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CHAPTER ONE: INTRODUCTION
Aim of the study
1.1 One of the most consistent themes in discussions about small business finance in the UK is whether or not there are 'gaps' in the market that justify intervention (Storey, 1994). It is sometimes suggested that finance providers are not providing the finance that small businesses need to fund their development and growth and that supply-side failures do exist, particularly relating to certain types of businesses ( e.g. new firms and rapidly growing young firms). However, such views frequently rely on rather anecdotal and partial evidence. This study is concerned with acquiring more robust survey data in order to establish whether or not there is evidence of market failure in the provision of finance to Scottish SMEs.
1.2 In particular, the purpose of this research is to investigate further the difficulties that a significant minority of Scottish SMEs that took part in the Annual Small Business Survey ( ASBS) (Scotland) reported in accessing finance from banks. The research was prompted by results from the 2005 ASBS survey which showed that, out of the 1002 SMEs that took part in the survey, 11 per cent of them sought finance in the 12 months prior to the survey and just under a quarter of these reported experiencing problems accessing finance. The firms experiencing difficulties were more likely to be proposing to grow, with younger businesses (less than four years old) being proportionally more likely to face problems. The ASBS produced some insights into the reasons for the difficulties, the most frequently cited reason being insufficient security (particularly in the case of micro-businesses); poor business performance/profit margins; no credit history; wrong business sector; and poor personal credit history. However, more evidence is required on the reasons for experiencing difficulties because of the small number of firms answering this question in the survey. Moreover, there is very little evidence in the ASBS survey relating to the sources of finance used by SMEs. Hence the purpose of this study is to explore the reasons for the difficulties that small businesses experienced in greater depth, focusing particularly on access to bank finance.
1.3 The key question at the heart of the research is whether firms are experiencing difficulties because of the unsuitability of the business case that they are putting to finance providers ( i.e. demand-side issues), or whether the difficulties result from sub-optimal lending practices, resulting in some potentially viable proposals being rejected ( i.e. supply-side issues). This requires knowledge of lending practices, including credit scoring methods used by the banks, and their implications for different types of small business, as for example differentiated by sector, size, age, and gender of the owner. The principal focus of the study will be bank lending to small firms, since evidence shows that commercial banks are the main source of loan and debt finance for SMEs, including a previous Scottish Government study of issues affecting SME financing decisions (Hamilton et al, 2002).
Existing Research
1.4 Before presenting the findings of the study, it is helpful to highlight some of the issues relating to bank finance and SMEs that have been identified in previous studies (for a recent review of much of the literature relating to the difficulties of accessing finance by SMEs see CEEDR (2007)).
Demand-side issues
1.5 Whilst overall the majority of SMEs appear not to have difficulties obtaining external finance, there is evidence to indicate that a number of groups and sectors do face distinct challenges in accessing finance. Existing research evidence indicates that dissatisfaction with the availability of loan finance and overdraft finance from banks is greatest among the youngest and smallest firms ( e.g.FSB, 2002). High levels of dissatisfaction with bank finance have also been found amongst women entrepreneurs (Fielden et al, 2003), which may reflect the fact that they do not necessarily fit the normal business owner stereotypes of bank lending managers and that they invariably run low tech enterprises in the personal service sectors. Compared to men, women perceive risks differently and are less inclined to use their own house as collateral (Wilson, 2007).
1.6 There is also evidence to indicate that Black and Minority Ethnic Businesses ( BMEBs) are more likely to experience difficulties in accessing external finance than non- BMEBs, and particularly those from the Afro-Caribbean community (British Bankers Association, 2002; Small Business Survey, 2006). In Scotland, research has shown a marked reluctance amongst Scottish BMEBs to approach or attempt to use bank finance, even amongst second generation owners (Deakins et al, 2005).
1.7 Much of the existing research on the relationship between banks and small businesses draws attention to the problems of information asymmetry. For example, a study of micro-enterprises (Lean & Tucker, 2000) found that whilst two thirds of them relied on bank overdraft facilities, many of the difficulties that were encountered revealed that financial providers had a lack of knowledge about the nature of the client's business on the one hand, and that many business owners had a lack of knowledge about the lending criteria and procedures of the banks on the other. As far as the business owners were concerned, a lack of securable assets was the most frequently cited difficulty in obtaining bank finance. This study also suggested that trends in the banking sector such as market concentration and centralisation have compounded the problem of information asymmetry.
