Source: EURLEX
Language: en
Format: md

**•** **' H i ! * .**

##### **COMMISSION OF THE EUROPEAN COMVttJNITIES**

```
                              COM(93) 528 final

                               Brussels, 10 November 1993

            COMMUNICATION FROM THF COMMISSION

```

**On the financial problems experienced by**

**small and medium-sized companies:**

**2**

**TABLE OF** CONTENTS

**I.** **INTRODUCTION**

**H.** **THE PROBLEMS OF GAINING ACCESS TO FINANCE FACED BY**

**DIFFERENT CATEGORIES** **OF** **SME.**

Conventional Business Start Ups

High Risk Start-Ups

The First Stage of Significant Expansion

Subsequent Periods of Substantial Expansion

**HL** **SOURCES OF FINANCE** - **THEIR** STRENGTHS **AND** WEAKNESSES.

Banks

Sources of Private Capital

Off Balance Sheet Finance:

Leasing

Factoring

Venture Capital and Seed Capital

Development Capital

Stock Markets

Internal Resources

**IV.** **EXAMPLES OF SCHEMES PROVIDING** FINANCE **FOR** SMEs.

National

Regional

European Community

Outside the European Community

**V.** **IDENTIFIABLE GAPS IN PROVISION AND POSSIBLE NEW**

**INITIATIVES**

**VI.** **INCREASING THE EFFECTIVENESS OF EXISTING COMMUNITY**
**ACTIONS.**

**VH.** **OVERALL CONCLUSIONS.**

**ANNEXES**

**ANNEX A -** **Examples of schemes providing finance for SMEs within the European**
**Community.**

**ANNEX B** **-** **Venture and Seed Capital Funding Mechanisms in the United States of**
**America.**

**ANNEX** **C** **The** **financing** **of** **SMEs** **in Japan.**

**ANNEX D -** **Results of a study by the Cranfield School of Management into the**

**attitude of** **smaller** **firms** **towards** **financing** **and** **financial** **institutions in**
**Europe.**

**I.** **INTRODUCTION**

**1.** **This document has been produced in partial response to a request, which was**
**incorporated in a Resolution of the Council dated 17th June, 1992.** **This** **asked the**
**Commission to submit an estimation of what proposals were required in order to ensure a**
**continuation of the policy in favour of** **enterprises,** **including general aspects of finance, in**
**relation to the strategies of these enterprises to** **Européanise** **and internationalise their**
**operations. In addition the Commission has already submitted its pluriannual programme**
**of Community actions to reinforce enterprise policy, notably in respect of SMEs. This**
**made specific reference to making an examination of the possibilities of improving access**
**to** **finance** **by SMEs, and was approved by the Council on 14th June** **1993.**

**2.** **This is not the first occasion on which the importance of improving the access of**
**SMEs to sources of finance has been identified as worthy of attention at the level of the**
**Community. Initial recognition of the problem was contained in the Resolution of the**
**Council concerning the Action Programme for SMEs (1) and re-emphasised in the**
**Communication of** **the** **Commission "An Enterprise Policy for the Community". (2). That**
**the Council has asked that the matter be re-examined indicates that problems remain, some**
**of which may require co-ordinated action at Community level.**

**3.** **In response to the Resolution of 1986 the Commission has produced a number of**
**detailed documents on various aspects of the problem including:**

**-** **a Communication from the Commission to the Council and the Parliament on Financial**
**Engineering (3), together with a "Guide to Financial Engineering Techniques used by**
**the Commission in the context of Regional Policy";**

**-** **a Communication on "The Role of Mutual Guarantee Systems in the financing of**
**SMEs in the European Community" (4);**

**-** **a Communication on** **"A** **Pilot Action to Stimulate Seed Capital (5);**

**-** **a Communication to the Commission "Community Instruments to encourage the**
**development of Venture Capital in the Community" (6);**

**-** **a special report commissioned by Directorate-General XXIII "On the European Seed**
**Capital Fund Scheme: Review of the** **first** **three** **years"** **(7).**

1 Council Resolution COM(86) 445 final of 7th August, 1986
2 Communication of the Commission COM(88) 241 final of 16th May, 1988
3 COM(86) 723 final
4 SEC(91) 1550 final
5 SEC(88) 1496 final
6 SEC(91) 2414 final
7 Dr. Gordon Murray and David Francis, Warwick Business School, May, 1992

**4.** **Despite the numerous studies that have been carried out, both at Community and**
**national level, in relation to this subject and the wide variety of schemes that have been**
**launched in an attempt to improve the access of SMEs to** **financial** **markets, claims are still**
**being made by some in the small business community that major difficulties continue to**
**exist, particularly when seeking finance at reasonable rates of interest without having to**
**pledge excessive amounts of personal assets as security, and that these are being**
**exacerbated by the current economic climate. This is said to be a sufficiently serious**
**problem as to affect their ability to compete on equal terms with larger companies, and**
**even in some cases to threaten their very viability. Whilst these assertions are not wholly**
**supported by recent studies (8) there do appear to be certain aspects of finance in relation**
**to SMEs that merit further investigation.**

**5.** **This document does not attempt to directly examine the perennial question of the cost**
**of** **finance** **to SMEs, as this has been the subject of a detailed study carried out on behalf of**
**other Commission services. (9) The main finding of this study has been that in the ten**
**years up to 1991 the cost of investment capital ranged between 1.5% and 12% lower in**
**the USA and Japan than in the** **EC,** **affecting the relative competitivity of** **firms** **of all sizes.**
**Instead the objective has been to:**

**-** **examine the** **financial** **needs of SMEs in various stages of development;**

**-** **look at the various sources of finance that are available and examine the extent to**
**which they meet the needs identified;**

**-** **review some of the noteworthy initiatives that exist to ease the access of SMEs to**
**finance, both inside and outside the Community;**

**-** **quantify the gaps that remain and what broad policy initiatives might be appropriate,**
**both at the national level and that of the Community.**

**6.** **In examining this problem it has been constantly borne in mind that the lending of**
**money to businesses is a commercial activity undertaken for profit, that most assistance**
**will continue to be provided at the national and regional level rather than that of the**
**Community, and that whatever actions are taken can only supplement, or provide easier**
**access to, finance provided by the market. Nevertheless, there are always two parties to**
**these transactions, and if the balance of advantage tips too heavily in favour of one of them**
**consideration may have to be given towards means of redressing the balance.**

**One difficulty that remains constant is to ensure that the proper requirements of SMEs are**
**met whilst avoiding upsetting either the balance of market forces or distorting competition.**
**In particular certain groups of businesses should not be assisted by means which adversely**
**affect other SMEs who do not benefit.**

8 "Financing Enterprise in Europe", 3i Cranfield European Enterprise Centre and "The Problems of Finance for
Smaller Businesses", Small Business Research Centre, University of Cambridge, June, 1992
9 "International Differences in the Cost of Capital", Coopers and Lybrand.

**7.** **In the final analysis the only reasons for intervention by national governments and the**
**Community in this area is to ensure that as far as possible the creation of SMEs, and the**
**expansion of those already established is not** **inhibited** **by a lack of access to capital,**
**whether short, medium, or long** **term,** **and they are not prevented from taking advantage of**
**the new opportunities presented by the creation of the Single Market. Were this to be the**
**result employment creation, an urgent priority in the current economic situation, would be**
**retarded, as would the optimum self-development of potential industrial and commercial**
**"champions" within the Community.**

**The importance of SMEs in Community economic activity is illustrated by the latest**
**available figures (10). which show that SMEs comprise 99.9% of total enterprises, provide**
**70.0%** **of total employment and account for 70.5% of total business turnover within the**
**European Community. In addition they appear to be responsible for the creation of up to**
**40%** **of all new employment in manufacturing. This trend appears to be strengthening, with**
**SMEs being the principal if not the sole hope of providing major new** **jobs.** **These statistics**
**graphically illustrate that the economic health of the Community is dependent on a**
**flourishing small firms sector.**

10 "Enterprise in the Community", EUROSTAT, September, 1992

_**l)**_

H THE PROBLEMS OF GAINING ACCESS TO FINANCE FACED BY
DIFFERENT CATEGORIES OF SME.

8. The financing of SMEs cannot be regarded as being a single problem and any attempt
at analysis has to be somewhat arbitrary, each organisation having its own particular
requirements, such as variations in the balance between working capital and investment
capital. Some businesses, notably in the trading and retail sectors are able to exist
comfortably with a high ratio of short term debt to equity and to long term loans. Those
making fixed investments with only a long term pay back ideally require a more long-term
debt profile.

Broadly speaking, needs differ according to the type of business and its stage of
development. Each set of circumstances requires separate analysis, taking full account of
investment capital requirements, if a proper perspective is to be obtained. To this end the
following types and stages of company development are examined:

- simple, conventional "start-ups";

- high risks "start-ups", particularly those involving high technology activities;

- the first period of significant expansion;

- subsequent periods of substantial expansion;

9. The definitions used by the risk capital industry are of value by helping to illustrate the
complexity of company financing: although a more flexible approach is taken in this
document in order to avoid establishing rigid classifications which do not wholly accord
with the situations in which SMEs may be placed.

**Seed:** Financing provided to research, develop and assess an initial concept before a
business has reached the start-up stage.

**Start-up:** Financing provided to companies for product development and initial marketing.
Companies may be in the process of being set up or have been in business for a short time,
but have not sold their product commercially.

**Other Early** Stage: Financing provided to companies that have completed the product
development stage and require further funds to initiate commercial manufacturing and
sales. They will not yet be generating a profit.

**Expansion:** Financing provided for the growth and expansion of a company which is
breaking even or trading profitably. Capital may be used to finance increased production
capacity, market or product development and/or to provide additional working capital.

**Bridge Finance:** Financing made available to a company in the period of transition from
being privately owned to being publicly quoted.

**Management Buy-Out:** Financing provided to enable current operating management and
investors to acquire an existing business.

**Management Buy-In:** Financing provided to enable a manager or group of managers
from outside the company to buy in to the company with the support of venture capital
investors.

**Turnaround:** Financing made available to established businesses which have experienced
trading difficulties, with a view to re-establishing prosperity.

**Replacement Capital:** Purchase of existing shares in a company from another venture
capital firm or from another shareholder or shareholders.

**Purchase** of **Quoted** Shares: Purchase of shares on a public stock market.

Neither is it wise to rely on the conventional three stage model of company development start-up, expansion and maturity, as situations and trends appear to be changing with
increasing rapidity in the current market place.

10. Even within these broad categories situations can differ to a considerable degree and it
is difficult in practice to divide the "seed" and "start-up" stages of development. Hence it is
only possible to look at the most usual factors that are likely to apply to the majority of
businesses at a particular stage of development.

Another factor is that SMEs are considerably more reliant on direct institutional finance
(overdraft, short and long term loans) than are larger firms. In fact this is the second most
important source of finance after retained earnings (11.) The Commission's BACH data
base of harmonized company accounts shows that European SMEs are under capitalized in
comparison with their equivalents in the USA. On average the percentage of working
capital represented by "own capital" falls in the range of between 15% and 20% and in
eight Community countries where company accounts were examined, (12) it was found
that in all cases SMEs had a higher proportion of short term liabilities in their balance sheet
than did large enterprises. This obviously makes them more vulnerable to external shocks.
Also, greater reliance on short-term finance would tend to increase their financing costs in
comparison with larger companies.

**CONVENTIONAL BUSINESS START-UPS**

11. The financial problems experienced by conventional business start-ups tend to receive
the highest level of publicity. Probably because they are numerous and such high hopes are
frequently placed in them as creators of new employment at a time when larger firms are
tending to shed labour. Unfortunately, new firms of this nature are characterised by a
failure rate of 50% in the first five years of trading, in the absence of counselling and other
supportive measures, when the death rate approximately halves. This is a factor which
reduces their attractiveness to financial institutions, who are unable to afford to provide
such services.

12. Although problems undoubtedly exist in some regions of the Community and for some
craft firms, there is no historical evidence of a shortage of available funding for
conventional start-ups that can show promise of achieving viability, incorporate a
reasonable financial stake by their owners, and who are also able to offer some security
against loans. Difficulties essentially exist for those unable to meet one or more of these
requirements, although the current economic situation has brought problems for a wider
range of businesses, particularly through the growth of credit rationing by banks.
Otherwise, the major problem is that all too few of those starting a business know how to
either assemble a convincing proposal for a bank, or to present it properly.

