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					Mobilizing Capital for SMEs:
Some Canadian Experience
                  Allan Riding
          Eric Sprott School of Business
       Carleton University, Ottawa, Canada
  SmartLink Fellow, University of South Australia
Why Worry About SME
Financing?
 – SMEs need financing to start, grow, survive
    • If financing is constrained, economic goals of
      national or regional economic prosperity are
      compromised
 – OECD (1998): SME births and growths account
   for a disproportionate share of:
    •   Knowledge generation;
    •   Technology diffusion;
    •   Innovation;
    •   Productivity gains; and,
    •   Job and wealth creation.
                           The “Economic Engine” Model …..
The Economic Engine Model of
Regional Growth
Economic Engine Model
   David Birch (1979, 1987):
       • revolutionized how policy makers view the process
         of job creation and economic development:
       • REAL ECONOMIC GROWTH OCCURS THROUGH THE
         JOB-GENERATING PROCESSES OF THE CREATION AND
         GROWTH OF SMALL FIRMS
           – While attracting outside business investment is useful,
             and common practice, fostering local
             entrepreneurship is critical
               • Examples: Austin TX
               • Canadian Examples: Ottawa; the Beauce region (QU)
    – John Baldwin (1993):
       • Business growth is associated with “innovation”
Innovation:
    a function of the level of local R&D

    Local businesses, other
    private sector R&D, etc.




        Public sector          Innovations
          labs, etc.



         Universities,                       Commercializable
          colleges,                          Innovations
          institutes
Innovation:
    a function of the level of local R&D

    Local businesses, other
    private sector R&D, etc.




        Public sector          Innovations
          labs, etc.



         Universities,                       Commercializable
          colleges,                          Innovations
          institutes
Viable Growth Businesses:
      a function of local business climate and
      managerial acumen
                       Goods & Services
                                   “Trading”             “Non-Trading”
                                     firms                   firms

                             $



                                              Innovative             Hollywood!
          Management
                                            Growth Firms
         Talent & Intent
                                             (Clusters?)

                                           Quality    Human
Commercializable       The “Economic       of Life   Resources
  Innovations          Foundations”
                                      Financial           Business
                                                  etc.
                                       Capital             Climate
Viable Growth Businesses:
     a function of local business climate and
     managerial acumen



                                   Growth of
                                Innovative Firms
                                   (Clusters?)
     Trading Profits
                                 Quality    Human
                                 of Life   Resources


                            Financial          Business
                                        etc.
                             Capital            Climate
Viable Growth Businesses:
     a function of local business climate and
     managerial acumen
                                More
                             innovation


                                   Growth of
                                Innovative Firms
                                   (Clusters?)
     Trading Profits
                                 Quality    Human
                                 of Life   Resources


                            Financial          Business
                                        etc.
                             Capital            Climate
What Are the “Economic Foundations”?

   Financial Capital
   Quality of Life
   Business Climate
   Physical Infrastructure
   Stock of Knowledge
   Human Resources
    – Technical
    – Managerial
   Others???
SMEs & Financing Sources
What is an SME?
   No generally-accepted breakdown
    – Often:
      • < 5 employees => “Micro firm”
      • 5-20 employees => “Small firm”
      • 21-50 employees => “Medium size firm”
    – SO … in Canada,
      • 95 percent of firms are small or micro
      • Vast majority of Canadian businesses are
        SMEs
What Is an SME? Cont’d
   Also, have administrative data that leads to
    different definitions
     – Canada
        • Government administrative data:
            – Have c. 1,000,000 “employer” firms (pay at least 1
              person using a tax record “T4 slip”)
            – Have at least 1,000,000 non-employer firms (no
              employees, self-employed, pay using contracts, …)
        • Lender data
            – Based on loan size: banks collectively report about
              800,000 borrower businesses with loans of < $500,000
        • Have about 3,000 firms listed on stock exchanges.
What Is an SME? Cont’d
   Small Business Financing
    – What kinds of small businesses?
       • Distinguish between growing firms and non-growing firms
         with respect to:
           – Debt
               • Banking relationships
               • Loan Guarantee Programs
           – Equity
               •    Self financing; “bootstrap” financing
               •    Angel financing
               •    Venture Capital Financing
               •    Public securities markets for early-stage firms
Requests for Financing
   Most firms (almost 3 of 4) do not
    seek any financing in any given year
    (Industry Canada 2001 survey of 11,000 SMEs)

