SMEs play a crucial role in the market with the provision of opportunities and service to the market segments that are underserved by the well-established firms that tend to serve select niche. However, SMEs operations are subject to various factors including their finance capacity. That means they need adequate finances to venture and thrive in the markets from the onset throughout their growth to become well-established enterprises. In that view, there are various sources of funding that can be utilized and which have different aspects that vary their appropriateness at different growth stages. In addition, SMEs face challenges in raising finances hence a need to analyze the different sources and their appropriateness, as well as challenges. In that respect, analysis of the advantages and disadvantages of different sources of finance available to SMEs and the challenges faced is the subject of this discussion. The analysis is done with reference to market practices and relevant data.
- Sources of financing
There are different sources of finance that are available of SMEs and whose suitability varies with size and stage of the firm’s development. However, each source has advantages and disadvantages. (McLaney, 2000) Some of the key sources are angel business financing, bank loans and public equity as well as debt discussed as follows.
Business angel financing:
It is the funding that is provided by high net worth individuals and agencies with a focus on innovative ideas. The source is suitable for initiatives that have viable market opportunities. The investments are usually smaller compared to other forms of financing such as venture capital. They also target businesses at the early stage of their establishments. In addition, they usually invest in high-risk businesses where there are opportunities. A typical Engel investments range from £10,000 to £2 million and can be done alone or as s syndicate. (Beck, 2013)
- The angels usually have industry experience hence have an understanding of the business operations and risks involved.
- They present flexible agreements to the businesses as they are less rigid compared to other forms such as venture capital.
- It is s suitable source of capital when the owners have exhausted other cheaper sources such as family and personal savings.
- They provide flexibility of raising small amounts of capital opposed to other forms that may only be necessary for large amounts of capital.
- Flexibility in the agreements is possible as the Engels are investing their money hence ability to negotiate for terms with the business.
- Involvements of the Engels in the daily running of the business are an advantage as it boosts the management performance and operations.
- It helps businesses operating in high-risk ventures. That means that they provide opportunities for ventures whose future is uncertain as opposed to other forms of financing that would require track record and prove of performance and sustainability.
- They save the business the burden to play punitive monthly or scheduled repayments like the case with bank loans.
- They are useful in helping the business connect with the society hence enhancing its CSR and sustainability. That is because the Engels mainly supports businesses in their local communities hence offering opportunities to the community that enhances businesses image in the community. (Hussain, Millman & Matlay, 2006)
- Owing to high risks involved, the angels do not follow up on the business
- The business owners are forced to give up some ownership interest in the enterprise.
- They provide funding in exchange of some controlling interest in the business.
- The angels may also hire other professionals to represent them in the business management. In that respect, they may present challenges to the owners in the management of the business.
- The Engels may lack industry experience while they are involved in the running the business, and that may present a challenge to the management. (Berger & Udell, 2006)
Banks provide short term and medium term bank loans that are suitable for enterprises that have established themselves and had stable cash flow to meet the repayments. They are demanding in terms of fixed schedule and collateral requirements. It presents a source of funds that is frequently sought after and can be accessed from the nearest institution.
- They have fairly quick processing when the business has qualified for the loans.
- They present an opportunity for the owners to protect their interests as they retain control of their ventures.
- They also present a variety of choices for businesses to choose from. (Beck, 2013)
- They are not easy to obtain, and their criteria keep changing that could be challenging to businesses.
- There is an obligation to be met by the business owners whether the business succeeds or not.
- The loans processing can be tedious through the application and appraisal process that may require much documentation.
- They present numerous options that may be confusing to the business owners as to which are the most suitable option for their business. (Hussain et al, 2006)
The method entails borrowing from the public through instruments such as corporate bonds. Thus, it requires a significant interest to attract investors and have a fixed payment schedule that requires a business to have sustainable operations and cash flows. It is suitable for businesses that have massive opportunities and performance. In addition, debt financing has a promise to pay back the principal and interests that are agreed upon.
