number of additional business sectors, including retailing, catering and vehicle repair; a single guarantee level was introduced; and the maximum turnover limit for service sector businesses was raised to £3 million per year.'
In our view one of the major drawbacks of the SFLG scheme is that it is not always used consistently by finance providers. Not every finance provider automatically considers the SFLG scheme in circumstances where traditional evaluation of a finance proposition would lead to its rejection.
There is evidence that some lenders are more inclined to propose the SFLG scheme than others. So a particular finance proposition may be turned down by one lender without the SFLG scheme having been considered. The proposition may then be dropped even though it would have been acceptable to another lender under the SFLG scheme.
We believe that the existing schemes, and in particular EIS, are already too complicated.
We believe that now would be an appropriate moment to review the EIS scheme and the extent and nature of the conditions that have to be satisfied to qualify for relief under the scheme. While we appreciate the need to safeguard the scheme from abuse we feel that some of the existing conditions are unnecessarily restrictive. We are aware that the EIS Association has put forward specific proposals in the context of the current Consultation and we would very much appreciate the opportunity to be involved in any review of the current regime.
The research quoted in the Consultative Document indicates that both EIS and VCT schemes 'appear to be reasonably effective in targeting the companies for which they are intended' and 'the schemes play a significant and growing role in the supply of private equity funds in the UK'.
EIS investee companies are typically younger, smaller businesses seeking start-up or early-stage finance, with half of all EIS companies raising less than £100,000 through the scheme. By contrast, 'VCT investee companies are typically larger, more mature businesses, raising much larger amounts of capital. They raised an average of over £1.5 million (or a median of £900,000) through the scheme.'
As this division between EIS and VCT investee companies has evolved naturally we are not convinced that it would be sensible to seek to change the structure of the VCT unless the later was failing in its policy objective or rationale. This does not appear to be the case from the most recent research quoted in the Consultative Document.
If despite the above remarks the Government does wish to encourage VCTs to invest in higher risk, potentially higher reward investments, then one way to do this is to utilise leverage. But this would only act as an encouragement to such riskier investment if the borrowings that create the leverage share in the risks of failure, so as to make the effect of the leverage asymmetric between successful and failing investments. So for example there should be an additional premium over the normal lending rate as the price of the leverage. This would make a safe investment, say in property, uneconomic, but allows the leverage to give investors an extra return on significant capital gains at modest cost. The long existing design of the SFLG scheme can be taken as an example for this leverage model.
We believe there could be advantages in encouraging more formal angel groups and facilitating links between them.
The Authorised Investment Fund (AIF) already offers a tax incentive for collective investment through the EIS scheme. We understand that there are less than 10 AIFs in the UK and we believe this may be because of the practical difficulty of setting up such schemes. We would encourage the Government to carry out some further research into the lack of take up of AIF. We would then be pleased to assist in considering practical ways in which AIFs could be made more attractive to potential providers and investors.
We note that Scottish Enterprise has recently set up a co-investment fund under which they propose to combine with several of the leading Scottish business angels in an arrangement which is similar to Small Business Investment Companies (SBIC) considered in Chapter 4 of the Consultative Document. Under the Scottish scheme, Scottish Enterprise is to put up an amount of £20 million as matched funding to be used, in the main, by business angel syndicates of which the first two, Archangel and Braveheart, were announced at the end of March 2003. A report of this initiative appeared in the 3 June 2003 issue of the Financial Times.
We would strongly recommend that the Government considers the Scottish scheme as well as the US SBIC scheme before it takes a decision to introduce a new formal scheme in the UK.
We believe that increasing the income tax relief would encourage greater investment and we believe it would be acceptable for this to be balanced by the replacement of the exemption for gains on EIS and VCT shares by business asset taper relief.
The ICAEW 1999 Survey of its members SME Finance & Regulation Enterprise indicated a strong feeling amongst our members that there should be increased information/education as to the various sources of finance.
The SBS and HM Treasury have set up a working party to consider how accountants can improve SME awareness of sources of finance, including equity finance.
The DTI is currently developing a new website whereby all government 'interventions' will be identified.
All the above provide opportunities to signpost to businesses the available sources of finance as well as how and where to seek appropriate advice.
We believe the Government should also look at the recent Scottish model,mentioned in paragraph 24 as this provides another model for a potential new scheme.
We have made some initial remarks about leverage in paragraph 21 As we noted there, leverage will only promote greater risk taking if the leverage is designed to bear risk itself. There is an existing model for this in the SFLG scheme.
It is possible that 'the supply of risk capital managers' and 'enhancing the impact of business angels' objectives are not mutually exclusive. At the smaller end of the market in the US, managers commonly are former larger institutional employees who have first hand experience and a network of potential investors before they branch out on their own as principals.
Moreover, their networks include individual angels, families and other financial and non-financial institutions and intermediaries, some types of which do not exist in the UK to the same degree (for example the incidence of US types of endowed University).
It is possible that simply improving the supply of managers in the UK may not be enough, and may need to be supported (perhaps only initially) by some additional 'lubrication' to the market for Private capital as well. One could look at the US model of using investment trusts to pool public capital and perhaps consider that in the UK this tool could be used instead to capture and pool private capital: such a more liquid and risk diverse model could encourage private investors and institutions into this sector.
The US has also successful avoided a model where 'one size' is designed to fit all possibilities. There are several fundamental types of SBIC (each with markedly different structural characteristics), and the US Small Business Administraton (SBA) requires each new applicant of any type additionally to commit in advance to an investment plan as part of the licensing process.
Together, these allow for prospective SBICs to be better matched to the needs of any particular situation. Translated into the UK context the Treasury could perhaps operate a set of core regulations, applicable to all SBICs, with a further 'variable' set of goals or guidelines which prospective SBICs would have to address when applying for approval.
The UK should also seek to replicate the best of the US experience in terms of public regulation and private initiative. In the US organisations such as the National Association of SBICs fund and provide research and push for new developments and ideas while the SBA provides the 'checks and balances' through its regulatory office.
Local & Regional Networks - Because of the fragmentation of the US infrastructure below the federal level into significant State, City and other regional blocs, which in turn affect inter alia the banking sector it may not be that 'localised' networks will be as appropriate in the UK, especially where key stakeholder institutions (banks, institutional investors etc.) are far more consolidated on a national scale making the UK perhaps equivalent to just one US 'region'. One other disadvantage of localization would be cost, which is after all one of the perceived causes of market failure in this area.