         • 85% of these stated they did not seek
           financing because …
Requests for Financing
   Most firms (almost 3 of 4) do not
    seek any financing in any given year
    (Industry Canada 2001 survey of 11,000 SMEs)

         • 85% of these stated they did not seek
           financing because … they didn‟t need any
Requests for Financing
   Commercial Loans:
    – 18% of businesses sought some form of debt
      financing
         – Mostly from banks (no brokers)
         – Hold ~ 85% of SME lending market
      • Applications were relatively less frequent for
        manufacturing; more frequent for services, retail
         – 80% of applications were approved,
             • ~18% turndown rate (rest were in progress at
               time of questioning)
Requests for Financing
   Commercial Loans:
       • Purposes
          – Term loans, usually for equipment acquisition
              • 23% of term loans were government-guaranteed
                (CSBF)
          – Operating loans (lines of credit) usually for financing
            of working capital
       • Average margins ~ 2% over prime (prime not „cost of
         funds‟)
          – Very few loans above 3% over prime
       • Business or personal collateral required for ~40% of
         cases
Requests for Financing
   18% of applications were turned
    down
      • usually because of
         – Poor cash flow,
         – Poor credit history
      • Turndowns were relatively more likely for
        smaller firms, services sector, KBIs
      • After being turned down, most firms sought
        credit from a second potential lender, few
        were successful
Requests for Financing
   Leasing and Equity:
    – 7% sought lease financing (93%
      approved)
    – 1% sought equity financing
    – Also, 21% of firms relied on supplier
      financing
Research Issues: Financing Gaps
   Based on theoretical & popular media
    coverage of financing “gaps”
    – What is a “financing gap”?
       • Shortage of supply?
       • Credit rationing?
       • Market imperfections?
    – Who is affected?
       •   Knowledge-based firms (BDC, 2001)?
       •   Women-owned firms (CFIB & Marleau, 1995)?
       •   Growth firms (Binks & Ennew, 1992)?
       •   Others?
Research Issues: Loan Guarantees
   Theoretical debate: should governments
    intervene?
       • Have pro‟s & cons
    – Most countries have intervened in the SME credit
      market, usually by means of loan guarantee schemes
           –   US: SBA loan guarantees
           –   Japan: Credit Guarantee System
           –   UK: LGS
           –   Korea, Taiwan, Germany, …
           –   Spain & France (trade assoc.), ...
    – Are loan guarantee programs warranted? What are
      costs vs. benefits?
Research Issues: Loan Guarantees
   Issues
            1. Costs (honouring guarantees on defaults) vs.
               benefits (fees, job creation).
            2. Incrementality (“additionality”)
    –   Most countries
        •   A disaster!
            –   High default rates, low incrementality
    –   Canada
            –   Almost at cost-recovery
            –   High level of incrementality
        •   Appear to be doing something right
SME Bank Financing
 For the vast majority of SMEs,
  especially those whose owners are
  not growth-oriented, bank loans and
  leasing provide all the financing
  needed
 No evidence of credit “gaps”
    – Turndowns not concentrated among
      any particular category of firm
SME Bank Financing
   Most SME owners are satisfied with their
    lending relationships
    – Didn‟t know this until comprehensive national
      surveys of SMEs
       • Previous to survey, heard only from