11 "Financing Enterprise in Europe", ibid
12 "The Structure of Industry Financing; a Short Inventory of Statistics", draft internal Commission document II/451/92

10

**Far too few potential business proprietors undertake prior market research, including**
**consideration of the potential competition they may have to face. As a result, even if they**
**or their** **financial** **advisers put together a** **financial** **forecast,** **this is largely based on** **guess-**
**work. Common faults are to overestimate initial sales and to underestimate the time that it**
**will take to reach profitability. This leads to a further under calculation of the amount of**
**initial working capital required, particularly if insufficient account is taken of fiscal charges**
**such as VAT, delays in payment, and for some new manufacturing firms the possibility of**
**there being hold ups in the receipt of certification for their products. New businesses are**
**also often more likely to incur a higher level of bad debt than established firms who know**
**the market better, a factor that is usually ignored when making** **financial** **projections.**

**Given these circumstances it is hardly surprising that banks are so frequently reluctant to**
**lend. If they do agree to do so the tendency is for them to require a high level of security**
**and/or charge an interest rate that covers their greater perceived level of risk.**

**The whole question of the provision of adequate security is extremely pertinent in the case**
**of SMEs seeking finance. The problem has been subjected to detailed analysis in the**
**previously mentioned study on Mutual Guarantee Systems (13) as has the German national**
**scheme to assist the creators of companies.**

**13.** **The twin problems of access to finance and survival become much less acute for the**
**new SME given the availability of practical low cost advice by experienced business**
**people, as has been demonstrated in a number of Member States. Many Chambers of**
**commerce and industrial and craft organisations have developed advice centres for**
**enterprises and entrepeneurs. Most of these organisations cooperate directly with the**
**clearing banks, cooperative banks and savings institutions specialised** **in** **financing SMEs,**
**who offer enterprises tailored financing. In addition, the European Community Business**
**Innovation Centres (E.CBICs) and their network (EBN) represent a comprehensive and**
**systematised approach to addressing the aforementioned problems, i.e. creating new**
**home-grown innovative companies and redeveloping existing firms in like manner in the**
**less favoured regions. The regional policy approach also consists of supporting certain**
**E.CBICs so as to enable them to become shareholders in the Community sponsored seed**
**capital** **funds** **and their network (see paras 42 and 43). Capital provision for SMEs needs to**
**form part of an overall support system which ensures that business potential is promoted**
**and processed into an on going flow of prospective and redeveloping companies which it**
**is possible for banks and outside investors to regard with reasonable commercial**
**confidence.**

**In fact, for the average small start-up the carrying out of basic market research, the**
**preparation of** **financial** **projections, and the calculation of working capital requirements is**
**not overly difficult once they have been shown how this should be done. This is especially**
**true of persons contemplating engaging in manufacturing or any other field in which they**
**prior experience as they have actual knowledge on which to base estimates of the potential**
**market and their requirements in terms of plant and equipment. What they frequently do**
**not possess is a sufficiently adequate level of management skills to enable them to translate**
**this know-how into a marketable financial** **proposition,** **or to judge whether their**
**prospective business is potentially viable.**

13 SEC(91) 1550 final

**11**

**14.** **A potential financing gap exists where a start-up has sufficient security available to**
**secure initial financing, but whilst not expanding substantially still outruns its capacity to**
**raise finance, particularly during the first three to four years of its existence when it may**
**not yet have had the opportunity to establish a** **financial** **track record. The same holds true**
**of those who benefit from initial aids for start-ups but then discover that additional**
**tranches of top up finance, or the scope for an extension of existing** **financial** **guarantees, is**
**limited or non existent.**

**HIGH** **RISK START-UPS**

**15.** **High risk start-ups, which may be defined as new businesses established in order**
**either to research or exploit a new process in an existing field or an entirely new discovery**
**which may well have resulted from their own** **research,** **face a totally different situation.**
**Such businesses form only a minority of all start-ups, and exhibit certain specific**
**characteristics:**

**-** **they will eventually engage in manufacturing, although not necessarily in mass**
**production;**

**-** **the management are likely to possess a high level of technical expertise;**

**-** **the potential market will have been researched - to the extent that this is possible;**

**-** **the market being underdeveloped or entirely new the speed of growth of sales will be**
**hard to predict accurately, particularly if** **major** **product development work remains to**
**be done;**

###### **- a significant degree of financial risk exists as there is no guarantee that the project will**

**ever become commercially viable. Even if it does, profitability may only be achieved**
**after a number of years. There are biotechnology projects, where because of drug**
**testing and certification procedures, this process has taken substantially longer than**
**five** **years;**

**-** **borrowing requirements are** **frequently** **substantial in relation to the amount of capital**
**provided by the founders and a series of subsequent capital injections are frequently**
**required before a level of profitability sufficient to sustain the activities of the company**
**is achieved. Estimates as to the amount of additional finance needed to develop and**
**launch a product on the market following the conclusion of the research and**
**development phase obviously vary because of the widely differing situations involved,**
**but generally appear to involve sums between ten and twenty times greater than the**
**initial investment in R & D.**

**Seed Capital Funds attempt to meet the needs of high risk start-ups for equity capital, but**
**the sums involved are too large for them to** **finance** **all the stages required before a product**
**is marketed without additional assistance. The fact that venture capitalists and capital**
**development funds are no longer interested in providing follow on finance, because earlier**
**projects have all too** **rarely** **met the rates of return required by these investors and the costs**
**of supervision proved disproportionately high, inevitably leading to the creation of**
**financing** **gaps,** **particularly where the financing of research, technological development**
**and innovation by SMEs is concerned.**

12

16. Projects of this nature are rarely of interest to conventional banks because of the
delayed returns and high level of risk, although they may be prepared to joint a financing
consortium and provide a proportion of the day to day working capital facilities. Whilst
Seed Capital Funds have been the providers of a proportion of long term finance in some
Member States and also in the USA, their contribution is slowing down markedly, largely
because of an inability to attract fresh funds. In any case support is only provided to about
5% of the propositions submitted (14). More positively there is evidence of slow but
definite growth in the direct provision of long term capital by private investors interested
in not only taking an equity stake but providing a degree of advice.

17. There would appear to be a greater willingness to finance high technology start-ups in
the USA than there is in the European Community, with over half the start-up investments
being made in high technology companies. This difference is almost certainly accounted for
by the different characteristics of the US and European markets, the US market for hightech products being much larger and offering major opportunities for rapid and profitable
expansion.

18. Not only start-ups, but also other SMEs have particular difficulty in financing
research, technological development and innovation due to under-capitalization, heavy
existing debt and an absence of collateral. The relative decline in the availability of equity
capital or subordinated debt from venture capitalists and similar sources has exacerbated
the situation. Indeed the relative importance of high technology investment continues to
decline.

19. In a situation where so few propositions eventually receive financial backing it is
highly probable that some worthwhile projects of potential value to the economies of the
Member States will never be funded or commence operations. In certain instances this can
well be the fault of the promoters of the scheme, either because they have made an
unpersuasive presentation of their plan, or have directed their applications to funds not
interested in their field of activity. Alternatively the rate of return required may be too high
in relation to the project. It is possible that the number of viable products that are never
developed because of poorly constructed projects could be as high as three to four per
cent of all those put forward for consideration, but it would be quite uneconomic for
potential financiers to attempt to restructure them, even if they possessed the management
with the necessary range of skills, which they frequently do not.

THE FIRST STAGE **OF SIGNIFICANT EXPANSION**

20. Having survived the initial risks of establishment, and the first period of growth, many
firms reach what might be termed the first stage of significant expansion. That is, the
business has become established in its market and demand has grown to the point where it
has become difficult to provide an acceptable level of service using existing facilities.
Alternatively trading experience may have reveal an opportunity for the development of a
product or service different from that originally offered.

This constitutes a further period of high vulnerability, where the risks of failure are very
real. This is particularly the case where financial and other managerial controls are
inadequate and there is an absence of even the most basic strategic planning. A serious
shortage of working capital can frequently result, bringing the enhanced risk of technical
bankruptcy. That is the business, whether or not profitable, has to cease trading because it

14 "The European Seed **Capital** **Fund** **Network:** **Review Of** **The** **First Three** **Years",** **Warwick Business School,**
April, 1992

**13**

**is unable to meet its financial commitments. It is clear that in such case the root cause of**
**failure is inadequate management rather than lack of access to finance. Banks could**
**perhaps do more by proffering advice, requiring regular progress reports from their SME**
**customers and ensuring that deadlines for** **submission,** **once established, are observed.**
**They appear better at doing this in some Member States than in others.**

**21.** **It is at this stage of development that a more sophisticated level of advice is required,**
**from financial advisers, in order to restructure the debt profile of the organisation so as to**
**accord more accurately with its commitments. Working capital will be required for the**
**purposes of day to day trading, whilst an additional medium term loan may be appropriate**
**for the purchase of fixed assets - plant and machinery, data processing equipment etc.**
**Alternatively, it may prove more attractive to factor sales invoices and lease capital**
**equipment, so reducing capital requirements to a minimum. Frequently a mix of these**
**financial instruments proves to be the most effective solution. In addition more suitable**
**premises may be rented or leased rather than purchased outright.**

**22.** **It is often stated that a major problem for SMEs is that there additional capital**
**requirements are not progressive but consist of a series of discrete and significant leaps,**
**which are initially out of proportion to the predicted returns. Where the purchase of**
**substantial fixed assets are concerned this may be true, but there are alternative methods of**
**coping with this problem instead of purely relying on banks. In any case this theory**
**regarding staged jumps in capital requirements is not relevant in all circumstances.**

**Essentially the access to finance by companies contemplating expansion largely depends on**
**the degree of confidence placed in them by lenders. This has to be earned right from the**
**time the business commences trading and is a factor not given the priority it deserves by**
**many managements. Theoretically, providing:**

**- financial information for the bank is clearly and concisely presented at the required**
**intervals;**

**-** **management accounts are kept up to date;**

**-** **the cash position is calculated at least weekly;**

**-** **good communications are maintained with the bank;**

**-** **all** **financing** **options are properly considered and utilised where appropriate.**

**There are no insurmountable barriers to a reasonably viable and profitable firm at the first**
**stage of major expansion obtaining additional finance. An interesting initiative by German**
**Banks has been to make EDP based** **financial** **planning models available to their customers,**
**a service which might usefully be taken up by a wider range of financial institutions**
**providing appropriate initial assistance with the preparation of the input material was**
**provided.**

**In practice fresh difficulties are appearing, both for** **firms** **at this stage of their development**
**and those in subsequent periods of expansion. Venture capital funds are generally no**
**longer providing smaller amounts of capital because of the high administrative costs,**
**disappointing returns on** **many** **investments, and the lack of exit routes. This is the major**
**reason why a gap in the provision of amounts of** **finance** **lying in the broad range of 70,000**
**ECU to 350,000 is appearing, the size of the minimum investment having grown to ECU**
**250,000, and even ECU 1 million in the case of some major lenders. This same gap, when**
**adjusted for** **inflation,** **used to exist in some Member States but was thought to have been**
**closed through the greater flexibility accorded to operators through** **financial** **deregulation**

14

**SUBSEQUENT PERIODS OF SUBSTANTIAL EXPANSION**

**23.** **Where subsequent stages of material expansion are concerned there are strong**
**indications that an "equity** **gap"** **could also exist, for the reasons set out above. Companies**
**at a stage where they need sources of permanent capital, find their short term borrowing**
**reaching a practical ceiling because of their unwillingness or inability to provide additional**
**security. This can be a particularly acute problem after a period of difficult trading when**
**capital resources may need to be rebuilt, either because profits have not kept pace with the**
**extra demands imposed by inflation on working capital, or actual losses have been**
**sustained. Another instance is when major re-adaptation is required. For example for those**
**previously heavily dependent upon orders** **from** **the defence industry.**

**Where substantial expansion is not contemplated some problems apparently still exist. A**
**recent report in the United Kingdom (15) identified a particular difficulty for firms of**
**between 50 and 500 employees in obtaining small sums to maintain a series of innovations.**

**Even should actual problems not have been encountered, to be seriously undercapitalised**
**and dependent on short term financial facilities is a basically unstable situation, making**
**long term strategic planning extremely difficult. Ultimately this can lead to a bank, or**
**banks in the case of a more substantial medium-sized enterprise, having effective control**
**over the destiny of the organisation.**

**For those managing an efficiently organised business who wish to escape from or avoid**
**such a set of circumstances there are only limited alternatives, and even these are not**
**available in all Member States. One is to approach venture capitalists or merchant banks**
**for long term finance, another to float part of the equity on a stock exchange. Both involve**
**the ceding of a certain amount of control. A third possibility is to deliberately restrict both**
**expansion and substantial new investment so as to apply a significant proportion of**
**earnings retained after tax to the reduction of borrowing.**

**Such an action may have the beneficial short term effect of improving the financial**
**situation, but frequently threatens future progress and profitability to a material extent, in**
**particular because it limits the ability to react to changes in existing markets and to seize**
**new opportunities. Reluctance on the part of mature companies to borrow in order to**
**finance the operations of a business are not new. Indeed it appears that in some parts of**
**the Community this attitude is quite widespread and traditional. Now this attitude is**
**becoming more evident in established SMEs of** **all** **sizes in areas not previously exhibiting**
**this tendency. A survey (16), which has a reputed accuracy** **of+/-** **5%, conducted in the**
**United Kingdom, in the last two weeks of July, 1992 revealed that 17% of the respondents**
**had paid off their overdrafts within the previous twelve months and would be extremely**
**reluctant to borrow from external sources in the future. This trend may have been**
**accentuated by the current combination of** **a** **slow down in business and high real rates of**
**interest, but if it were to become more widespread it would retard the pace of growth and**
**innovation in the Community.**