- It presents an opportunity for tax deductions for the business since the debt interests is classified as an expense.
- The business owners can retain control and full ownership of the business as there are no new partners brought into the business through the funding agreements. (McLaney, 2000)
- High debt level presents a high risk to a business hence not desirable for its credit rating.
- It requires that the business has certain operations that can repay the loan and also involves collateral that can be used in case of a default by the business. (Beck, 2013)
It ss the highest level of financing for a business that has achieved growth and were in need for large capital for expansion. The method entails sharing ownership with the public in exchange of share capital. (Berger & Udell, 2006)
- The payments to equity holders are paid back as dividends and are usually dependent on the business profitability. In that respect, it is flexible and allows a business to reinvest the earnings for expansion and pay varying amounts to shareholders as they develop the business.
- The sourcing is suitable of businesses where banks and other funding means are not appropriate. That entails situations like when a business does not have adequate tangible assets for bank financing and when there is no certain cash flows to sustain fixed repayments for bank loans.
- Investors’ makes a follow-up with the business hence keeps influencing decision making towards business sustainability and success. (Beck, 2013)
- It requires the business to meet several legal and regulatory requirements before qualifying for equity funding.
- It results to a business losing business interest to the equity holders who have an influence of key decision making. (McLaney, 2000)
In India, the statistics collected in 2009 for the Fourth Census of SMEs revealed that only 5.18% of both registered and unregistered enterprises accessed funding through institutional sources such as loans. In addition, only 2.05% of the enterprises accessed funds through non-institutional sources while the majority of 92.77% were dependent on self-finance or had no finance sources. Further, research by the Center for Analytical Finance and the Indian school of business that indicated that a large portion of SMEs financing is from non- market sources. (Raj, 2012)
In view of the statistics, it is clear that SMEs’ major source of finance is the internal sources that marked an increase in 2005 compared to the 2001-05 average. In addition, there is a decrease in use of Equity as a source of finance for SMEs while all firms’ average is marked by increase in use of equity funding. Further, there is an increase in SME’s reliance on promoters financing as well as use of other sources. (Raj, 2012)
However, in Europe, most SMEs are financed by bank loans while equity and angel financing accounts for a small portion of funding. For example, in 2010 investments equivalent of £1.9 billion were funded through bank loans while business angels funding for SMEs ranged between £4 and £5 billion. (CES, 2012)
- SMES’ challenges in raising finances
Challenges common to the four finance sourcing
Literature on enterprise financing identifies three key obstacles in SMEs Financing. The obstacles include information asymmetries between investors, lenders and the SMEs, the higher risk of small scale enterprises, sizable transaction costs in SMEs financing. Finally, there is a lack of collateral. (McKee & Kimball, 2003)
Other challenges include SMEs’ high-risk profile hence make it difficult to access finances. There are a number of reasons why the finance source of lenders refers SME’s as high-risk businesses. One is because they face uncertainty in a competitive environment compared to the large firms. (Klapper, 2006) In that respect, SME’s are prone to the high rate of failures and low return. Another reason is that SMEs are usually less equipped in capital and human resources hence vulnerable to economic adversaries. Third, the enterprises have inadequate accounting systems hence undermining reliability and accessibility of their finance information on aspects such as profitability. In that respect, it is difficult to assess their repayment capacity. Finally, SMEs are mainly found in developing countries where they face more volatile environment hence a risk to their transactions security. (Hussain, Millman & Matlay, 2006)
Further, the high transaction costs in SME financing makes it more expensive for the businesses hence inability to access affordable financing. The enterprises present a higher risk that lenders will not be paid back hence inability to access financing easily. In addition, loan appraisal and due diligence exercise cost are dependent on the size of the funding in consideration. However, there are some fixed costs such as legal fees, administrative cost and information acquisition cost. In that respect, it becomes difficult to recover those costs from small loans and funding transactions as those associated with SMEs financing. Further, there are high costs for outside financiers owing to the higher costs of disbursing funds and conducting inspections. (Irwin & Scott, 2010) The problem is most prevalent in developing countries owing to the following.
