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Brian Barbour
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Currently studying for a Masters in Oil and Gas Law , University of Aberdeen Past: LLB Law (Hons) & Diploma in Professional Legal Practice,University of Aberdeen. Self-taught in investing from the age of 17 and traded with leverage due to low available funds. From the age of 18 I have been... More
  • The Main Options Available To Small And Medium-Sized Companies When Seeking Finance 0 comments
    Apr 3, 2013 6:27 PM | about stocks: AAPL, AMZN, EBAY, RIG, ALXN, KO, BAC

    The main options available to small and medium-sized companies when seeking finance for their businesses.

    This is my first article and is just for any readers who are interested.

    In the UK there are multiple options available for small and medium sized businesses to obtain financing in order for them to expand. This essay shall explore the various options available and critically review the advantages and disadvantages of each, splitting them up into internal and external types of obtaining financing for their business. Furthermore, it shall look at what problems the business have in obtaining these financial provisions and how they have an effect on what is called the funding gap.

    To understand the options available for financing small and medium sized enterprises (SMEs), it is necessary to understand the precise definition under the Companies Act 2006 for "small" and "medium" sized companies. Section 382 of the act states that a small company is one that has been within the limits of two of the following thresholds since incorporation or, if not then within the limits during the current financial year and the previous financial year of the following: a turnover of £6.5 million or less; a balance sheet total of £3.26 million or less; and the number of employees is 50 or less on a monthly average. Synonymously, a medium sized company is covered by section 465 of the same Act. It is described as one which has been within the limits of two of the following thresholds since incorporation, or if not within the limits of incorporation, then for the previous and the current financial year which has the following: a turnover of £25.9 million or less; a balance sheet total of £12.9 million or less; and finally a number of employees of 250 or less on a monthly basis.

    Firstly, this essay shall look at the internal sources of finance for small and medium sized businesses in the UK. There are three distinct options that these businesses can make use of in order to obtain finance, these are: retained profits; better financial management; and risk management through contractual provisions.

    When businesses have shareholders that receive dividends through the profits of the operations of the company they can choose the percentage yield of the dividend that is distributed to its shareholders. Instead of distributing a large dividend to its shareholders, the company can retain more of the profits so that this money can be put into expanding the business for future operations or investment.

    Alternatively, the business can protect money from the management of risk through certain contractual provisions. In contractual agreements there is the choice of inserting either exclusion or limitation clauses that either completely exclude or limit the liability the company has to another company or individual. This is used in every day contracts of purchase and sale between businesses and customers in relation to products that are sold by businesses in case they become faulty over time. The exclusion clauses are popular however are more likely to be scrutinised. Many businesses prefer using limitation clauses, as they are more appealing to the customer wanting to contract with them and this makes it look like the business have more faith in the success of their services or products. Also, the money used in limitation clauses can come from insurance that the business has. If a contract fails completely and the business cannot pay for something, it can set it off a debt that the other contracting party owes. Many businesses are willing to do this, as they want to keep the relations between themselves and businesses that they contract with on good terms.

    Another way to control risk management by a small or medium sized enterprise is to include retention of title clauses. This allows a party to keep ownership of property passed to the debtor until it is paid. A prime example of this can be seen in the case of Aluminium Industrie Vaassan BV v Rompala 1976. The plaintiffs were sellers of aluminium foil. The plaintiff's clause stated that they would remain owners of the foil and any things that the defenders made the foil into until the payment of the foil was completed. The court of appeal upheld the use of this type of retention of title clause.

    The last internal source of finance for a company can be obtained through better financial management. Businesses commonly have the problem of late-paying debtors. Businesses can make use of diligence to try to rectify this problem. The main forms of diligence in the UK are: attachment of money; arrestment and attachment of moveables; and the inhibition and attachment of land. The business can get a decree of the court to order the debtor to pay certain debts.

    SMEs are also able to get financing through various external options. One major route they could use is through potential lenders. The businesses can get external funding through the use of share issues and debt issues. The available options can be: venture capitalists, business angels, banks, family and friends. However, many problems can arise trying to get funding from these options. One main reason is that, especially for smaller companies there is a much greater risk involved when lending or buying a stake in a company that has not established itself properly yet. There is always going to be a high uncertainty as to whether the company can survive as there is a much larger percentage of smaller and medium sized companies who fail than the much larger, well established ones. This could be due to the fact of the economies of scale, the smaller companies just cannot produce products for the cheap rate that much larger companies could so everything costs more, therefore putting a strain on them to be able to compete. Alternatively, the smaller companies do not have the same amounts of cash that larger ones have to be able to experiment into new markets. The accounting and management of smaller companies can also cause failure, as they do not have the wealth of experience and knowledge compared to larger companies. Especially when there has been a recession and we are only just seeing signs of recovery this has put a struggle on SMEs to obtain funding as the economic conditions have changed the ability of banks to lend as freely as they used to be able to do.

    SMEs also have the ability of issuing shares. They can issue different classes such as: Ordinary 'A', 'B', 'C', shares; weighted voting shares; various types of preference shares and founders shares. There are both positives and complications in doing this. There can be complications over class rights and the more shares the company issues then the more of the companies voting power and potential profits are being given away. The market for shares is a lot less liquid than that for larger companies due to the lack of demand. On the other hand, the issuing of shares can be very beneficial to the company's growth as it provides a means of income that spreads the risk away from the company and to the shareholders. If the share price drops after issue, the company will not be liable to pay back the amount that the shareholders bought them for.