1.8 Furthermore, information asymmetry is particularly acute in new ventures. At this early stage information is limited and not always transparent (Hall et al, 2000; Schmid 2001) and assets are often knowledge based exclusively associated with the founding entrepreneur (Hsu, 2004). Within established businesses information is more efficiently transferred by, for example, an established track record and product branding, mechanisms not readily available to business start-ups. Actual and potential investors in start-ups work with less historic performance data on which investment judgements can be based and this issue is exacerbated because entrepreneurs possess a considerable informational advantage about the businesses for which funds are required. Entrepreneurs may be reluctant to provide full information about the opportunity because of concerns that disclosure may make it easier for others to exploit (Shane and Cable, 2002). Additionally, entrepreneurs seeking funding have an incentive to emphasise the strengths in a business proposal and to keep hidden what they know to be any flaws.
1.9 There is much debate to the exact nature of a finance gap but the perception of such a gap may reduce the willingness of SMEs to approach the banking network to secure appropriate financing. A report for the SBS (Allinson, 2005 p.3) commented: "if people do not present themselves to a financial institution in the first place, because of self-selection and possibly underpinned by belief in a myth, then it may appear that the institutions' rates of granting loans are quite high - that they are meeting demand." This can lead to businesses seeking to 'bootstrap' rather than securing more appropriate financial packages. Typically these businesses become dependent on financial support from their own resources and family and friends. "But that leaves a problem for anyone with a viable proposition but without family and friends without any resources to help" (Irwin and Scott 2005 p.6). This scenario is a key issue for some businesses at the start-up phase, Fraser (2005) for example, found that obtaining finance is a major problem at start-up for 10 per cent of businesses: 11 per cent of businesses needing new finance experienced outright rejection; 19 per cent received less than they wanted; and 8 per cent felt discouraged from applying because they expected to be rejected. As Irwin and Scott (2005 p.7) comment: "These figures of course, disguise two problems - the businesses for whatever reason, are unable to raise finance and, perhaps more importantly, those prospective businesses that never actually start because they are unable to raise the finance."
Supply-side issues
1.10 Some recent work on bank lending decisions, focused particularly on credit scoring, highlights the variability between lending officers working for the same clearing bank in the way in which they applied the same credit scoring framework (Wilson et al, 2006). Interestingly, it also showed the importance that was attached to the character of the business owner, compared with other factors such as collateral and capitalisation.
1.11 There is some evidence that accessing finance may be affected by differences in supply-side practices and policies i.e. in commercial banking policy ( BBA, 2002), insofar as they affect the perceptions and attitudes of small business owners seeking to raise finance. For example, commercial banks differ in the extent to which relationship banking is applied to the small firms sector, with some differences in the extent of centralised decision-making, based on credit-scoring methods but with local relationship bankers working with small firm clients, compared with more localised systems of decision-making.
1.12 The extent to which banks work with intermediaries may also affect access to finance for some business owners (Watanabe 2005). For example, this may include referral from agencies or brokers. It is arguable that access to such networks may, in turn, affect access to finance through the ability to call on recommendations (Deakins et al, 2003).
1.13 A related and emerging issue in the literature is the discouraged borrower effect (Kon and Storey, 2003; Fraser, 2005), which can also affect attitudes to seeking finance and the approach to providers of finance. That is, some small business owners may not access finance because at some stage they are discouraged from applying. For example, it may be that some of those firms reporting difficulties may be discouraged from applying by 'reputational' effects (as sometimes happens with ethnic minority or women owners, who may be discouraged by perceived bureaucracy or financial requirements) or are discouraged by a first refusal. It has been suggested that banks with extensive and close relationships with some small firm communities may be able to overcome these adverse effects (Watanabe, 2005).