**24.** **Even when it is decided to consult a merchant bank or other adviser on the right**
**course of action to take the business may find that it falls between two stools. Whilst its**
**financial requirements may have become too large for conventional bankers, they may be**
**too small to be an economically viable proposition for a merchant bank, venture capitalist**
**or capital development company.**

15 Advisory Committee on Science **and** **Technology** ( **1990).**
**16** Policy Unit, Institute of Directors

**15**

**MANAGEMENT BUY OUTS AND MANAGEMENT BUY INS**

**25.** **A relatively new development within the European Community has been the growth** **in**
**popularity of Management Buy Outs (MBOs) and Management Buy Ins (MBIs). MBOs**
**normally, but not exclusively, occur when a company is, in the view of all or part of its**
**existing management, suffering from being part of a larger group and could be more**
**dynamic and profitable if operated as an individual entity, and those managers launch an**
**offer for the shares of the company. MBIs occur when a team looking at a business from**
**the outside judge that it could substantially improve on the performance of the existing**
**management team. MBOs in particular can lead to the creation of** **a** **new and independent**
**SME.** **For this reason the financing of this relatively new phenomenon appears to logically**
**fall within the scope of this study, although its importance in terms of the overall problem**
**of the** **financing** **of SMEs is marginal.**

**Finance for both the above activities has to be obtained from an institution prepared to**
**take a long term view, provide a high proportion of the purchase price and required**
**working capital, hoping to eventually release its investment at a profit through the flotation**
**of** **the** **client company on a stock exchange, or more probably through its sale to another**
**business or group of investors. Typically such institutions would be either a venture capital**
**fund or a merchant** **bank,** **although normal banks may also become involved as part of a**
**consortium,** **in order to provide** **short** **term working capital.**

**There is little evidence of a shortage of available capital for such purposes, financing of**
**such deals accounting for 35% of** **all** **European venture capital spending, with deals falling**
**within a range of ECU 1.4 million to ECU 28 million. This is despite the fact that some**
**MBOs and MBIs have been spectacularly unsuccessful, requiring major reconstructions of**
**their finances. Should the success rate deteriorate further the market may be more**
**selective in the schemes it is prepared to support. Nevertheless, this does not appear to be**
**an area of activity where** **financial** **problems to SMEs give cause for concern.**

**3)**

16

BŒ SOURCES OF FINANCE - THEIR STRENGTHS AND WEAKNESSES

**BANKS**

26. Apart from funds raised from family, friends or associates, banks are normally the first
source of outside finance approached by SMEs, and are the dominant source of finance in
all Community countries (17) accounting for five sixths of their external debt finance.
Their attitudes, together with the terms and conditions they offer differ from Member
State to Member State, still being heavily influenced by tradition, although operating
systems and costs are tending to converge across the Community. Most banks specialise in
the financing of short term requirements, that is additional working capital, although
German banks are more inclined to consider taking an equity interest. Elsewhere within the
Community the situation has changed to some extent during the past two to three decades
with more medium term facilities for purchases of capital goods being offered in the form
of fixed term loans.

Whilst banks do have the advantage of being local, and offer amounts of finance that
would be uneconomic for other lenders to provide, they have certain disadvantages in the
eyes of many SMEs:

- a developing tendency to rely solely upon mechanical credit rating techniques, known
as credit scoring;

- the growing practice of judging the amount of security as being more important than
the quality of the proposition put before them. This is largely because of the substantial
losses sustain in recent years, particularly on loans to small business start-ups;

- being unduly restrictive in their attitude towards existing companies. For example
requesting a reduction in the amounts borrowed because of a decline in the value of
property pledged as security, although the degree of risk to which they are exposed has
not worsened;

- at least in some countries, providing variable rate loans only to larger companies;

- attempting to gain additional profit from charges such as procuration fees and high
transmission charges on cross-border transactions.

The normal response to such charges is that the banks are not lending their own money but
that of their depositors and have to make a profit on such transactions. Rates of interest
and charges, together with demands for security, have to reflect the degree of risk involved
in financing the proposition put before them. Whatever the truth of this argument the fact
remains that for the majority of SMEs banks will remain the sole source of outside finance.
It is therefore of considerable concern when a considerable degree of dissatisfaction
appears to exist among their small business customers.

27. A possible explanation of the problem is that banks have substantially modernised
their operations in recent years, making much greater use of information technology in the
process. This appears to have lead to a withering away in many cases of the traditional one
to one relationship between banker and borrower. Instead lending decisions are either
being taken at regional centres, or even if made locally, are subject to much greater
overview by management remote from the actual borrower.

17 C. Mayer. Financial systems, corporate finance and economic development", CEPR ( 1989).

17

28. At present banks also have certain difficulties, which are reflected in the manner in
which they deal with their customers. Their ability to lend more imaginatively and
competitively has been undermined not only by their massive losses on loans, but also by
the provisions of the Basle agreement on capital adequacy by the Bank for International
Settlements. Under this accord commercial loans will require 8% capital backing, first
residential mortgages only 4%, and investment in government securities none. This could
affect the lending priorities of some banks and make the generality of banks more
restrictive in their commercial lending than would otherwise be the case, leading to
basically sound larger SMEs finding their ability to borrow reduced.

**OTHER SOURCES OF PRIVATE SECTOR CAPITAL**

29. Given that most SMEs will tend to seek finance locally the fact that various sources of
private capital from individuals are once more developing, albeit slowly, is of significance.
The concept of "Business Angels" is one that is rather better developed in the USA. A
"Business Angel" is a person possessing both experience of business and free capital who
is prepared not only to invest in local businesses but to assist their performance through
the provision of advice on a continuing basis. It is now claimed by those involved in its
development to be the primary source of capital for high technology and high risk start-ups
in the US.

The only formal official attempt to encourage the increased provision of private capital in
this form within the European Community appears to be in the United Kingdom where five
pilot projects are currently under way with government assistance. There the objective is
to create a series of semi-public marriage bureaus aimed at bringing together investors and
borrowers. This initiative is very new and progress has been slow, with the initial
organisational phase taking much longer than anticipated. One reason may be that it is a
long time since those with available capital have been accustomed to making direct
minority investments in unquoted companies, coupled with the fact that they do not enjoy
the tax advantages reputedly accruing to US investors. The fact pointed out in the
previous Section, that the majority of small business owners are reluctant to allow
outsiders to acquire shares in their business seems to be less of a problem where private
investors are involved.

Another development is the "Capital de Proximité" scheme in France. Between 30 and
forty regional structures now exist to channel the investment of varying amounts of private
capital into local businesses. Fourteen Local Enterprise Agencies in the United Kingdom
have been operating a similar network for some time.

Apparently a substantial pool of potential private investors exists in both the United
Kingdom and Germany. In Scotland no less than 1500 investors were identified recently,
each prepared to invest up to ECU 50,000. Many more were found willing to invest in
excess of ECU 6,000. A recent survey (18) conducted in the United Kingdom estimated
the availability of potential funds of between ECU 2.5 and 5 bn. In Germany there are
apparently a considerable number prepared to invest up to ECU 125,000. The major
problem appears to be that no mechanisms exist to bring them together with companies
requiring additional equity. At the moment most private investors obtain information
regarding propositions through friends and business contacts. Interestingly, one bank in the
United Kingdom is now investigating the feasibility of creating a national data base of
those individuals interested in investing in private companies.

18 The financing of technology based new firms in the UK: the role of informal venture capital, Mason & Harrison

**18**

30. Local Seed Corn Capital Funds, largely capitalised by local/regional administrations
but with some private sector involvement, have the objective of financing new businesses
and appear to be growing in number. The level of individual advances are customarily
quite small, but can be valuable in instances where the amount of security that can be
offered by the owners is too low to obtain finance from conventional sources. The problem
is that there appears to be a high failure rate amongst those receiving assistance, unless
considerable levels of unpaid advice and support are offered. Also, some schemes seem to
place greater importance on achieving local social and economic objectives than making
profitable investments.

**OFF BALANCE SHEET FINANCE**

**LEASING**

31. Leasing can be an extremely important financial instrument for SMEs where the
acquisition of fixed assets such as plant, machinery and vehicles is concerned. Involving as
it does the making of regular payments over a fixed period it avoids the tying up of
significant amounts of valuable working capital. Payments should be financed from
revenues arising from the use of the items leased. Normally the only security required by
the leasing company is that provided by the asset itself.

A problem with leasing is that this avenue may well be closed to newly created businesses
unless outside guarantors are available, as a two to three year trading history is often
demanded. In addition a new company is unlikely to be making sufficient profit to take full
advantage of the payments being offsettable against tax. In any case, these tax advantages
are tending to be reduced. In these particular circumstances leasing is a very expensive
and inappropriate form of finance.

**FACTORING**

32. Factoring allows SMEs to finance a higher level of trading than would otherwise be
the case through the earlier receipt of money owed by customers. For example a factoring
company might advance 80% of the value of an invoice immediately following its despatch
to a customer, with the balance, less factoring costs, being due on payment of the invoice
or at a pre-determined date. Factoring techniques have developed to the point where a
variety of facilities are available and which can be matched to the needs of the customer:

This is a most useful and appropriate financial instrument for SMEs, although not usually
open to the newer firm because their turnover would be insufficiently high to qualify.
However, many who could make use of it are discouraged by the apparent cost. In fact, if
the increased cash flow and reduced or eliminated bad debts are taken into account the
charges are not as high as they at first appear. Savings can also arise if the factoring
company takes over administration of the sales ledger, although these disappear if the
SME uses a computer software system that updates the sales ledger and sales day book
immediately after the completion of an invoice. Even so, factoring could probably be
utilised with advantage by many more SMEs, particularly as fears that customers may be
offended by the introduction of a third party into the transaction appear to be largely
unfounded.

**19**

**VENTURE CAPITAL AND SEED CAPITAL**

**33.** **Venture Capital Funds came into being in order to fill the need for a source of longer**
**term equity finance. As has been seen this is particularly important in the case of high risk**
**start ups; the financing of** **research,** **technological development and innovation; for well**
**established SMEs contemplating significant expansion; and management buy outs and**
**management buy ins.**

**Those assisting with the financing of product development and start-ups are normally**
**known as Seed Capital Funds, in order to distinguish them from main stream Venture**
**Capital Funds which normally invest in established companies. They are currently facing**
**particular difficulties in raising funds, anyone investing in them having to see a major cash**
**outflow during the early years of any fund, make provision for possible further cash**
**injections, and possibly only begin to see a positive return after five to ten years. Managers**
**also face the heavy cost of making initial investigations into propositions put to them and**
**providing a high level of management support to those** **in** **whom they invest.**

**The concept of venture capital originated in the USA but spread to Europe during the**
**1980s,** **providing significant amounts of capital for a considerable number of firms, but**
**still limited in terms of** **the** **total stock. A factor now causing difficulty is that in the mid**
**1980s the venture capital industry promised the investment institutions rates of return on**
**capital that it proved incapable of achieving.**

**Decisions whether or not to investment in a particular proposition are made on the basis of**
**a detailed company plan and accompanying financial projections, but the assessment of**
**whether or not to invest is frequently determined in the final analysis by the perceived**
**quality of the management team.**

**Finance is normally provided through a combination of** **loans** **and investment in the equity**
**of the company, or through pure equity participation. An executive of the fund is**
**sometimes appointed to the board of directors in order to provide advice and safeguard the**
**interests of investors. In some instances this is this factor that puts off existing**
**shareholders from seeking venture capital, even if this would otherwise be in their interest**
**and that of the company they control.**

**In the early days of European venture capital some of the investments were relatively**
**small. As the sector has become more mature the objectives of those running funds has**
**changed, with the emphasis being on investment in more established companies and**
**management buy outs, seldom contemplating investments of less than ECU 250,000. This**
**creates a problem for many expanding SMEs, who are only looking for amounts of**
**between ECU 10,000 and 100,000. There were a number of reasons for the reorientation**
**of priorities: the amount of time required to supervise many small investments proving** **out**
**of proportion to the return; the number of companies that failed was too high; and there**
**was a difficulty in releasing the investment at the end of the planned period. As a**
**consequence, the major venture capital funds now tend to be risk averse.**

**In addition only a limited number of projects can be supported because of the time needed**
**to assess propositions. There also had to be enough experienced personnel available to**
**undertake proper supervision of client companies once investments have to be made. A**
**complaint from clients is that too often this advice is confined to financial matters rather**
**than other strategic considerations.**

**Another major problem facing funds, together with those in whom they invest, is that they**
**need to realise their investments after a certain period. This would ideally be five years, but**
**is more often ten to twelve where a high technology company that is supported from start-**
**up is concerned. Possible exit routes should be planned at the time the original investment**
**is made, although this is not always done.**