- Lack of adequate management information systems by the businesses
- Poor state of public services such as registration of collaterals and property titles
- Undeveloped nature of the economic information system.( Berger, Rosen & Udell, 2007)
In view of those challenges, lenders tend to raise the cost of borrowing through high-interest rates and closing fees. The lack of collateral by SMEs as lenders request for collateral for risk mitigation is another obstacle. In addition, the amount demanded collateral owing to SMEs high-risk profile is relatively high hence the challenges for them in rising finance. (OECD, 2013)
- Banking and debt financing challenges
In developing economies, the banking sectors are less competitive and highly concentrated. That owes to high regulation by governments and it reinforces the adoption of conservative policies in lending. Thus, businesses are charged high-interest rates for bank loans. However, if banks could thrive with well-established clients, they lack the incentive to seek the SME clients through innovative products tailored to their needs. (Ayyagari, Beck & Demirgüç-Kunt, 2007)
In some economies such as the Latin American countries, there is increased crowding out when banks buy the government debt and make hefty profits leaving no funds for SMEs. Further, the inadequate development of necessary legal systems prevents financing instruments development such as collateral use as a risk mitigation element. Such cases apply in determining the suitable collateral and its protection. In addition, even in cases with adequate legislation, there are problems with access of records of the movable assets where they could be missing or misplaced. Finally, there are also lengthy processes of filing for mortgages as well as pledges in addition to longer times taken to ascertain assets costs. (McKee & Kimball, 2003)
Banks are also reluctant to lend money to enterprises with uncertain operations and those without track records as is the case for many SMEs. In addition, the loans are less flexible and involve penalties for early repayment and charges for unused funds. Further, the nature of SME’s business uncertainty and challenging cash flows becomes a challenge for the rigid repayments that are required for bank loans. Finally, need for collateral or directors guarantees are challenges for SMEs access to bank financing. (Beck, 2013)
Examples of such challenges are the US banks credit rating analysis of any business that seeks financing with them. In that respect, lack of credit track record for SME’s could be challenges for a business in providing credit history. (Djankov, McLiesh & Shleifer, 2007)
- Equity finance
The financing method is costly, demanding, and time-consuming thus SME’s finds them to be expensive for their business model. With equity funding, enterprises become subject to various forces that influence their management and strategic decision making. Further, the need by potential investors to access past performance information and scrutinize business performance becomes a challenge owing to lack of adequate accounting systems and records. The method also presents challenges to owners who would want to retain control of their businesses. That is because equity funding dilutes their ownership with the introduction of new investors. Further, there are higher regulatory and legal requirements that an enterprise should comply with in raising finance. Finally, it presents a need for continuous provision of business information to investors. (McLaney, 2000)
Good examples of a challenge that may face SMEs are the SEC requirements for businesses seeking to raise equity capital in the US market. The businesses are required to meet set performance level, management composition and structure that could be difficult for an SME to achieve.
- Angel business financing
SMEs seeking angel financing face challenges ranging from identification of investor with a common interest in their business area. That is usually critical as the angels become part of business decision makers hence have an influence on the direction that the business takes. However, it is difficult to find investors with common interest, experience in the area of operations. In addition, businesses face a challenge in raising adequate capital for major ventures because the financing is limited and may not support massive business expansion. (Djankov et al., 2007)
In view of the analysis, it has been shown that there are various sources of finance available to SMEs and their application’s appropriateness varies with the firm’s growth stage. On the other hand, the major source of financing for SME as shown by the Indian case is the internal sourcing that entails owners and family sourcing, promoters/angel financiers as well and other non-market sources. That owes to the high level of requirements that challenges the access of loan and equity financing. In addition, the two are not costly and entails much commitment in delivering information and influencing management’s decisions. On the other hand, the European market is marked by high level of bank loans financing compared to equity and business angels financing. Finally, it has been made clear that SME’s source of finance faces challenges with some being common in all finance sources while others are the source specific.
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