SME

Small Business Investing With a Populist Twist
by reena aggarwal, daniel gorfine and dana stefanczyk

reena aggarwal and dana stefanczyk are Robert E. McDonough professor and assistant director of the Center for Financial Markets and Policy, respectively, at Georgetown University's McDonough School of Business. Daniel Gorfine is a vice president of OnDeck and an adjunct fellow at the Milken Institute. This article is adapted from their contribution to the forthcoming book Sustainable Markets for Sustainable Business, edited by Güler Aras. (Farnam: Gower, 2015). Copyright 2015.

Published January 20, 2015

 

SMEs — short for small- and medium-size enterprises — are everybody's darlings these days, celebrated globally as engines of economic growth. That said, it's not always clear what analysts mean by an SME.

The World Bank defines them by multiple numbers, requiring firms to meet two of three criteria related to employment, assets and annual sales. (Firms too small to be "small," are classified as micro.) U.S. official statistics cut the deck somewhat differently, classifying small businesses as those with fewer than 50 employees and medium-size enterprises as those with fewer than 500.

For its part, the International Finance Corporation (the World Bank's arm focused on the private sector in developing countries), forsakes the quantification game for an operational description, viewing SMEs as, "firms whose financial requirements are too large for microfinance, but are too small to be effectively served by corporate banking models."

But no matter how they're sliced and diced by international lenders, fostering development of SMEs is a priority for both developed and emerging economies because they're seen as a primary driver for job creation and GDP growth. According to the Small Business & Entrepreneurship Council, a trade association, SMEs in the United States contribute nearly half of private non-farm GDP and employ nearly half of the private-sector workforce. Moreover, the trade association credits the sector with creating two-thirds of net new jobs in the U.S. economy from the end of the financial downturn in mid-2009 through the end of 2011.

Note, however, the conceptual difficulty of accurately measuring the impact of SMEs on job creation. New firms generally start out small. The successful ones usually expand rapidly and account for a large share of total job growth. Thus, it is important to look at two factors: the employment growth rate and current employment share. Even though many jobs are destroyed when startups go out of business, the net job creation in SMEs is higher than in large firms. In the United States, for example, the net impact of large firms on employment growth is actually negative.

While SMEs generate a much smaller portion of GDP and employment in emerging markets than in high-income, service-based economies, they fill an important niche in the ecology of development since they are both more efficient than micro-enterprises and more dynamic than large firms. They fill out the supply chains of large corporations and create markets in the formal sector for largely underground micro-enterprises. Indeed, they are active at nearly every point in the value chain as producers, suppliers, distributors, retailers and service providers, often in symbiosis with larger businesses.

Critically, SMEs are also drivers of innovation. For example, before Cisco Systems broke into the big leagues of digital technology, it spent the better part of the early 1990s on the Forbes list of America's Best Small Companies.

Less well recognized, SMEs can also facilitate important forms of social engagement and change. In Arab regions of the Middle East and North Africa, for example, women-owned SMEs tend to hire more women than men, narrowing gender disparities. Women also argue (with good reason) there is less potential for harassment in women-owned SMEs. So, increasing the number of female entrepreneurs is likely to expand the role of women in the workforce and foster positive social externalities driven by such participation.

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The Big Picture

For all the significance of SMEs, few countries have sufficiently broad and deep capital markets to meet their financial needs. In most developed countries, including throughout Europe, the vast majority of business financing comes from traditional banks, which tend to favor lending to large corporations and "national champion" businesses at the expense of SMEs. Capital markets in the United States are regarded as the exception to this rule, given the diversity and depth of non-bank financing options.

Since the financial crisis in 2008, however, problems with SME financing – even in the United States – have been exacerbated by the further retreat of banks into low-risk lending in reaction to both shareholder anxiety and regulatory pressure. Indeed, the crisis highlighted the reality that financial innovation is needed to ensure that these firms have access to capital.

A lack of viable equity financing options is also problematic, especially for high-growth businesses that lack the cash flow needed to secure credit early in their development. There are only a handful of private equity firms that specialize in emerging market SMEs. And only the largest companies in many emerging economies have access to equity financing by way of IPOs.