Market Failure
1.14 There is still some academic debate about whether there is still market failure in small firms' access to finance (Bank of England, 2004). Market failure only exists if small firms with viable propositions are unable to raise the amount and type of finance required. Market failure will always be a difficult issue to research, since judgements are required about the viability of propositions. However, the issue can be discussed in terms of access to sources of equity and sources of debt finance for small firms.
1.15 On access to equity, there is general agreement that there have been reductions in equity gaps over time. Although venture capitalists face cost issues in carrying out due diligence process for relatively small amounts of equity finance (below £250,000), a number of factors such as the development of business angel networks, the work of LINC Scotland and the success of the Scottish Co-Investment Fund ( SCF) in Scotland have all contributed to increased availability of small amounts of venture finance, that is improvements in the supply of equity required by small firms. An indication is the success of the SCF which has provided 219 investments in 109 companies since 2004 (Scottish Government, 2008). In addition, on the demand side, improvements to the quality of business propositions have been possible by investor-ready schemes, better quality of advice and the focus of specialised support on the high growth firms that would qualify for equity finance. However, the former Small Business Service (now the Enterprise Directorate) review of evidence on access to finance suggested that "small businesses find it difficult to obtain modest amounts of private equity finance" ( SBS, 2004). Thus, despite developments in the promotion of sources of informal venture capital, there is still some debate about whether there is market failure for small firms seeking venture finance below £200,000.
1.16 Access to debt finance is generally concerned with the ability of small firms to raise finance with the commercial banks. Market failure may exist if small firms are unable to access loan funding for the length of time required, assuming that propositions are viable. Commonly collateral will be required and market failure may also exist if business owners do have the security levels required by commercial banks. As with access to equity finance, supply-side improvements have been made, for example in advice, making propositions more fundable and in awareness of the requirements of bankers to small firm owners and through greater emphasis by the commercial banks on relationship banking. The announcement by the Bank of England that it was no longer going to produce an annual report on the finance of small firms (the last year that the Bank produced its annual report was 2004) would suggest that the official view is that there are no longer significant issues for small firms in raising finance from the banks. However, some issues still remain that may indicate some continued market failure. For example, entrepreneurs from deprived areas will have limited security which can affect their ability to raise loan finance. The Small Firms' Loan Guarantee ( SFLG) Scheme is designed to tackle precisely this form of market failure and is discussed in more detail, when discussing findings from interviews with bankers later in the report (see section 6.5).
1.17 A separate issue relating to market failure, referred to above, is whether entrepreneurs may perceive difficulties with raising financing ( CEEDR, 2007). Whether these difficulties exist or not, entrepreneurs may not seek finance if there are perceived issues. This could be either that they think they will be unsuccessful so there is little point in applying or a perception that they will not have the information and good credit history that it is perceived that banks require. It may occur where entrepreneurs from certain groups distrust bankers, as for example can occur with ethnic minority entrepreneurs who can be discouraged borrowers since they perceive institutional bias in banking institutions. Other work has suggested that women seeking to start-up businesses may also form a category of discouraged borrowers (Roper and Scott, 2007). The extent of any discouraged borrower effect is unknown, but it may be important amongst ethnic immigrant groups.
Methodology
1.18 The research has comprised a number of linked stages. An important feature has been to obtain information on the supply as well as the demand for bank finance. A novel aspect of the research has therefore involved interviews with a number of bank managers using the technique of protocol analysis based on a number of actual case study scenarios.
Analysis of ASBS (Scotland) survey data
1.19 The starting point was to undertake analysis of the questions on access to finance in the 2006 ASBS (Scotland) for the 64 firms that indicated problems in accessing business finance. As well as information on various characteristics ( e.g. age, sector, growth orientation) of the businesses, this provides some data on the nature of the difficulties that the businesses experienced, the type and amount of finance being sought, and reasons for the difficulties.
Telephone survey of SMEs reporting difficulties in obtaining finance
1.20 To investigate the issues in greater depth, a telephone survey of 51 Scottish SME owner/managers was undertaken during July and August 2007, drawn from respondents to both the 2006 and 2005 ASBSs in Scotland who had indicated that they had encountered some form of problem in accessing external finance for their business. These comprise businesses that: (i) obtained no finance; (ii) obtained less finance than they required; or (iii) obtained what they required but with difficulties.