    Another method whereby a company can obtain finance is through trade credit. This is where goods and services delivered to a SME are not paid for immediately but are supplied in credit. The business is given an invoice for the service or goods, which states it has to be paid within a specific period. The normal credit length is 30 days, however upon negotiations this can be extended longer, maybe up to 60 days. This means the trade credit acts as a loan that you can have for longer, which in any case is favourable as seen from the Modigliani-Miller theory that argues that the optimal capital structure can be complete debt finance. The reason for this is that debt is treated preferably over equity as the interest payments of the debt can be offset against the taxable profits to the government.

    In order to obtain trade credit though it might be necessary for a company to obtain a credit check. This can be done through trade references or bank references. This is a cheap way of getting the information on a company and the bank will give an opinion of the creditworthiness of the customer. If the creditor wants to know specific information about the customer then he have to make sure his questions are not vague which could lead to the bank giving vague or ambiguous answers which could lead to a creditor giving finance to a company that then fails. This is what happened in the famous case of Hedley Byrne v Heller Ltd 1963. It was held in this case that the bank would have been negligent had it not been for a disclaimer clause that allowed it to avoid liability. The reference from the bank was given "in confidence and without responsibility". What the credit agencies would do is go through the accounts and public records of the company getting the credit check to see if any court judgements have been made against the debtor.

    There are various advantages of trade credit. Firstly, the company does not have to pay cash up from which means it can use its cash for other things in the mean time. Also, the process is informal, convenient and cheap and is widely used and accepted in all business. There is also an advantage to the suppliers of trade credit as they get more business by giving trade credit than if they did not. Lastly, it is available to any size of company but especially useful to the smaller companies who might struggle in getting finance by other means.

    The SMEs can also borrow from the banks rather than another company that gives trade credit.

    An SME might also which to use financial leases. This means that if they need certain equipment or buildings that they might not have the means to purchase themselves they can seek a financial company to buy whatever the SME needs and then lease it back to the SME. In this situation the financial house is called the lessor and the SME is the lessee (borrower and user of the asset for a rental payment.) This has obvious advantages to the SME in the fact that if they need to use their capital for purchasing other things then they pay smaller increments for the asset leased to them. This could also be more easily obtained than certain other forms of long-term finance, while also being cost saving. This also means that the SME can have the flexibility to get the most up-to-date equipment where there are rapid changes in technology.

    Alternatively, SMEs can raise finance by selling large assets such as their offices to a financial institution on the agreement that they would lease it back to them. This could be good in the sense they could get a large amount of capital to use, however they would lose any appreciation in capital from the buildings if they increase in value over time.

    SMEs can also save capital by acquiring assets by hire purchase so they would pay in increments that would eventually add up to the asset being purchased and owned by the SME. This however requires a deposit and if the SME pays many invoices then cannot pay anymore then they have spent a lot more money for something that they will not legally own.

    Another way a SME can get finance is by the use of factoring. It is where the factor takes over the SME's debt collection. The Factor will usually make an advance payment for the debts (up to 80% of their value) at an interest rate similar given by the banks. The advantage of this is that the company does not have to wait for the debt to mature. A factor will usually charge around 2% on the sales revenue of the SME as a service charge. When the debts mature and the factor obtains all of the money from the debtor he will pay the percentage remaining to the SME, minus any interest payments and expenses. There are two types of factoring: recourse factoring, and full factoring. Recourse factoring is where if there are bad debts in a package, for example, if someone goes bankrupt the factor will take these out and give them back to the SME to take the loss. So the factor will not be at a disadvantage here as the bad debt will be the SME's problem. On the other hand, full factoring is an alternative. This is more expensive to get however the factor will do everything such as chase up even your bad debts. In addition, the SME does not need any fixed assets as a safety net for the factor. In both cases once the factoring deal is completed, it lasts however long the contract lasts.

    One might ask why would an SME want to obtain finance through factoring rather than the more common bank loan. There are various advantages that factoring can offer over getting a bank loan: the SME does not need to be concerned that the facility might be withdrawn at very short notice, or even no notice at all -which would be the case with a bank overdraft- as the factoring arrangement can only be ended by following notice period so the SME would know for a period of time beforehand; the factor is more lenient when it comes to the financial status of the SME compared to a bank; and finally the factor does not require fixed asset backing as a condition of the loan as with what a bank would want.

    Finally there is Invoice discounting. This is described in Salinger on Factoring: the Law and Practice of Invoice Factoring as "confidential factoring". It is normally basically recourse factoring however invoice discounting gives the SME an upfront payment of 90% of the face value of the invoices. The SME has to hand over the value of the invoices at the end of the period and take in any losses from bad debts. In return, the finance house gives the client the remaining 10% value of the invoices minus any fees and expenses. The fees are normally lower than that of normal factoring. In most cases the fees are between around 0.2% to 0.8% of the SME client's sales with the rate of interest on top, which is similar to that of a bank. In invoice discounting the SME has to pay administration costs to chase up the debt and any losses from bad debts belong to the SME. Also, the invoices won't be in the name of the SME but will be the financial house as the SME is just an agent here.

    To conclude, there are various ways, both internal and external, that a SME can raise finance ranging from: retained profits; risk management through the use of contractual provisions; loans from banks; share issues; to factoring and invoice discounting. It is definitely the case that it is harder for SME's than large companies to obtain finance, this is the case due to larger companies having more assets, better credit checks and the creditors are more likely to get their money back. Especially after the financial crisis the attitude of banks to lend money has become more stringent and the SMEs have been finding it harder to get lent money or at a reasonable rate. This has created a funding gap, which is the gap between the SME growing and developing to become a large company. A proposal has been put forward by Vince Cable to create a special bank called the 'British business bank' which would provide £10b of funding to Small and Medium sized Enterprises.

    Disclosure: I am long AAPL, AMZN, EBAY, ALXN, BAC, RIG, KO.

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