         „squeaky wheels‟ => disproportionate
         political impact
       • Careful collection and independent analysis
         of large-scale survey data is dispelling
         widely-held myths
SME Bank Financing
   KEYS:
    – Undertake to develop good rapport with bank
      loan account manager(s) well before credit is
      sought
       • Maintain & nurture relationship
       • No surprises!
          – SKYJACK example – bank financing is
            not appropriate for growth firms
Financing Growing SMEs
Equity Financing of Growing
SMEs
   Note: Most SMEs are not growth-oriented
          – In Canada, only 50% of owners actually even
            want their firms to grow (Orser, 1997)
          – US: < 10% of firms account for > 80% of
            employment growth (“gazelles”)
       • Growth is rare
          – Reflects diversity of management skill (Orser,
            2003) & tradeoff of owners‟ wishes with respect
            to (Orser, 1999):
              • Attitudes towards outcomes of growth
              • Opinions of significant others
              • Sense that growth is feasible
Equity Financing for Growing
SMEs
   Have initiatives to help mobilize:
    – Angel financing
    – Institutional venture capital
Angel Financing
Angel Financing
   Roles of angels
     – Provision of funds (~ $10,000 to $300,000)
        • Collectively invest $5 to $20 billion per year
     – Involvement in business
        • Advice, contacts, hands-on-assistance,
          market intelligence, governance,
          accreditation (VC, Banks)
        • Presence of angel financing is associated
          with eventual VC financing
     – Address “gaps” (sectoral, regional)
Angel Financing
   Angel Financing
    – Public policy issues
       • Tax issues
         – Removal of tax disincentives
             • Preferential capital gains tax treatment
             • Rollover provision
       • Regulatory issues:
         – Mobilization of angels
            • Fora, matchmaking, local networking, roles in
              cluster development
Equity Financing for Growing
SMEs
   Mobilization of Angels
    – A local marketplace
    – Canadian Community Investment Program
       • Pilot Program: 1997-2002, based on Ottawa OCN
       • Federal financial support for regional economic
         development offices to help facilitate access to
         business angel financing
           – Help with business development, matchmaking
             services, maintenance of local angel communities
           – Fora
       • Viewed as highly successful
           – has led to development of local angel networks and
             angel groups
Venture Capital
VC Funds
   Have five categories of VC funds
       • Labour sponsored (“LSVCC”)
           – e.g., Working Ventures, Fonds Solidarite
       • Private independent
           – Celtic House
       • Financial subsidiaries
           – Banks each have VC division
       • Government-related
           – BDC
       • Hybrid & other
    – Very little participation by pension funds,
      mutual funds, other institutions
Equity Financing for Growing
SMEs
   Institutional Venture Capital Financing
       • Labour Sponsored Venture Capital Funds
           – Funds derive capital from subscriptions by
             individuals
           – Individuals receive substantial front-end tax relief
             for investing (subject to some conditions,
             including a minimum holding period) in labour-
             sponsored funds
       • Labour sponsored funds have led to substantial
         growth in the pool of VC funds under management
VC Funds Under Management
Mostly due to growth & proliferation of labour sponsored funds