1.21 Survey data was collected via extended telephone interviews, undertaken with owner/managers of SMEs. These interviews typically lasted around 30 minutes and in some of the more interesting cases, follow up interviews took place in order to gain greater clarification on the financial status of the firm and the proposed projects that the owner/managers were seeking external finance for. The survey probed in order to find out whether the access to bank finance problems encountered were as a result of (i) risk averse bank lending procedures and decisions, as opposed to (ii) poor business proposals and/or the poor financial status of applicants.
Case studies
1.22 The telephone survey also acted as the basis for selecting a small number of test cases of firms that, on the face of it, appeared to have put forward a strong business case for bank finance. These cases are of particular interest to the research since they provide instances of where a seemingly good business proposition has been rejected for loan/debt finance or where the failure to obtain external finance has seriously curtailed the growth of the business. Seven case scenarios were selected and presented to a bank lending expert who narrowed them down to five cases that were suitable for the protocol analysis that was to be used in the interviews with current bank lending officers.
Interviews with bank managers
1.23 A total of eight face-to-face interviews were conducted with managers at different seniority levels within three of the four Scottish commercial banks. These interviews utilised the five chosen case study scenarios developed from the business interviews. The protocol analysis technique involved asking the interviewed managers to think through their decision-making processes using the information provided for the individual case studies. Verbal protocol analysis is a proven social research technique where the subject of the research is managerial decision-making. In this study, there was a need to obtain information on the 'protocols' that decision-makers use when making decisions. The technique involves using real scenarios or real cases, or if hypothetical scenarios ones that are as close as possible to real cases, which are then used to ask managers to talk through their decision-making process. As such, the technique is deliberately open-ended and to some extent dependent on the skill of the researcher, as well as on the quality of the real cases. Better analysis can be obtained if a variety of real cases is provided (Ericsson and Simon, 1993). In some cases, it may be an explanation of how a case may be recommended to a central decision-making unit, or it may involve more localised decision-making based on additional material. The purpose of the interviews was to obtain information on the processes decision-makers use in banks, how loan applications are dealt with and the main reasons for acceptance and referral.
1.24 Verbal protocol analysis has been used previously in the analysis of bank managers' and other funders' decision-making, although the extent of its use has been limited and the quality of the studies rather varied. This is not surprising given the demanding nature of the technique on resources, on researchers and on access to the key decision-makers. Previous examples include Wilson, et al (2007) who used one hypothesised business proposition in their research with 35 bank managers who were asked to describe their reactions, the criteria they were considering and their loan decision. Also Mason and Stark (2004) used verbal protocol analysis with three bankers, three venture capital fund managers and four business angels who were asked to examine three outline business proposals (taken from Venture Capital Report and Business Angel Bureau). Apart from these examples, however, previous research on decision-making in this area, using verbal protocol analysis has been limited to analysis of venture capital decision-making (Mason and Stark, 2004).
Structure of the Report
1.25 This chapter has discussed the purpose of this study within the context of the various issues raised by existing research on access to finance by SMEs and also has outlined the multi-method approach used in the research. The next three chapters are concerned with the results of the demand-side analysis. Chapter two presents the findings from the 2006 ASBS relating to those SMEs that indicated they were experiencing problems in accessing finance. Chapter three then takes the analysis further by presenting the findings relating to the SMEs that were interviewed for the purposes of this research before looking in more detail at those firms that had particular difficulties accessing bank finance in chapter four. The next two chapters focus upon the supply-side analysis, with chapter five presenting the results of the protocol analysis conducted with the interviewed bank managers using five selected SME case studies and chapter six discussing more generally the way in the which Scottish banks deal with applications from SMEs. The final chapter presents the study's conclusions from both the business survey and the interviews with the bankers, before returning to the key question at the heart of the research of whether the difficulties that SMEs experience in accessing bank finance are the result of sub-optimal lending practices, or whether they are the result of the unsuitability of the business cases that SMEs are putting to finance providers.
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