Not surprisingly, then, governments, multilateral lenders and markets have pursued new approaches to expanding financing opportunities for SMEs. Here, we survey some of their initiatives. We begin with developments in the United States.

Since the crash, structural changes and the relative decline in community and regional banks coupled with increased risk-aversion, have led to a shortfall in bank lending for SMEs. From its peak in 2008 through 2011, the value of small business bank loans declined by 18 percent. All told, bank lending to small businesses contracted by $100 billion between 2008 and 2011.

Meanwhile, lending standards have tightened throughout the banking industry in response to tighter regulatory requirements. The effect of these rules may result in increased costs to banks, which could further reduce lending to SMEs. Moreover, bank consolidation and decreasing engagement with smaller borrowers will likely exacerbate the decline in overall SME lending activity.

On the equity side, a number of factors, including the real and perceived costs of public market participation, have contributed to a decline in IPO activity among smaller firms. Enterprises raising less than $50 million made up nearly 80 percent of the IPO market for most of the 1990s; today those firms account for less than 20 percent.

Early-stage angel and venture capital investors have also become increasingly risk-averse. This reluctance to lend or provide equity has led smaller companies to look for alternative sources of capital – and for both the public and private sector to respond.

Consider first some federal and state-run initiatives that promote SME lending. The Small Business Administration's flagship 7(a) Loan Program offers guarantees on loans issued to SMEs by participating banks, so long as the borrower satisfies certain criteria, and the bank lender complies with stringent SBA loan-compliance requirements. Overall, SBA 7(a) loans totaled about $18 billion in 2013; when combined with a sister SBA loan program, they made up about 4 percent of all loans to SMEs.

But due to regulatory costs, participation rates among community and regional banks is quite low. They simply lack the scale to build internal teams focused on SBA compliance. State loan programs have attempted to fill this hole. But, unlike the SBA, states cannot back their own guarantees with their own taxing power, limiting both the scope and implicit subsidy value. Little wonder, then, that the U.S. Treasury's $1.5 billion State Small Business Credit Initiative of 2010, which is designed to leverage lending through state-run programs, has only dispersed half of its funds to date – and less than half of that half had been deployed by the states as of December 2013.

The SBA's Small Business Investment Company (SBIC) program, however, is frequently considered the model of a successful public-private partnership. Under the program, the SBA reviews and licenses investment funds focused on SME lending, then provides funds with subsidized loans. In 2013, SBIC-licensed funds loaned more than $3 billion to more than 1,000 small businesses.

One of the more common structures for SBIC-licensed funds today is as a registered business development company. BDCs are a type of investment company mandated to serve small and medium-size businesses. Like more-familiar real estate investment trusts, BDCs are structured as pass-through entities, allowing them to avoid corporate income tax so long as more than 90 percent of all income is paid out to investors. Many BDCs are publicly traded on national exchanges and give retail investors access to SME lending markets, which have traditionally been the domain of banks and private-equity firms.

BDCs have grown in importance as traditional banks retreat from SME lending. As this is being written, there are currently 43 publicly traded and 11 non-traded BDCs in operation; BDC loan balances grew from $15 billion just prior to the financial crisis to over $40 billion in 2013. Contrast those numbers with the state of play in 2003, when there were only three BDCs, with combined assets of about $2 billion. The overall volume of BDC loans will likely increase. Moreover, the continued success of the SBIC-licensing program is likely to ensure that BDCs serve smaller companies within the SME landscape. All this suggests that emerging market countries would benefit from exploring domestic application of similar BDC models.

sme chart 2

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Online Lending

The Internet is also primed to play a growing role in small business lending. Innovative companies are building online platforms that combine elements of social networking, automated data analytics and finance in a way that creates an efficient and scalable form of community banking. Indeed, these platforms should allow groups of retail investors and institutional investors to lend to small businesses at rates that are competitive with traditional banks.

"Big Data" analytics is at the heart of the approach, providing new ways to assess creditworthiness of firms. A company called ZestFinance, for example, uses data from thousands of online transactions to offer an underwriting model. Assessments of creditworthiness that do not rely on traditional credit scores, instead using variables such as online reputation and social-media analytics, hold significant promise for SMEs in all countries – notably those lacking traditional credit-tracking infrastructure.