**20**

**The advantage of venture capitalists is that they will supposedly provide finance in**
**circumstances when it is unavailable from any other source. The disadvantage for**
**management is a** **partial** **loss of control, which can be substantial if the business does not**
**perform as well as predicted, and having to orientate the objectives of the business to the**
**needs of investors. This can lead to a situation where, after five or more years of strong**
**growth they are virtually forced to sell the business to a larger** **organisation,** **or see the**
**venture fund's equity stake sold on to another group of investors.**

**A problem that currently exists within the EC is the uneven distribution of** **funds.** **In 1992**
**some 89% of all investments were concentrated in the United Kingdom (39%), France**
**(21%),** **Germany (13%), Italy (11%) and the Netherlands (5%). Total cross-border**
**investments within the Community only amounted to 7.9% of the total.**

**DEVELOPMENT CAPITAL**

**34.** **This form of financing has a longer history than has venture capital. The main**
**difference between the two is that development capital companies are prepared to take a**
**longer view and do not require a pre-planned exit route. Probably because their** **degree** **of**
**long term** **financial** **commitment is smaller.**

**Why this source of funds may have enjoyed limited popularity as a** **financing** **vehicle is that**
**up to 90% of the funds advanced will bear market rates of interest and be repayable in five**
**years at most. The remainder is normally advanced through the purchase of convertible**
**preference shares in the company, which will eventually secure 25% to 40% of the total**
**equity when converted, the proportion depending on the valuation of the company at that**
**time. After conversion the client company will frequently be expected to pay up to one**
**third of after tax profits to ordinary shareholders in the form of dividends.**

**This makes the use of a development capital company only really suitable for companies**
**anticipating high levels of profitability in the short to medium term. Otherwise, not only**
**will repayment of** **the** **loan place a strain on working** **capital,** **the need to maintain a high**
**level of dividends will affect the ability of** **the** **company to finance future growth through**
**the medium of retained earnings. In view of the above factors** **development capital**
**companies will only be of assistance to a very small proportion of SMEs and thus will not**
**make a significant contribution to solving their** **financial** **problems.**

**STOCK MARKETS**

**35.** **Stock markets are under developed in a number of the Member States and the**
**majority only have a limited number of companies quoted on them. As an example the**
**Athens Stock Exchange had, as of 31.12.1991, only** **157** **companies listed on the main**
**market and 8 on the Parallel Market. Through its approval of the Directive Concerning the**
**Coordinating of the Conditions of Admission to a Stock Exchange Listing (19) the**
**Council has emphasised the importance it attaches to the achievement of** **a** **greater number**
**of companies being listed on stock exchanges, including suitable businesses with a**
**comparatively short history, through the reduction of unnecessary barriers to this process.**

19 Council Directive 89/298/EEC of 17th April, 1989

**21**

**Nevertheless, this method of raising permanent capital is currently of limited value to all**
**but a tiny minority of small limited companies. This is not just because of** **the** **difficulty of**
**achieving a successful flotation under current economic conditions but also on account of:**

**-** **the high costs of the procedure for obtaining a listing, not least accountancy and legal**
**charges;**

**-** **the extra expenses of a recurring nature: higher accountancy fees; the drawing up and**
**publication of annual reports in a much more detailed form; the holding of much larger**
**annual general meetings etc;**

**-** **shares in the majority of small public companies are relatively illiquid, being rarely**
**traded even when listed on the most active of the European Stock Exchanges;**

**-** **whilst it may be possible to arrange an initial listing and placing or public offer of a**
**portion of the equity, the relatively illiquidity of this stock can make raising of finance**
**through subsequent issues well nigh impossible, unless there is a radical advance in the**
**trading and profitability of the company concerned.**

**It also has to be recognized that, even in the** **USA,** **the stock markets have become a**
**negative contributor to enterprise funding, with a growing trend since** **1984** **for companies**
**to re-purchase their shares (20).**

**INTERNAL RESOURCES**

**36.** **Virtually all companies, with the exception of a handful of exceptionally well managed**
**businesses, can reduce their need for capital through the improvement of management**
**controls and:**

**-** **maintaining a tight control on stocks, reducing the level to the minimum consistent**
**with providing the required level of service;**

**-** **having a definite sales ledger management policy, including clear procedures for the**
**prompt pursuit of overdue accounts;**

**-** **calculating the true cost of all operations, including the degree of working capital**
**absorption;**

**-** **examining the potential savings arising from the contracting out of internally provided**
**support services such as transport.**

**20** **C.** **Mayer, ibid.**

**22**

The importance of proper management of debt by SMEs is illustrated by an analysis of
balance sheets in the United Kingdom (21) which revealed that creditors formed a higher
proportion of liabilities for small than for large firms. In manufacturing trade creditors
comprised 35.3% of liabilities for small firms and 23.6% for large. For non-manufacturing
firms the figures were even more significant; 41.9% for small firms, 12.9% for large. This
situation is replicated in the Community as a whole, where trade creditor financing is even
more important than short term bank finance (22). Despite the strikingly better situation of
large firms in the non-manufacturing sector vis-a-vis trade creditors, some still manage to
finance all their stocks on trade credit, illustrating the benefits that accrue from tight
management controls.

A problem is that such exercises are frequently only undertaken by the management of
SMEs when they are facing a financial situation varying in severity between an emergency
and a crisis. Cuts may then be made without sufficient regard being taken to longer term
objectives, should these have even been defined. Whilst the economies made may enable a
business to survive in the short term, reductions in the wrong areas could well adversely
affect long term viability.

21 Hughes, **A. The problems of finance for smaller businesses, Small Business Research Centre Working Paper**
**No.15,1991.**
**22** BACH: DG H Database.

23

**IV EXAMPLES OF SCHEMES PROVIDING FINANCE FOR SMEs**

**NATIONAL AND REGIONAL**

**37.** **The main sources of conventional funding available to SMEs have been detailed in the**
**previous section. This, however, only provides a partial picture as a whole variety of**
**additional schemes offering assistance exist. So many in fact that it has been impossible to**
**obtain details of all of them. Consequently the approach taken in this section has been to**
**summarise the main types of scheme available. Where any appear worthy of further**
**explanation details have been set out in Annex A.**

**38.** **Sources of finance vary considerably. Some schemes are largely backed by public**
**funds,** **even if delivery is through private sector bodies such as banks. Others are**
**administered by public or semi-public bodies, but depend on the private sector for the**
**provision of** **risk** **capital for onward lending. A third category are wholly privately financed**
**and administered.**

**As far as national schemes are concerned, all Member States use packages of financial**
**instruments in order to support SMEs in terms of** **their** **financial** **requirements. According**
**to a recent analysis (23) these fall into three broad categories. Some countries, including**
**the Netherlands and the United Kingdom, rely mainly on the provision of** **loan** **guarantees.**
**Others, including Belgium, Greece, Ireland and Italy, provide support through grants for**
**investments, soft loans** **and/or** **interest rate subsidies. Finally, a minority which includes**
**Belgium,** **France, the Netherlands and Germany, are involved to a varying degree in the**
**supply of** **risk** **capital to SMEs.**

**39.** **Examples of nationally organised systems include:**

**(i)** **Government sponsored schemes to guarantee loans made to SMEs who lack both**
**a track record and adequate security to offer a bank;**

**(ii)** **Those offering full or partial support, in the form of loans or grants, for**
**expenditure in the fields of technology and research and development;**

**(iii)** **The provision of loans to help with the cost of penetrating new export markets;**

**(iv)** **Income support for those previously unemployed during their first year of** **self-**
**employment;**

**(v)** **Grants or low interest rate loans on offer in specific areas of deprivation. Some**
**have the objective of aimed at assisting deprived inner city areas, others at encouraging**
**diversification in predominantly rural regions;**

**(vi)** **Sectorally or regionally organised Mutual Guarantee Systems which provide**
**guarantees on loans for rebuilding and modernization of premises, the opening of new**
**branches, transfers of ownership, the provision of working capital etc.**

**(vii)** **Loans by Mortgage Credit Banks for the purchase of property, and sometimes**
**even machinery, which are secured on the value of the asset** **itself.**
**(viii)** **Long term loans provided by private institutions with government backing, at**
**favourable rates of interest, for environmental improvements and energy saving measures.**

23 "Gateways to Growth", a paper by the Research Institute for Small and Medium-sized Businesses, Netherlands
(October, 1992).

**0**

**24**

(ix) Small loans by the same organisations for general purposes of between 6,400 ECU
and 95,000 ECU in one case, but with an average value of 32,000 ECU.

(x) Venture capital type investments made by similar private bodies, but without
government support.

(xi) European savings banks have developed separate venture capital companies in **a**
number of Member States and savings banks are the main promoters of Epargne
Developpment, a European development capital company based in Paris.

**REGIONAL**

40. Those most worthy of note include:

(i) Regional Venture Capital Funds. These appear to be growing in importance.

(ii) Regional incentive grants or low interest loans falling within the guide-lines for aid to
SMEs established by the Commission. These are available for a variety of purposes
including the purchase or leasing of premises, and even feasibility studies in certain
instances.

**EUROPEAN COMMUNITY**

**41.** The objective of the Commission, taking account of the limited amount of funding
actually available for this purpose, has been to avoid duplication of national and regional
schemes, instead helping to fill gaps in provision, investigating new possibilities, **and**
promoting best practice, by means of demonstration and pilot projects. Efforts have **been**
concentrated on the stimulation of the provision of seed and venture capital, the encourage
of networking between providers, the better use of the results of Community Research **and**
Development projects, and the alleviation of disadvantages suffered in the peripheral **and**
less well developed regions through a series of programmes financed by the **Structural**
Funds. Outline details are provided below. Further particulars are contained in Annex A.

42. The Seed Capital Pilot Project was established following the adoption of the 1989-94
pilot action to stimulate the provision of seed capital within the European Community(24).
Twenty five such funds were approved for support by means of reimbursable advances
covering 50% of operating costs within the first five years of their existence. In addition,
15 European Community Business Innovation Centres in the assisted areas of **the**
Community availed themselves of the option of receiving capital from the E.C.BIC **budget**
line in order to allow them to become shareholders in the funds and thus strengthen **their**
role in providing management and technical support to prospective recipients of **seed**
capital funding. All of the 24 are now operational and one well on the way to reaching
that stage. As at June, 1993, 141 investment projects had been finalised.

**24** **OJ C 204,3.8.1991 at** **page 10**

**25**

**The overall objective is to foster enterprise creation in the Community by strengthening**
**the financing opportunities available to new enterprises and improving the quality and**
**survival rate of** **"seed** **stage projects". The typical proposition receiving support is one with**
**a relatively long development phase, often involving new technology, and which, by its**
**nature, offers both high risks and high returns.**

**A report on the first three years of operations was prepared by the Warwick Business**
**School at the request of the Commission (25). A summary of the findings are contained in**
**Annex A, but the principal conclusions were that this Community initiative had not only**
**led to the creation of Funds which might otherwise not have existed, but indirectly helped**
**in the raising from the private sector of twice as much additional funding for those projects**
**that required it.**

**43.** **At the same time as supporting the establishment of the above funds the Commission**
**has built up a European Network of Seed Capital Funds in cooperation with the European**
**Venture Capital Association. The objective of this pilot initiative is to encourage the**
**training of venture capitalists, stimulate cross-border initiatives, and promote the exchange**
**of information**

**44.** **The Commission is also providing support for the expansion of the provision of risk**
**capital facilities within the Community, in particular through the Venture Consort and**
**Eurotech Capital programmes. The objective of Venture Consort is to encourage**
**investment by venture capital companies in small and medium sized enterprises in all**
**industrial and service sectors through the formation of transnational syndicates. Aid is**
**given towards the search for partners, establishment costs and a contribution to the**
**investment itself in the form of a repayable advance of up to 30% of the input, or** **300,000**
**ECU, whichever is the smaller.**

**A review of the Scheme (26( revealed:**

**-** **that in 1988 and 1989, of the eligible number of transnational investment deals that**
**took place in the market, almost one third were** **financed** **by Venture Consort;**

**-** **a leverage ratio of private investment in equity to Community funds of just over 6:1**
**was achieved;**

**-** **there was a concentration of investments in high technology propositions, as a**
**consequence of the priority given to innovative projects; however, there was a low**
**level of demand for innovation in traditional manufacturing and service sectors;**

**-** **the distribution of the portfolio by investment countries showed a geographical spread**
**more balanced than that observed for overall venture capital activity in the**
**Community: hence the scheme has also contributed towards decreasing differences in**
**the supply of venture capital between Member States.**

**The Eurotech Capital scheme became operational in 1990. The object is to stimulate**
**private capital funding of transnational high technology projects and thus encourage SMEs**
**to undertake new transnational ventures.**

**25** **"The European** **Seed Capital Fund** **Network:** **Review of** **the First Three** **Years",** **ibid**
**26** **Review of the Venture Consort Scheme,** **KPMG** **Management Consultants**

26

**At present, Eurotech Capital consists of a network of** **11** **financial entities, which have**
**agreed to invest approximately ECU 170 million in SMEs involved in transnational high**
**technology projects. Each of these entities has an investment capacity of at least**
**ECU 50 million, of which a minimum of 20% is committed to high technology**
**investments. In return for this commitment, they benefit from a Community financial**
**contribution and two services: Eurotech Data, an expert information service, and**
**Eurotech Innvest, a project identification service.**