25000

20000

15000

10000

 5000

    0
        1990   1991   1995   1996   1997   1998   1999   2000   2001   2002
VC as Percent of GDP
(2002, Source: GEM)
Number of Companies Funded
(2002, Source: GEM)   BUT…..
Size of Investment in US is
much higher … how to compete?
Equity Financing of Growing
SMEs
   Venture Capital Financing
    – Bill Bygrave (Babson, MA): “Generally over-
      researched”
          – More people doing VC research than doing VC
          – VC financing is a rare event
           – ~ 1,000 firms/year in Canada get new investment
           – Compares with: 800,000 SME bank borrowers,
             maybe 20,000 angel financings (Canada data),
             3,000 publicly-listed firms
       • At very early stages of developing research project
         that seeks to measure returns on VC investment
Public Financing of Growing SMEs
Public Financing of Growing SMEs
   Public Securities Markets
    – Usually for larger firms
       • US: for >$20 million
       • Canada: for >$10 million
       • High fixed costs of issuance
           – Canada:
               • Prospectus, legal, accounting ~ $500,000
               • Fees ~ 6-9% of issue
               • Underpricing ~ 8-12%
Public Financing of Growing SMEs

   Internationally, have had many
    attempts to finance early-stage firms
    using public securities markets
    – Examples:
      • Europe: Neiuw Markt
      • Japan: MOTHERS, NASDAQ Japan
      • US: SCORs
    – Generally unsuccessful
Public Financing of Growing SMEs
   Canada: Capital Pool Companies
    – Mechanism by which very early (pre-
      idea!) stage firms can raise ~ $500,000
      from sale of common shares to the
      general public on junior-tier stock
      exchange
       • Has been operative in Alberta,
         Canada, for 15 years (>1,300 firms)
       • Now (as of 2003) approved nationally
CPCs
   Two-stage process
    – Initial IPO
    – Qualifying transaction
CPCs: Initial IPO
 Founders must invest $100K to $500K in
  firm
 Using TSX Venture Exchange (CDNX), firm
  can raise $200K to $500K
 Direct costs (total ~ $60K to $90K)
    – Agent‟s commission (10% of issue)
    – Legal fees ($10K to 20K)
    – Stock exchange ($9K to $15K)
CPCs: Qualifying Transaction
   Acquisition of assets (including another
    business) that establishes the firm as a
    trading business
    – Company retains stock market listing
    – Able to raise additional capital through stock
      exchange
    – Firm has 18 months after IPO to complete the
      QT
    – Ideally arm‟s-length but non-arm‟s-length are
      permitted
Example of Non-arms-length QT

   CPC Advanced Sensing Systems Inc.
    (ASSI) acquired IROC H2S
    Consulting Ltd.
    – The principal shareholder of ASSI as
      well as another director (both with same
      last name) were also directors, officers,
      and principal shareholders of IROC.
Example of Non-arms-length QT
   Avalon works corporation‟s (CPC)
    purchase of Danek associates inc.
    – Sole founder of Danek was also controlling
      shareholder of Avalon.
       • Avalon had raised $500K from CPC IPO stating that
         they “…will use the proceeds of this offering to
         provide Avalon with a minimum of funds with which
         to identify and evaluate businesses or assets for
         acquisition.”
       • What happened to the $500K raised from the
         public??
Ethics: Can it get worse?
   Prospectus of one CPC reveals:
    – Founder and principal shareholder had been
      disciplined by the former ASE for malfeasance
      with respect to a previous JPC he founded.
    – Directors and officers of same firm all declared
      material conflicts of interests with the
      business of the firm
Ethics: Can it get worse?
   Prospectus of successful CPC reveals:
    – Founder and principal shareholder had been
      disciplined by the former ASE for malfeasance
      with respect to a previous JPC he founded.
    – Directors and officers of same firm all declared
      material conflicts of interests with the
      business of the firm
    – Yet … Firm‟s CPC IPO was fully subscribed,
      raised $300,000 from the public
Summary
   Have provided an overview of a
    variety of initiatives that Canadian
    governments have employed to
    stimulate capital formation for
    early-stage firms
    – Some seem to have worked
    – Some seem to have worked to well
    – Jury is still out on others
Related Documents
   Theses
    – PhD, Masters
   Academic papers
    – JBV, Venture Capital:…, CJAS, JSBE, Entrepreneurship &
      Regional Development, Journal of Financial Services
      Marketing, others
    – Babson, ICSB, CCSBE conferences
   Government reports
    – Work very closely with Industry Canada, SBL Administration,
      other government bodies
        • Several reports, monographs available on Strategis website
   Books
    – “Beyond the Banks”, “Financing Prosperity”
QUESTIONS??

				
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