To date, peer-to-peer lending platforms in the United States have concentrated on consumer loans and are now facilitating billions in lending annually. Attention is now turning to small businesses, with industry leader Lending Club recently announcing its entry into the market. And with yield-starved institutional investors lining up to fund borrowers, volume should grow rapidly.

The Internet is serving as a go-between here. In its first year of operation, the BiD Network facilitated 19 matches and total investments of $2.8 million. Matching can also be facilitated through Internet information-exchange platforms, which would mirror the model of peer-to-peer lending organizations by allowing small investors to access online profiles of small businesses with the goal of providing modest sums as loans.

Online lending markets will, however, inevitably run up against regulations that never anticipated this lending model. Additionally, the new credit-risk assessment technologies have yet to be tested by a recession. Last but not least, use of the new technologies may raise questions regarding transparency and fairness. Despite the potential for hiccups, however, the Internet's role in providing capital to small businesses is here to stay in the United States, and, as discussed below, is expanding to foreign markets.

sme chart 03

Equity Models

Three factors inform recent developments in equity financing for SMEs in the United States. First, following the financial crisis, traditional equity investors attempted to reduce risk by focusing on more mature companies. At the same time, these investors became more selective about the sectors and geographic regions to which they would commit, leaving many companies behind.

Second, the Internet and other modern forms of communication increasingly proved at odds with existing securities laws restricting the ways companies seeking capital could communicate with the public. And finally, an effort to democratize investment opportunity has gained traction, with a push to permit retail investors to put their money in a sector that historically was only available to high-net-worth individuals and institutions.

This led to the passage of the bipartisan 2012 JOBS Act. The law is best known for legalizing debt and equity crowd investing, a model that builds off of nonfinancial-return crowdfunding made popular by Kickstarter and Indiegogo. Once regulators finalize the rules, companies will be free to raise up to $1 million within 12 months from the general public through qualified Internet platforms. To limit downside risk, investors will be subject to annual investment caps based on their income or wealth. Companies raising capital will be subject to requirements for financial disclosure and investor education, as well as limits on advertising.

The ease with which individuals can use the Internet to channel funds to promising entrepreneurs and businesses offers countries, rich and poor, a new channel for funding SMEs. Indeed, given major capital access problems for SMEs in Europe, it is not surprising that Italy and the Netherlands are following the path to legalizing crowd investing. Going forward, crowd-investing models may also build on existing microfinance Internet models, such as Kiva, to direct capital to SMEs in emerging markets. Other international crowdfunding platforms include Cumplo in Chile, Ideame in Latin America, OurCrowd in Israel, and Funding Circle in the U.K. and the United States.

 
Alipay employs transaction and payment data instead of third-party credit information to assess risk, making it possible to offer small loans at acceptable cost.
 

Mass Marketing of Private Offerings

The JOBS Act also changed how private securities offerings could be marketed. Such offerings are exempt from traditional registration requirements in the United States, but could only be advertised to "accredited investors" – that is, wealthy individuals and traditional investment funds.

Now, companies are permitted to market private offerings to the general public, so long as the ultimate buyers are verified to be accredited investors. This allows the use of mass communications including the Internet to access a far broader pool of potential investors. The expectation: added transparency to previously opaque markets, as well as reduced costs in matching investors with small businesses.

On a global scale, the opening of private markets to new Internet-based platforms could facilitate deeper and more international venture capital and private-equity markets. Additionally, the gradual blurring of the line between online investment platforms, alternative trading systems and exchanges is being hastened by the Internet, and may foreshadow a time where swapping securities in private companies will more readily become an international activity. Global networks that facilitate SME investment could connect SMEs in emerging economies to otherwise inaccessible pools of capital.

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Facilitating a Mini-IPO

The decline of small-company IPOs in the United States is easier to document than to explain. While there are numerous contributing factors, many point to an overly burdensome disclosure, compliance and governance regime that renders the costs too high for small-company participation in public markets. The JOBS Act created a streamlined mini-IPO registration process for offerings of up to $50 million with the aim of creating a more realistic balance between investor protection and underwriting costs. Securities sold through this so-called Regulation A+ exemption could be marketed to the general public and resold in secondary markets without restriction.