**45.** **One of the action lines of the SPRINT programme is designed to bring together firms**
**having innovative projects with potential investors. This process is facilitated through the**
**holding of a number of fora attended by firms from several countries looking for financing**
**with** **financiers,** **also from several countries, looking for investment opportunities. Twelve**
**of these are scheduled to be held in a range of European cities in the period until the end of**
**1993.** **Those held so far have resulted in approximately half of the firms attending securing**
**financial support. Organisation of these fora has been delegated to associations of venture**
**capitalists, and attendees are being selected by a panel drawn from national venture capital**
**associations.**

**SPRINT Technology Performance Financing has been launched to stimulate the uptake of**
**new technology in traditional industries. In practice this means that a supplier can install**
**new technology in a customer firm and receive payments from the acquirer over a two to**
**three year period, depending upon the attainment of predefined performance targets. A**
**third party source of finance, usually a commercial** **bank,** **is also involved in order to**
**provide unsecured advance funding to the supplier firm to bridge the gap in payments.**
**These advances are repaid out of** **the** **performance payments received. Typically the bank**
**will advance between 60 and 80% of the cost of the project and will be paid back in a**
**series of instalments over a period of two to three years. Payment schedules are negotiated**
**in the light of** **pre-determined** **performance targets for the equipment. If the technology**
**does not work as well as stipulated, users need not pay the full amount. The value of**
**projects ranges between 50,000 and 200,000 ECU, meaning that they are of direct interest**
**to the more substantial SME.**

**SPRINT provides a partial safety net to participating banks by underwriting a proportion**
**of their risk, although whether to make an initial advance is entirely up to the financial**
**institution concerned. The programme has signed up a core group of large commercial**
**banks to implement and manage the TPF scheme during a two-year pilot phase. The aim is**
**that when the pilot phase is over most of the banks will continue their TPF programme**
**without further Commission support. Moreover it is anticipated that because of the**
**competitive nature of** **the** **financial** **services industry the use of** **TPF** **will spread rapidly to**
**the rest of the** **financial** **community.**

**46.** **Mutual Guarantee Systems were identified by the Commission (27) as an effective**
**means of improving the access of SMEs to sources of financing. The main role of such**
**systems, and the exact operational details vary considerably, is to enable SMEs to provide**
**each other, by coming together in a cooperative system, with the necessary guarantees to**
**obtain funding from banks. Another important function is to help SMEs to prepare**
**financial presentations to banks, which gain credibility from the fact that many of the**
**Systems are activity based and have detailed market knowledge against which they can test**
**business plans and** **financial** **projections.**

27 SEC(91 ) 1550 final, September, 1991

**27**

**The Commission has stated its intention to encourage the growth of Mutual Guarantee**
**Systems in a number of ways. Notably by helping in the establishment of a European**
**Guarantee Association (actually established** **10.11.92)** **and by providing aid for studies,**
**seminars and conferences which will make these Systems better known, and in the process**
**assist in the formation of new ones.**

**47.** **Although many SMEs throughout the Community appear to face financing problems**
**to a greater or lesser extent, these tend to be more acute in the less developed regions for**
**a number of reasons: the smaller average size of** **SME;** **the less developed financial sector;**
**distances from main** **financial** **centres etc. Within the framework of regional policies, and**
**since the reform of the Community Structural Funds, the Commission has also been able to**
**assist in the creation of SMEs in depressed areas as a means of generating wealth and**
**employment.**

**In this context Community support for SMEs takes three forms:**

**-** **the co-financing of national schemes of regional assistance that have as their objective**
**the stimulation of productive investment;**

**-** **supporting the provision of advisory services to business;**

**-** **encouraging the development of sources of finance other than bank loans: the Seed**
**Capital Scheme largely financed by the ERDF; factoring and leasing facilities; the**
**creation of guarantee funds; interest rate subventions; the development of venture**
**capital; and the encouragement of mutual guarantee systems.**

**48.** **Loans at advantageous rates of interest (between** **2%** **and 6% below market rates) are**
**also available through** **financial** **intermediaries. These are** **financed** **by global loans from the**
**European Investment** **Bank,** **which passes on the advantage arising from its status as a**
**highly rated borrower on the international** **financial** **markets.** **These loans are administered**
**in a variety of different ways. In Portugal one savings bank has nine different credit lines,**
**partially financed through this source, covering agriculture, fishing, industry, tourism and**
**services. Finance is provided through a mixture of** **grants** **and credits, and a full range of**
**separate supporting facilities are offered through other organisations established by the**
**savings bank. These include leasing, insurance, investment funds and venture capital. Other**
**savings bank schemes known to be utilising** **EIB** **loans are operating in Denmark, France**
**and Italy.**

**OUTSIDE THE EUROPEAN COMMUNITY**

**THE UNITED STATES OF AMERICA**

**49.** **The United States has a longer experience of schemes for the provision of** **both** **start**
**up and venture capital than any country within the Community. Indeed, the market in these**
**instruments is showing signs of reaching maturity. In 1990 the number of venture capital**
**firms declined for the** **first** **time, although the funds under management increased slightly**

**28**

**Recent years have seen medical and health related businesses receive the greatest share of**
**financing. This was followed by software development and telephone and data**
**communications. On the other hand private venture firms invested more than 70% of their**
**capital in high technology industries (28).**

**Firms supported by venture capital have apparently been a positive factor in job creation,**
**even at a time of rising unemployment. One survey (29) estimated that 401 start-up**
**companies** **generated 58,000 new jobs in 1990. It must be remembered that "start-up" is**
**defined differently in the US, frequently covering a five year period from the actual**
**foundation of the business. During that five year period the firms surveyed had spend $1.3**
**billion (ECU 1.02 bn) in new process and product** **research,** **generated three and a half**
**times the number of positions for highly skilled professionals than did the average US**
**company, and required 30% less funds than the largest 500 US companies in order to**
**generate** **a new** **job.**

**50.** **The range of programmes in the US is very wide, seemingly with no two being exactly**
**alike because of the widely differing conditions in which they operate, but when viewed in**
**broad terms they fall under the same headings as in the Community:**

**-** **public programmes;**

**-** **programmes that are effectively a partnership between the public authorities and**
**private sector sources of capital;**

**-** **totally private initiatives.**

**51.** **The role of the Federal Government is to act as a catalyst and facilitator for the**
**provision by both state governments and the private sector of finance for small business**
**development. As far as direct** **funding** **is concerned, federal agencies are a major source of**
**research and development financing through the provision of** **grants,** **direct equity funding**
**by them being prohibited. A detailed description of Federal Programmes is set out in**
**Annex B. In outline the significant ones involve:**

**-** **providing matching funding together with the individual states for the finance of**
**technology based start-ups under the Corporations for Innovative Development** **(CIDs)**
**programme;**

**-** **direct funding of research and development through the Small Business Innovation**
**Research Programme** **(SBIR).** **Any Federal Agency with a budget in excess of $100**
**million (ECU 78 million) being forced to participate;**

**-** **the Small Business Investment Company Programme** **(SBIC),** **which provides a source**
**of finance for small companies experiencing difficulty in raising equity or loan capital**
**from conventional sources through the giving of low interest loans to supplement the**
**private capital raised by** **SBICs.** **Despite cuts in Federal financial support during the**
**second half of** **the** **1980s 350 separate funds still exist, representing $13 billion (ECU**
**10 bn) of** **financing** **facilities for small business;**

**-** **the Loan Guarantee Scheme offered by the Small Business Administration, which was**
**the first of its kind and covers** **90%** **of approved loans.**

28 "US Industrial Outlook", US Department of Commerce
29 Coopers & Lybrand, USA.

**29**

**52.** **The reduction in federal spending on small business financing has been**
**counterbalanced to some extent by an increase in initiatives by both state and local**
**governments involving four basic approaches:**

**(i) direct investment in companies through publicly funded agencies;**

**(ii) investment in venture capital funds, often through the use of state pension funds,**
**something which has its parallels within the Community;**

**(iii) providing special tax incentives for private investors;**

**(iv) promoting development of the business infrastructure through the support of**
**entrepreneurs and funding research and development projects.**

**The number of these programmes that are wholly public is relatively small and, in the** **main,**
**these are funded by public pension funds. The majority of public initiatives operate**
**relatively independently within a legislative framework, being funded either by a state**
**government financial** **appropriation,** **or even in some instances a state lottery. Private**
**programmes fall into two groups. First there are private limited partnerships that are**
**capitalised by public pension funds. Secondly, those funded by private sector investors**
**who receive tax credits as a consequence. Most of the larger funds have a bias towards**
**assisting** **firms** **in the high technology sector.**

**53.** **One study (30) financed by the Commission examined the focus and overall coverage**
**of fourteen of these funds as they appeared to represent a good cross section of the whole**
**sector. Of** **the** **half with a defined focus five out of seven concentrated on the support of**
**high technology firms. Only 3 out of** **the** **14 were not prepared to support both seed and**
**early stage development. Two of the programmes provided equity funding only; six**
**provided equity and/or debt** **finance;** **one provided debt finance only; four provided grants**
**and received any payback in the form of** **royalties;** **and one provided debt finance and/or**
**grants. This survey probably under estimates the overall bias in the majority of state**
**programmes towards early stage finance**

**54.** **On the basis of US experience essential elements in the establishment of a range of**
**successful programmes which appear equally applicable in Europe, include:**

**-** **identifying** **gaps in** **financial** **provision in the area or sector targeted and ensuring that**
**those businesses supported do not experience later difficulties in obtaining follow-up**
**funding;**

**-** **establishing a specific investment policy allowing managers to build a diversified**
**portfolio and avoiding over exposure to any one sector, unless high technology is**
**mvolved,** **when specialisation in one closely defined area appears to pay dividends;**

**-** **ensuring that the management team possesses not only** **financial** **skills and an ability to**
**assess a variety of businesses, but experience in the sectors of activity targeted. Where**
**the appraisal of high technology investments are concerned it may frequently be**
**necessary to call on assistance from experienced persons from outside the management**
**team;**

**30** **Survey of Public Authority Programmes for promoting the supply of Venture and Seed Capital in the USA** **-**
**Venture Economics Ltd., June,** **1988**

**30**

- obtaining maximum leverage of own funds by mobilising the highest possible level of
additional private sector investment. A proportion of public funding appears to give
added credibility to a project, especially if a lower rate of return is set for the public
funds;

- programmes must have the correct level of funds needed to achieve their objectives. If
funds are too great there will be a pressure on management to make hurried investment
decisions, if too low worthwhile propositions will have to be turned away, lowering
public confidence in the initiative;

- administrative costs should not be under-estimated. This is particularly important
where early stage and start-up investments are concerned;

- ensuring that funds do not compete with existing private sector provision. In certain
circumstances it may be prudent to include "lender of last resort" provisions;

- striking a balance between receiving sufficient information from the applicant company
and creating a deterrent through the use of over complicated procedures. It is essential
to incorporate a rapid decision making process once all the required information has
been received;

securing a sufficient commitment of cash by the entrepreneur to seriously involve them
###### in the financial risks of the enterprise;

- matching the projected returns on investment with the objectives set for the
programme;

- ensuring the financial instruments used are appropriate to the needs of the business
being financed. Financing structures for start-ups must not require heavy repayments in
the early years;

- formulating an "exit strategy" prior to any investment of equity capital being made and
agreeing this with the owners of the business, particularly where flotation on a stock
exchange or acquisition by another organisation may not be realistic objectives.
Otherwise the fund can eventually end up with a portfolio of unrealisable investments;

- all programmes being subjected to regular periodic views in order to ensure that they
continue to meet both their objectives and the requirements of the market.

55. Experience in the US has shown that is difficult to even begin to judge the success or
failure of any programme until it has been in existence for at least five years. With many
US funds having been in existence for a shorter period this makes an overall assessment of
their success difficult.

56. What any study of the US demonstrates is the importance of the regional factor. Local
circumstances have to be taken into account when programmes are launched. Care must
nevertheless be taken when seeking to transpose American experience to a European
context. The US has a different legislative and tax structure, with the individual states
having a much wider competence than the Federal authorities in this field. Attitudes also
differ towards entrepreneurship, with a generally more positive attitude to risk taking.

57. One relatively new US initiative that is well worthy of investigation is the
establishment of funds exclusively for the purposes of product development by established
companies and where the fund is remunerated by a royalty on net sales. This can be as
high as 5%.

31

**JAPAN**

**58.** **In order to compare the financial problems of SMEs in Japan with those in the**
**Community, and the significance of the various governmental schemes offering special**
**finance to them, it is first necessary to understand their position within the economy, the**
**sources through which they have historically obtained finance, and the serious financial**
**constraints with which they are now having to cope. Differences in definition are not**
**apparently so large as to make comparisons meaningless.**

**In 1963 the Japanese government, as part of its economic policy regarding small**
**businesses, enacted a law which expressly defined the type of** **firm** **falling into the category.**
**If either of two criteria, expressed in terms of equity capital and number of employees**
**were met, a firm was officially regarded as being small. In manufacturing, mining,**
**construction and transportation the value of equity capital must be Yen 100 million**
**(ECU 636,000 approx) or less and 300 or fewer be employed (1000 in mining). For**
**wholesaling the levels are Yen 30 million (ECU 190,000 approx) and 100 persons or less.**
**For those engaged in retailing or other services Yen 10 million (ECU 63,000 approx) or**
**50 employees.**

**Japan's economic success is often attributed to the achievements of large corporations.**
**This greatly under rates the extent to which small firms are a dominant factor in the**
**national economy, which is partially explained by the quite sizable firms that fall within the**
**criteria set out in the previous paragraph. Of the 421,749 enterprises engaged in**
**manufacturing at the end of 1989, 99.1% were small businesses. These accounted for**
**72.5%** **of sectoral employment and 51.8% of turnover.** **(31)** **In wholesaling, based on 1988**
**figures the contribution of small firms was even greater. No less than 99.3% of all**
**enterprises were small, providing 85.8% of employment and 62.1% of sales.**
**Unsurprisingly, given the difficulties of opening large retail units in Japan, in retailing**
**99.5%** **of enterprises were small, providing the vast majority of employment (88%) and**
**accounting for a very high proportion of sales (78.5%). (32)**

**According to Japanese sources, (33) the importance of small businesses stems not only**
**from their numerical superiority but because of their flexible responses to changing**
**conditions. Over the past few decades, small businesses have made significant**
**contributions to Japan's ability to meet effectively such problems of lack of capital,**
**inadequate supply of skilled labour, difficult business climates in some sectors, and the**
**need to develop and introduce technology that contributes to the efficient use of resources.**
**Examples are the introduction after the 1973 oil shock of** **mo 2** **energy efficient equipment**
**and production processes, and over a number of** **years,** **pollution abatement equipment. It**
**is reported that, prior to the current economic down** **turn,** **small firms were aggressively**
**seeking out and employing new techniques to improve efficiency and the quality of their**
**products. It is significant that historically SMEs had a 40% share of private sector**
**investment, although there has been a sharp down turn in monetary terms since April,**
**1990.**

31 Japanese Census of Manufactures 1989.
32 Japanese Census of Commerce 1988.
33 Annual Report of the Small Business Fiance Corporation of Japan, 1991.

**32**

**59.** **It would appear that although the EC, unlike Japan, lacks precise definitions as to**
**what constitutes an SME, the overall contribution to the respective economies of the SME**
**sector is not dissimilar, once the relative inefficiency and over manning in the Japanese**
**wholesaling and retailing sectors is allowed for. On the other hand Japanese SMEs appear**
**to be more willing to invest in up to date processes and equipment. It is impossible to**
**judge to what extent this is based on independent decisions by management in these SMEs,**
**or as a result of pressure from the larger organisations to whom so many in the**
**manufacturing sector act as long-term suppliers of components. The fact that they have**
**historically been able to fund such investments makes the avenues through which they**
**obtain finance of particular interest, at the same time the current financial and economic**
**situation must be taken into account in order to provide a balanced picture.**

**60.** **In broad terms (more specific information in contained in Annex C), and according to**
**the previously mentioned report, (34) at the end of** **March,** **1991 the commercial banks**
**(city banks plus regional banks) accounted for about 65% of total loans to SMEs for**
**investment in plant and equipment. Government institutions provided just under** **11%,** **and**
**the balance was derived from a variety of other private financial institutions, particularly**
**credit associations.**

**The position when long-term operating funds are included is broadly the same, but with**
**two main differences. Firstly, loans for investment in plant and equipment account for**
**under a third of total loans, showing a significant proportion of fixed investment being**
**undertaken out of retained profits, probably because of the more favourable tax treatment**
**given to SMEs.** **Secondly,** **the National (People's) Financial Corporations, which derives its**
**fiinds from private savings, and the Shoko Chukin Bank (Central Bank for Industrial**
**Commercial Cooperatives) play a greater role in the provision of operating fiinds.**

**A** **MITI** **publication,** **(35)** **makes particular mention of credit guarantee arrangements**
**enabling SMEs, which typically have a low net** **worth,** **to borrow more easily from private**
**sector financial institutions. Comparisons of the total amount guarantied in** **1989,** **Yen**
**10,208,248 million (ECU 78,172 million), against total loans outstanding of Yen**
**288,200,000 million (ECU 2,206,000 million), illustrate that guarantied borrowing, whilst**
**still very significant, probably covers only a small portion of total SME borrowing from**
**private sector** **financial** **institutions, with the bulk being raised on purely commercial terms,**
**although this cannot be stated with absolute certainty.**

**A further source of finance is provided by Japanese local authority incentives aimed at**
**attracting inward investment. It has been impossible to quantify the scale of** **these,** **or the**
**extent to which SMEs benefit.**

**61.** **Recently SMEs in Japan have been suffering from serious** **financial** **problems. Start-up**
**costs have been higher, increasing by** **60%** **between** **1983** **and** **1991,** **(36) partly because of**
**the increased price of land. As a result the need for external** **funding** **from financial**
**institutions increased from 35.2% in 1982 to 42.2% in 1990, with an actual peak of** **43.7%**
**in 1987. (37) As a result of the generally low net worth of SMEs this made borrowing**
**difficult, although during the 1980s commercial financing organisations were largely able**
**to meet demand because of the ease with which they could finance themselves directly**
**through share issues or share-linked bond issues.**

34 Annual Report of the Small Business Finance Corporation of Japan, 1991.
35 Outline of Small and Medium Enterprise Policies of the Japanese Government, 1991.
36 Small and Medium Enterprise Agency, "Survey on Start-ups", December, 1991.
37 Ministry of Finance "Statistical Annual Report of Incorporated Enterprises".

**33**

**The drastic falls in both the stock market and the value of land, beginning in 1991, have**
**radically altered this situation. Not only has the financial capacity of private lenders been**
**reduced, they are taking an increasingly cautious attitude to lending because of the high**
**level of bad loans on their books. In an attempt to strengthen their capital position and**
**improve profitability they have raised interest margins on loans, with SMEs feeling the**
**worst effects.**

**The interest rate reductions effected by the Bank of Japan since** **mid-1991** **were apparently**
**seriously influenced by this factor. Lending by public sector institutions has increased, but**
**this has done nothing more than partially offset the fall in loans from other sources. A large**
**part of the economic stimulatory package announced at the end of August, 1992 consisted**
**of measures which extend the opportunities for SMEs to borrow from public sector**
**financial institutions for investment in plant and equipment. Whilst this will represent an**
**increase of some 10% in the level of government financing for such investments, the**
**overall effect could only be marginal.**

**62.** **Finance from public sources has been available to SMEs since the passing in** **1963** **of**
**the Medium and Small Enterprise Modernization Promotion Law. The government has**
**established three financial institutions (the Small Business Finance Corporation, the**
**People's Finance Corporation and the Small Business Credit Insurance Corporation) to**
**furnish small and medium-sized enterprises with funds for their business operations and to**
**promote specific policy objectives. These are supposed to qualitatively and quantitatively**
**complement finance available from private banks.**

**In brief (further particulars are contained in Annex C), four different programmes currently**
**exist.**

**1.** **A special loans** **system,** **providing loans at concessionary rates of interest in order to**
**achieve certain objectives, such as improving the industrial structure, prevention of**
**pollution,** **energy saving etc.**

**2.** **Loans aimed at improving the management of SMEs, which is operated in conjunction**
**with the Societies and Chambers of Commerce and Industry. Such loans are obtainable**
**without the lodging of collateral or guarantees.**

**3.** **The Public Credit Supplementation System which provides loan guarantees and**
**insurance.**

**4.** **The Financial Assistance System for Small Business** **Rer iforcement** **which appears to**
**be aimed at aiding restructuring by companies. Funds are provided by the private sector as**
**well as by national and local government, a high rate of gearing apparently being achieved.**

**63.** **Whilst it has not been possible to examine the assistance given in the less favoured**
**regions, it would seem that, in general, Japanese SMEs face similar financial problems to**
**their Community brethren and are currently experiencing an equally difficult situation.**
**Whilst government assistance, particularly loans for capital investment is significant, and**
**may well have assisted SMEs to embrace new technology more easily, it is not**
**overwhelmingly large. In the same way loan guarantees, whilst important, appear to only**
**affect a minor proportion of all loans, although this view is based on a rough and ready**
**estimate.**

**34**

The most significant features, which might well be worthy of note when considering
measures to ease the financial problems of SMEs within the Community, appear to be that:

except in the case of loan guarantees financial assistance from public sources is
regarded as being supplemental to that available from the private sector:

- some loans, at beneficial rates of interest, are specifically targeted at enabling SMEs to
more easily meet public policy objectives i.e., pollution control and energy saving;

- the importance of providing funds specifically for those SMEs having to restructure,
and who may find difficulty in raising private sector funds, has been recognised;

- financial assistance is given specifically towards schemes aimed at improving the
quality of management within a company.

The direction of these initiatives indicate that they must have been introduced following
comprehensive analysis and are specifically targeted at reducing the most critical financial
problems facing SMEs. What the present difficulties of Japanese SMEs illustrate is that no
measures of official assistance can wholly shelter them from market forces.

35

V. IDENTIFIABLE GAPS IN PROVISION AND POSSIBLE NEW INITIATIVES

64. To summarise the financial problems that have been identified: for conventional startups and similar businesses in the first stage of significant expansion the problem is more a
lack of management skills than shortage of available finance. Nevertheless, difficulties do
exist and the current economic climate exacerbates this situation, making problems of
access to finance more acute for an increasing number of businesses. The most acute
problems occur in the case of high risk start-ups and well established companies
contemplating a significant degree of expansion, or financial reconstruction following a
period of difficult trading. In the case of Management Buy Outs and Management Buy Ins
the situation regarding the availability of finance appears to be broadly satisfactory.

65. The most significant reasons for the existence of these problems include:

(i) the lack of management and financial skills by many contemplating the establishment
of new enterprises, making it difficult for them to draw up and present satisfactory
business and financial forecasts;

(ii) the restricted amount of security that can be offered to banks by many potential
business borrowers. This problem is not confined to start-ups and very small firms, and is
exacerbated in some Member States by restrictions on what will be accepted as security
i.e. personal life insurance policies;

(iii) the inadequacy of management controls in many expanding companies, which
exacerbates shortages of working capital, coupled with an ignorance of available EDP
systems that might correct the situation;

(iv) the high and irrecoverable costs involved in the supervision and assistance of SMEs
receiving small loans;

(v) the need for adaptation by many SMEs, especially for those whose major activities lie
within the defence sector, although many more firms need to react positively to structural
changes within their traditional markets;

(vi) the lack of networking between regional financial centres and their lack of knowledge
regarding the actual financial needs of SMEs ;

(vii) the inadequate number of marriage bureaus that exist to bring together private
investors and SMEs seeking finance;

(viii) the ignorance of many SMEs regarding financial techniques such as financing and
leasing, and sources of finance other than banks;

(ix) the apparently declining supply of funds for early stage development and for true
venture capital activities leading to the appearance of a financing gaps, broadly in the
range of 70,000 to 350,000 ECU in some parts of the Community (38), but also quite
frequently for much smaller amounts;

(x) the increasingly rigid lending policies of banks, largely brought about by a
combination of the economic climate and their weakened capital bases;

38 "Financial Times" 21.9.92 and "Report of the Early Stage Committee of the European Venture Capital
Association to the Commission, 20.10.92.