If finalized by the SEC, the regulatory changes could provide important new capital-­raising tools to SMEs. Securities sold in this way could trade on Internet platforms, increasing public participation and liquidity. Some anticipate that large exchanges will develop their own alternative trading systems for smaller companies that would list on their traditional exchanges once they reach sufficient size.

Innovations in Emerging Markets

The impact of this new push for alternative SME financing in developed-country markets parallels initiatives in emerging markets. Some examples follow.

Supply-Chain Finance in Mexico

Nacional Financiera, Mexico's multi-purpose government finance agency, created a reverse-factoring initiative to assist high-risk suppliers through their links to large corporate buyers. Once a buyer agrees to pay on the due date, suppliers' accounts receivable are discounted on a non-recourse basis, thus transferring credit risk to the buyer. Two options are available: 1) Factoring without any collateral or service fees, at variable risk-adjusted rates, and 2) contract financing, which provides financing for up to half of contract orders from big buyers, again with no fees or collateral and a fixed interest rate.

Such arrangements are particularly attractive to SMEs, which often supply much larger firms and can borrow based on their buyer's credit rating. In developing countries, where financial information structure is weak, these mechanisms offer a good source of funding. Training and assistance are also provided. As of mid-2009, the program had enlisted 455 big buyers and more than 80,000 SMEs and had extended over $60 billion in credit.

 
As smartphones are increasingly being used to accept payments, banks are increasingly distanced from the payment process.
 

Venture Capital in Brazil

The Brazilian government's Inovar program created an SME venture capital market that has since been replicated in Peru and Colombia. It was designed in 2001 by the government's Financiadora de Estudos e Projectos (FINEP) in partnership with the Inter-American Development Bank. Aimed at supporting technology-based SMEs, the program created a platform to share research and information and developed managerial capacity to accommodate VC investments. The portal has some 2,600 registered entrepreneurs and over 200 registered investors. FINEP also created a Technology Investment Facility for investors to analyze VC funds, already used performing due diligence on approximately $165 million in financing. Finally, FINEP has created forums for SMEs to interact with potential investors, resulting in 45 SMEs receiving more than $1 billion in funding.

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Crisis Funding in Turkey

The Union of Chambers and Commodity Exchanges of Turkey (TOBB), an association representing broad business interests in that country, created the TOBB Support Program in 2001. It brings together local chambers of commerce and commodity exchanges to support SME exporters during (alas, too frequent) financial crises. Funds from TOBB and its members create pools that provide loans to SMEs at below-market rates. As of 2010, the program facilitated $813 million in funding to over 33,000 SMEs.

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Financing Women-Owned SMEs in Nigeria

The Enterprise Development Centre at Pan-Atlantic University has teamed with Nigeria's Fate Foundation and the IFC on a program to support women-owned SMEs. It offers advisory services to financial institutions that promote women entrepreneurs, coordinating efforts with the IFC to support credit for women-owned SMEs. From 2006 to 2010, the program loaned some $35 million and trained nearly 700 women.

Lending and Equity Funding in China

Alipay Financial was launched in 2010 by the giant Chinese e-commerce platform Alibaba. Alipay, a micro-credit company, offers loans from its own cash resources to SMEs that use its e-commerce service. The company employs transaction and payment data instead of third-party credit information to assess risk, making it possible to offer small loans at acceptable rates. One-month working capital advances of up to RMB 500,000 (about $80,000) were initially provided to fund sales via Taobao, Alibaba's online marketplace. The company has since expanded and has begun offering a wider range of financial products. Larger loans are offered to groups of three SMEs acting as guarantors for each other. Later, Alipay Financial began originating loans on behalf of China Construction Bank and the Industrial and Commercial Bank of China to expand its lending capacity. In the first two years, Alipay Financial had made loans worth approximately $2 billion.

In this case, China is leading the United States and Europe, where similar alternative financing mechanisms have been started. With little fanfare, Amazon has begun to offer loans – up to $800,000 – to affiliated suppliers. Meanwhile, the mobile payment company Square is now customizing loans to vendors that use Square's payment system, employing the merchants' payments data to measure credit risk. These developments are closely related to the peer-to-peer online lending models discussed above.

Lending and Mobile Payments in Africa Traditional loans in lightly banked Africa can take at least six months to be approved – if at all.