**36**

**(xi) the present reluctance of some leasing companies to finance the acquisition of plant**
**and machinery;**
**(xii)** **the relatively short investment horizons of many venture capital and capital**
**development companies, together with a growing aversion of the majority to take risks;**

**(xiii)** **a lack of suitable exit routes for venture capital companies, so making it difficult**
**for them to realise their investments;**

**(xiv)** **the almost total lack of properly functioning "over the counter" stock markets on**
**the American pattern within the Community;**

**(xv)the over-rigid categorisation of investments by lenders, leading to the creation of gaps**
**in the provision of follow-on funding.**
**66.** **In response a number of new initiatives seem possible, although at this stage only**
**broad indications can be provided as to the options available, more detailed consideration**
**being required before definite actions can be launched. Whilst in most instances this would**
**involve action at the level of** **the** **individual Member State, there are instances where joint**
**action,** **or at Community level alone, would be appropriate. For example, the relative under**
**capitalization of Community SMEs compared with their US and Japanese counterparts and**
**the wide disparities in** **financial** **provision that exist between the more developed and less**
**favoured regions of the Community. In both instances examples of best practice would be**
**best collected at Community level.**

**67.** **New and original initiatives to improve managerial and financial skills must be**
**introduced urgently. An essential first step would be to build on those schemes already**
**offering integrated and comprehensive advice and counselling for new and existing**
**businesses in some member states. Those have been organized by, amongst others, the**
**chambers of commerce or the industrial and craft organisations of those states. If these**
**were developed, then together with those schemes offered through the European**
**Community Business Innovation Centres and their** **network,** **essential** **advice services**
**would be available within a reasonable distance of the majority of businesses operating in**
**the Community. Experience has shown that physically counselling by an experienced**
**business person on their own premises has far greater impact on those running smaller**
**businesses than any formal course of training. This is not to say that the provision of**
**distance learning materials would not be of value, but their main purposes would be to**
**build on advice that had already been proffered and accepted.**

**For those about to establish themselves in business, one recommendation would be to**
**make any access to financial and other assistance conditional upon attendance at courses**
**providing basic instruction in management skills, as this can lead to at least the halving of**
**death rates among new businesses.**

**Where better established SMEs and the improvement of their management control systems**
**was involved, this would almost certainly require the use of outside** **professional** **advisers.**
**Official intervention should probably be limited to ensuring that all involved in providing**
**advice were able to provide evidence from a recognised professional association that they**
**were able to demonstrate a minimum level of competence, together with meeting a portion**
**of their fees in approved cases.**

**Introduction of programmes would clearly be the responsibility of national and/or regional**
**organisations, although actual implementation might well be carried out by semi-public or**
**private commercial organisations in some instances.**

**37**

**68.** **The cost of investigating, supervising and advising the recipients of smaller longer**
**term loans and equity injections of the venture capital type (up to ECU** **150,000,** **but more**
**in certain instances) appears to make them commercially unattractive and difficult to**
**obtain as a consequence. There would appear to be three broad policy options. Firstly, to**
**do nothing on the grounds that the scale of the problem was too large for official action to**
**have any worthwhile impact, leaving any solutions to emerge from the market place.**
**Secondly, to assist financial institutions with the costs of supervision in appropriate and**
**approved cases. Thirdly to mobilise existing advice and counselling resources in order to**
**assist.**

**Assuming rejection of the first option, both the second and third merit further**
**consideration, although not without their problems. The third option is the most attractive,**
**particularly as the cost would be likely to be lower, and would certainly be possible to put**
**into effect in certain areas within the Community, but in others it might be difficult to find**
**advisers of the right calibre. Also, in many instances, the providers of funds would have to**
**carry out their own "due diligence" investigations, so leading to a degree of duplication**
**and a reduction in the cost advantage. For the counsellors to carry out such work would**
**be extremely time consuming, diverting their attention from equally worthy clients, and**
**would raise questions of professional liability in the event of problems arising**
**subsequently.**

**The second option would almost certainly be more costly in the short term and care would**
**have to be taken to see that any support given was not used to reduce the proper**
**commercial risks associated with investments of this nature. Any assistance towards the**
**cost of initial investigations should be in the form of advances rather than grants and be**
**wholly or partially repayable within a fixed period, based on a formula related to the**
**overall success of a defined portfolio of investments. Costs would be further reduced if**
**more "business angels" could be induced to take part in syndicates making loans. They**
**could then both assist with initial investigations and act as non-executive directors**
**representing the interests of outside investors. This would have the additional advantage,**
**particularly in the case of seed capital funds, of increasing the number of proposals that**
**could be given detailed consideration. In view of the lack of practical experience with this**
**second policy option and the need to identify a mutually acceptable scheme for public**
**support for such an initiative, it would be advisable initially to explore its viability by**
**means of fact-finding pilot projects.**

**Inevitably most schemes, of whichever type, would have to take place at national and**
**regional level in order to ensure that local needs were met. In the less favoured regions,**
**Structural Fund co-financing may be made available for measures to improve the access**
**for enterprises to the capital market, particularly by the provision of guarantees and equity**
**participation. On a Community-wide basis however the Commission could assist through**
**the** **carrying** **out of further studies, the dissemination of information about the most**
**successful** **schemes of each type, and the launching of** **a** **number of pilot projects, so that**
**the benefits of wider access to development finance were available to concerned SMEs,**
**wherever they were located in the Community.**

**69.** **The provision of national and local government guarantees for loans, or the**
**underwriting of part of the obligations of organisations having the same function, has**
**clearly proved its value. There now seems a need to review these schemes in order to**
**ensure that the needs of the medium sized company experiencing difficulty in obtaining**
**urgently needed finance are fully taken into account. It has however to be appreciated that**
**these schemes can never be wholly** **financially** **viable unless the access premiums paid by**
**SMEs are set at such a level as to make them unattractive. Despite this, providing the**
**criteria are established with some care, the high degree of leverage created by a relatively**
**small net public** **financial** **contribution makes** **this** **a very cost effective exercise.**

**38**

**An interesting initiative, also in the context of providing loan guarantees and managerial**
**support is the new financial engineering project which is included in the proposed Fourth**
**R & D Framework Programme. Its objective is to improve, through an appropriate**
**Community action respecting the subsidiarity principle, the European environment for the**
**financing of the exploitation, adaptation and dissemination of technologies.**

**This will comprise:**

**-** **indirect measures which aim to reinforce the communication between financiers and**
**the promoters of technological projects, to support the establishment of effective**
**systems for mobilising private capital and the exit from investments, to and to promote**
**the most appropriate legal structures;**

**-** **pilot actions which will aim to establish or test** **financial** **mechanisms for the absorption**
**of research results and technologies by SMEs. The technology performance financing**
**scheme started under the SPRINT programme will be continued and a new instrument**
**compatible with those of the Member States and adapted to national contexts will be**
**established. In accordance with established agreements, its management will be**
**entrusted to public or private specialist** **financial** **intermediaries selected in the different**
**Member States particularly for their ability to provide equity co-financing. This scheme**
**should facilitate the granting of loan guarantees, interest rate subsidies and measures to**
**support associated technical and managerial assistance.**

**More should also be done to encourage the formation of more Mutual Guarantee Systems.**
**These have the advantage of a flexible structure, making them adaptable to local or**
**regional needs, or in some cases sectors of activity. By bringing SMEs together, either as a**
**group or within a local** **organisation,** **they can build a sense of community as well as**
**stimulating local economic activity, and have proved their worth in countries both inside**
**and outside the Community.**

**To build on this success and to widen the availability of these systems would appear to be**
**a practical way of easing the access to finance of a substantial body of SMEs, not least**
**new firms and those in the crafts sector. If such a beneficial process is to take place two**
**questions will have to be addressed. Firstly, the extent to which assistance is given towards**
**the costs of establishment. Secondly, whether public administrations are prepared to**
**should the burden of being guarantors of last resort, particularly in the early years of a**
**scheme when reserve funds may be inadequate. It is recommended that these questions be**
**the subject of further study.**

**70.** **One form of financial assistance that appears to be lacking is in the field of product**
**development. Specifically for firms having to adapt their activities, especially as a result of**
**reductions in defence expenditure or fundamental changes in their traditional market place.**
**A small number of Venture Capital Funds devoted to assisting product development have**
**been established in the USA (see paragraph 57). It would seem appropriate for the**
**Commission to prepare a study into the overall situation in the Community and how the**
**establishment of funds of this type could be encouraged.**

**71.** **The same problem also manifests itself** **in** **the case of individual entrepreneurs, such as**
**those engaged in research within universities or institutes. Frequently, when the objective**
**is solely to develop a technology to the point where intellectual property rights can be**
**registered and the idea become a marketable** **proposition,** **involvement of a Seed Capital**
**Fund through the normal means of investing in a company is inappropriate and inordinately**
**expensive. A possible answer to this problem has recently been introduced by one venture**
**capital fund in the United Kingdom.**

**39**

**This is known as Product Development Investment and the objective is to finance projects**
**to the point where a method of producing a product can be licensed to a larger**
**manufacturer. Apparently there is a ready market place for product developments of this**
**nature. A** **"shell** **company" is used as a vehicle, having injected into it the rights to the**
**intellectual property by the inventor and the first tranche of financial support from the**
**fund. The originator of the idea is contracted and paid by the shell company to develop the**
**idea and further cash is injected on a monthly basis so that the project can** **be** **wound up**
**immediately should it cease to be viable. If** **and** **when a manufacturing process is licensed**
**to a manufacturer fees received are paid into the company, with the financing company**
**recovering its expenses first. Afterwards royalties are divided on a pre-agreed basis.**

**The advantage of** **this** **concept is that the originator does not have to find capital in order**
**to complete a project and is not forced to become involved in the management of** **a** **trading**
**company. Overall legal fees can be substantially reduced and ideas are brought to the**
**market by companies that are in a better position to exploit them fully than a new business**
**in the early development stage. The same type of vehicle has also been applied to develop**
**specific products for an established company.**

**It will take some years before it is possible to judge the worth of this new initiative. It**
**does,** **however, demonstrate an original approach to solving the problem of developing**
**projects, particularly those with a high technological content. It would appear worthwhile**
**examining the feasibility of the Commission launching a study into how to encourage the**
**creation of more product development vehicles of this nature. It has to be acknowledged**
**that this will not provide a total solution as there are firms and individuals who, whilst**
**wholly dependent for success on the technology they are developing, are unable to protect**
**this by means of** **patents.** **The time and costs may be too high for a small firm, and larger**
**competitors can often find their way round a patent even should one be granted, making**
**the process uneconomic.**

**72.** **There appear to be two areas where networks to improve the links between potential**
**investors,** **particularly** **private investors and those seeking funds could be improved. The**
**first is through assisting the development of links between regional financial centres and**
**the training of staff in those centres so that they acquire expertise in the** **financing** **needs of**
**SMEs, so enabling them to bring together companies with appropriate institutional**
**investors from another centre. It has been indicated by those engaged in this field of**
**activity that initiatives of this nature will be carried out in due course by the regional**
**financial centres themselves, although not in the present financial climate. In view of the**
**financial problems that have been seen to exist, there would** **be** **value in exploring how the**
**process might be expedited, to the benefit of SMEs in some thirty regions of the**
**Community where distinct regional** **financial** **centres exist.**

**Another possible initiative, taking account of the findings that a largely untapped and**
**potentially substantial pool of private investors exists, would be to build on a current pilot**
**action in one Member State establishing marriage bureaus bringing together private**
**investors and SMEs needing finance. Actions would have to be based at local or regional**
**levels,** **as research has shown that private investors are not generally interested in making**
**investments in companies located more than 150 kilometres from their base.**

**Apparently, in at least one Member State, there is a degree of uncertainty about the**
**application of the law governing the provision of financial services which is leading to**
**financial advisers avoiding this area of activity. Whilst investors must be protected, those**
**seeking to take equity stakes in private companies are likely to be reasonably sophisticated**
**in** **financial** **matters and it would appear important for the Commission and Member States**
**to ensure that Community and national legislation is not framed in such a way as to**
**needlessly inhibit this form of activity.**

**40**

**73.** **Certain factors affecting access by SMEs to finance do not fall into such convenient**
**categories as those considered above and any proposals to alleviate them have to be drawn**
**up in the light of two major questions. The first is whether present restrictive lending**
**policies by financial institutions will be relaxed when economic activity picks up. The**
**second, whether as some predict, the 1990s will be an era of comparative shortage of**
**investment finance, particularly when compared with the 1980s.**

**In regard to the first, history shows that a severe economic down** **turn,** **with the substantial**
**increase in bad debts that it brings in its** **train,** **colours the attitude of lenders for a**
**considerable period, perhaps as long as ten to fifteen years. It would be prudent to assume**
**that this will again hold true and that it will be less easy to obtain business finance in the**
**next few years than it has been in the recent past. Those in what** **are** **judged to be high risk**
**categories will certainly face particular problems in such circumstances and many may**
**have to endure higher interest spreads, increased fees, and credit rationing.**

**It is less easy to judge whether an actual physical shortage of capital will make this**
**situation worse, but the signs are not altogether encouraging. As has been seen banks and**
**other institutional investors have suffered substantial losses because of business failures,**
**declines in the value of property and other fixed assets, and defaults on loans, including**
**those of sovereign governments. Although significant numbers apparently remain, many**
**individuals who might normally have been expected to invest will also have had their**
**ability to do so undermined by recent economic conditions, particularly by declines in**
**property values in some Member States Additionally, nearly all governments are facing**
**budgetary pressures which will limit their ability to intervene actively through the creation**
**of new initiatives, even should they wish to do so.**

**It would, therefore, be wise for policy making purposes to estimate that financial**
**conditions will remain tight for at least the next five years. If** **the** **situation recovers more**
**quickly that should be viewed as being a bonus. This could effect the whole perception of**
**the internal market programme in the eyes not only of SMEs but the general population,**
**virtually half of whom are employed by firms in this sector. It follows that it would be in**
**the general interest to see what actions might be taken to ease the situation.**

**74.** **One area in which national** **and/or** **regional governments can influence the need for**
**access to additional capital is through their taxation policies. For example:**

**-** **the more capital that can be reinvested, as opposed to being paid in corporate taxation,**
**the less the need to tap outside sources. A very important consideration for many**
**European SMEs, who are under-capitalised in comparison with their counterparts in**
**Japan and the** **USA;**

**-** **the move to a cash accounting system for value added tax can have a beneficial impact**
**on the working capital requirements of SMEs;**