Services such as M-Shwari, a product of the M-Pesa mobile-phone-based money transfer system, have added loan options. M-Shwari has partnered with the Commercial Bank of Africa to offer sums up to the equivalent of $235. This service has greatly increased bank account creation at CBA, adding two million accounts in three months and making it the second-largest retail bank in Kenya. Some six million Kenyans have used the service, with M-Shwari experiencing default rates of less than 3 percent.

SMEs often have limited infrastructure and need to accept credit card payments on the go. Companies like iZettle and Square enable customers to accept credit card payments on smartphones and tablets through swipe technology. As smartphones are increasingly being used to accept payments, banks are increasingly distanced from the payment process. Some banks, such as OCBC Bank in Singapore, have chosen to get in the game: OCBC created an app for customers to scan barcodes, obtain billing details and make payments with merchants.

In Africa, the remarkable penetration of mobile phones has enabled users to transfer funds without the benefit of brick-and-mortar banks. M-Pesa (referred to above) had approximately 20 million users in 2013. It is now operated by Vodafone, which has also made the service available in India and Afghanistan. But M-Pesa has competition from, among others, EcoCash and Textacash in Zimbabwe.

General Innovations

In addition to country-specific programs, financial technology promises to increase the efficiency of markets for SMEs on broad fronts.

Risk-Adjusted Investment Return

Investors frequently complain that expected returns on SME investments are insufficient when adjusted for risk. A variety of fixes may apply here. Larger scale for investment funds can make a difference, allowing overhead to be spread thinner. By the same token, funds can share technologies or apply their expert analysis to broader geographic regions.

There may also be room here for technical assistance (public, philanthropic or even for-profit) that generates economies of scale and scope. Technical assistance is expensive, but may generate a big bang for a buck. Note, however, it can be difficult to sustain funding if the investors have no profit stake.

To encourage banks to supply more capital to SMEs, governments may provide guarantees to lenders that cover a portion of their potential losses – akin to the SBA lending programs in the United States. Guarantees can also decrease currency risk by basing payment in a stabler foreign currency. Shared Interest, a New York-based nonprofit, offers guarantees to a variety of lenders in South Africa that (among other objectives) supply credit to SMEs. The nonprofit has been pleasantly surprised by how much leverage such guarantees can provide.

Exit Mechanisms

In emerging markets, exiting SME investments can be difficult, discouraging investors in the first place. One approach, then, would be to design exit-finance facilities. The Overseas Private Investment Corp., a U.S. government agency, is developing a self-sustaining exit vehicle to make capital available to principals or third parties to buy out other investors. SMEs contribute some capital to the exit fund, and OPIC or another financial institution would provide the balance. Again, note that the goal is for the fund to be self-sustaining; the facility would only fund buyouts expected to be financially viable.

A second approach would be to make use of a permanent capital vehicle – an investment entity with an indefinite time horizon like a pension fund – to facilitate investor exits. One format would be similar to the business development companies in the United States. Shares of the fund would be liquid and could be readily traded, facilitating investor exit. Another format would be similar to a mezzanine buyout fund. Investors could sell their equity interests into this structure, which would generate ongoing income for the investors from a diversified portfolio.

Finally, exit deals could be based on royalties. Business Partners Ltd., a financial group specialized in SMEs in South Africa, has pioneered this approach, providing entrepreneurs the capital to buy out their co-investors in return for a percentage of future sales. This allows the entrepreneur to control the business even as it gives Business Partners a far more predictable flow of income than could be had from a formula based on shared profits.

* * *

While the global financial market meltdown demonstrated the potential for damage from finance gone awry, efficient capital markets remain a prerequisite for sustained economic growth. And nowhere is their inefficiency felt more than in small- and medium-size enterprises – most critically, in developing economies that lack alternatives to traditional bank finance.

That's why the emergence of alternative financing platforms for SMEs – in particular, those that exploit the low overhead of the Internet – is cause for celebration.

This revolution in finance will certainly not take place without hiccups, especially before regulation appropriate to the new institutions is refined. But make no mistake: the failure to nurture new ways to allocate capital to small businesses would be an error of grave proportions.

main topic: Crowdfunding
related topics: Capital Markets, Job Creation, U.S. Economy