**carefully worked out tax incentives for private investors could mobilise significant**
**extra sources of equity capital.**

**Obviously this is something that has to be examined by each administration in the light of**
**its budgetary and legal situation and policy objectives. Some examples of current initiatives**
**have been included in Annex A.**

41

**75.** **In drawing up and prioritising solutions to the specific problems identified as making**
**it more difficult to gain access to finance it is important not to accord any one source a**
**greater degree of importance than it deserves. Venture Capital receives a great deal of**
**publicity but less than 5% of SMEs will ever be suitable or eligible to make use of**
**commercial sources, as will less than** **1%** **of total start-ups. Also, whilst it is important as a**
**policy objective that an efficient "over the counter" market in shares develops in** **the**
**Community this will assist only a small percentage of those in receipt of venture capital**
**investments, and is likely to prove difficult to achieve in practice. Why this method of**
**raising finance is important is not because of the number of SMEs who will benefit, but**
**because they are the ones who will probably grow fastest and make the greatest relative**
**contribution to growth and employment creation. A US survey of 5.6 million SMEs (39)**
**showed that the most successful 5% accounted for 77% of all growth, with the top 10%**
**accounting for no less than 87%.**

**The Community requires a wider availability of true venture capital if dynamic high**
**technology and developing medium-sized companies are to have access to the scale of**
**funds needed to take advantage of the opportunities created by the Single Market and to**
**compete on world markets. Venture Capital Funds will not provide the hoped for support**
**for these objectives unless their difficulties are addressed. An example is where a**
**management buy out is** **financed** **which revitalises a company previously constricted within**
**the confines of a larger group. Should expansion be sufficient to lead to a full stock market**
**listing the whole exercise could have positive results. If not, the only alternative, except for**
**the rare possibility of a redemption of the loan by management, may be a sale of the**
**company to another large group.**

**This can work well with old and new management cooperating well, but the history of**
**takeovers is littered with examples where the objectives were not realised and the new**
**acquisition did not flourish. So often this led to a** **"rationalisation"** **process being launched;**
**a curtailment of future projects; and a slowing down in activity. This was almost inevitably**
**followed by disagreements between old and new management, leading to the departure of**
**the former.**

**Such a result largely vitiates the original objectives of the exercise if viewed in the light of**
**the economic health of the Community, which requires the development of a steady flow**
**of companies to the point where they can make a significant contribution to economic**
**activity, the creation of employment and the maintenance of competition. If** **this** **objective**
**is to be achieved some action will be required to enable investment by venture capitalists**
**to invest in the wider range of companies than is presently the case, and to examine ways**
**of providing them with exit routes which do not damage the** **future** **development prospects**
**of the company concerned.**

**It is unlikely to be possible to induce commercial venture capitalists to make a greater**
**number of investments, as they can only subject a finite number of applications to the final**
**and more detailed stage of "due diligence" examination. What needs to be examined is**
**how existing funds might be induced to widen their investment** **criteria,** **particularly so as**
**to include a proportion of higher risk start-ups, and more investing institutions encouraged**
**to invest in the more entrepreneurial seed capital funds.**

**This may require consideration of some** **refundable** **contribution to administrative**
**overheads in specific circumstances and the creation of guarantee funds where suitable**
**ones do not exist. This idea would require much more detailed examination but it should**
**be made clear that a contribution to the guarantee fund would be expected from companies**
**in which investments were made as well as** **from** **the public authorities.**

39 Professor Birch, Mass. Institute of Technology.

**42**

**76.** **The problem will still remain of those firms who need additional long term equity but**
**cannot gain access to normal venture capital funds. An option would be to encourage the**
**creation of** **local/regional** **funds, perhaps with some level of official financial backing, but**
**also tapping other sources of capital and forms of** **support,** **such as large firms, universities,**
**research institutes, and private investors, on at least an equal basis. There are objections to**
**such an** **approach,** **not least that it might be difficult to build a management team capable**
**of administering the fund, and this would have to be addressed through the organisation of**
**appropriate training and the incorporation of appropriate** **financial** **incentives.**

**77.** **For the majority of SMEs, the only source of outside finance will remain their** **bank,**
**including in certain member states, the large European network of the cooperative banks,**
**savings institutions, and clearing banks specialised in the financing of SMEs.. It has been**
**seen how the present difficulties of these institutions is causing problems for SMEs of all**
**sizes.** **Apart from the SPRINT Technology Performance Financing Schemes there is**
**probably little that can be done by public authorities, other than to improve the availability**
**of** **financial** **guarantees. Generally, the role of the Community is unlikely to extend beyond**
**the extension of guarantees in respect of certain programmes associated with research and**
**development and seed and venture capital. For the rest, some banks are already launching**
**experimental schemes to provide relatively small amounts of equity capital to SMEs and to**
**securitise export trade receivables. Also, certain encouraging developments can be noted**
**in the banking sector:**

**-** **the Italian government is proposing to repeal a law dating from** **1936** **which effectively**
**prevents SMEs developing a one to one relationship with a bank and negotiating short**
**term** **financial** **facilities:**

**-** **the Association of Greek Banks is in process of developing an improved mechanism**
**for lending to small firms;**

**-** **a bank in the United Kingdom has introduced a pilot scheme whereby small firms are**
**provided with security of funding for a five year period at a slightly enhanced rate of**
**interest providing they meet certain** **financial** **reporting conditions.**

**It seems necessary to see whether or not these are successful, and even built upon by**
**others, before considering, in cooperation with banks, whether other initiatives are**
**necessary.**

**78.** **Whilst the current reluctance of some leasing companies to finance plant and**
**equipment is unhelpful, in present economic circumstances it is understandable. The**
**probability is that attitudes** **will** **change with the onset of economic recovery and that this is**
**not a situation that requires consideration unless it unexpectedly persists. One the other**
**hand SMEs could benefit if more independent advice as to the advantages of factoring**
**were made available at the local level.**

**79.** **Neither is it going to be easy to alter the relatively short investment horizons of** **many**
**financial institutions. They have to have regard to the interests of their investors, who wish**
**to see a return on their investment within a reasonable** **timescale.** **Although those pension**
**funds who have invested in this field could take a longer term view even they would not**
**wish to have their money tied up in relatively or totally illiquid investments indefinitely.**

**43**

**What is required is a more assured exit route than is currently available in the case of the**
**majority of potential investments, taking account of the underdevelopment of secondary**
**markets in the Community. Consideration should be given to the advisability and**
**possibility of promoting the development in Europe of securities markets such as**
**NASDAQ (National Association of Securities Dealers Automated Quotations System),**
**which operates in the United States, on the basis, inter** **alia,** **of work by the Association of**
**European Regional Finance Centres and by Europe's Venture Capital Association, (40)**
**and in close conjunction with other Community policies, including innovation policy.**

**80.** **The criteria for schemes assisting firms should not of themselves be so constructed as**
**to lead to the creation of financing gaps. It has been noted that in the US potential**
**investors do not compartmentalize themselves in the same way as in the Community. Thus,**
**a fund providing seed capital plans from the beginning at what stage further investment**
**may be required and which sources may be called upon. Schemes designed to assist start-**
**ups,** **and indeed other categories of SMEs should be encouraged to make similar**
**provisions. This will be more easily achievable where projects are in receipt of public**
**funds.**

40 EVCA Early Stage Committee, Report to the Commission of the European Communities, 20th October, 1992,

roneo.

**44**

**VL** **INCREASING THE EFFECTIVENESS OF EXISTING COMMISSION**
**ACTIONS.**

**OVERALL CONSIDERATIONS**

**81.** **A major problem to be faced when formulating policies in this area is a lack of**
**coherent statistics covering the whole European Community. In some instances these are**
**apparently not even available on a national level. Specific examples include:**

**-** **the rates of business births and deaths. Ideally these should cover at least a three year**
**period in order to indicate trends. Without such figures it is impossible to know**
**whether or not existing start-up programmes are succeeding, and of the businesses that**
**have ceased trading, how many are relatively new and how many mature;**

**-** **movements by number of companies into different size categories, preventing any**
**estimation as to whether companies with say 20 to 50 employees are growing or**
**declining in numbers. It is impossible, therefore to discover whether a negative trend**
**exists in relation to any particular size category;**

**-** **the amount of capital employed by SMEs, and the percentage division between "own"**
**and** **"borrowed"** **capital;**

**- figures regarding the importance of leasing and other off balance sheet financing**
**methods to SMEs;**

**-** **the net increase in employment generated by SMEs in their first three years of life in**
**comparison with** **firms** **in other size categories.**

**Whilst it is possible to draw on statistics from other sources they have their drawbacks,**
**making this is far from satisfactory situation. Policies could be far better focussed if better**
**statistics were available.**

**It is understood that some additional demographic information on SMEs (births, deaths,**
**size class shifts, the weight of young enterprises** **in** **job creation etc) will begin to become**
**available around the end of 1993. As to financial variables, the adoption of a new**
**Community legal text on business statistics, which will cover this point, is scheduled for**
**the first half of 1994. It is to be earnestly hoped that it will be possible to adhere to, or**
**even improve** **upon,** **these deadlines. Any remedial measures taken should not lead to a**
**materially greater burden of form filling for SMEs. In many instances sample surveys**
**and/or** **the use of new estimation techniques would be quite sufficient for the purpose.**

**SPECIFIC PROGRAMMES**

**THE EUROPEAN SEED CAPITAL FUND SCHEME**

**82.** **It is still far too early in the life of the Scheme to be able to make any meaningful**
**assessment of the longer term outcome, either in regard to the success of the funds or the**
**projects in which they invest, but that there have been only ten failures on the 141**
**investments made to date is encouraging. Experience shows that it can require ten years of**
**actual operations before it is possible to begin to make an objective appraisal of the**
**performance** **of** **a fund.**

**45**

**As far as the Seed Capital Scheme itself is concerned, its initial pilot phase has coincided**
**with an overall down turn in the availability of seed capital. In the view of researchers at**
**the Fraunhofer-Institut fur Systemtechnik und Innovationsforschung in Germany, if**
**Community support were now reduced and not replaced from other sources, there would**
**be a decline in the availability of** **seed** **capital for high technology start-ups. In the view of**
**providers of seed capital participating in an Anglo-German workshop on the subject, held**
**in the United Kingdom at the end of September, 1992, the Seed Capital Fund Network**
**was both imaginative and valuable.**

**As noted under Point 75, the Community needs more entrepreneurial seed and venture**
**capital funds in order that those with good new ideas for products and processes may have**
**money for their development and its most dynamic and growing companies receive the**
**additional equity funding they require in order to maintain their impetus. The European**
**Community using its resources and influence has successfully stimulated funding for seed**
**capital and the support of start-ups, not least in the field of** **high** **technology. Despite this**
**achievement, with private institutional provision of venture capital for early stage**
**investments in decline (from 25.4% in 1985, of which seed capital 2.9%, to 5.3% and**
**0.6% respectively in 1992) and with an unbalanced dispersal of funds throughout the EC,**
**there seems a major need for this work to be continued under a structure more appropriate**
**to long term operations..**

**This makes it necessary to devote continued attention to tackling the problems identified**
**by existing funds within the Scheme. These include:**

**(i) the relatively small size of most fiinds, making administrative costs disproportionately**
**heavy. This was only conceived as being a pilot action and valuable lessons for the future**
**have already been learned as a result. It would not, therefore, be a disaster if repayment of**
**some advances had to be delayed. The priority is to ensure, as far as is possible, that all**
**funds reach viability. If the performance of some is affected by the requirement to take**
**more account of local or regional social development requirements than to engage in**
**profitable investment, it should be for official local bodies to take over part of the running**
**costs.** **The remainder of the existing funds are in process of raising more fiinds, so as to**
**increase their money available for investment to at least ECU 5 million.**

**(ii) a demand for additional training and information provision has been identified and the**
**Commission is providing this through the medium of the Seed Capital Network.**

**(iii) greater emphasis needs to be placed on the projects receiving investment expanding**
**their sales into new markets. There is a clear need to explore the degree to which the**
**established network could facilitate inter-country trading within the Community.**

**(iv) it appears necessary to study whether or not the eventual viability of funds within the**
**Scheme might not require a revision of some of** **the** **criteria governing their operations in**
**order to allow a certain degree of additional flexibility.**

**(v) the review has revealed that whilst the** **financial** **advice offered to companies receiving**
**funds is good, other advice in fields such as marketing is less** **helpful.** **This indicates that**
**the range of entrepreneurial skills and experience within the management team needs to be**
**broadened. This can only become economically possible if the average size of** **fund,** **or the**
**amount of** **financial** **assistance given, is increased.**

**46**

**What this pilot project has revealed is that official support and encouragement of venture**
**and seed capital funds can attract substantial private sector financial participation and, if**
**the schemes are properly structured and supervised, achieve an encouragingly low early**
**failure rate amongst those projects in which investments are made. For the Community to**
**carry on this exercise permanently would be inappropriate, action at national and regional**
**level based on the lessons learned would appear to be preferable. Even so, the network**
**established between funds has proved its worth and deserves to have support maintained**
**on a long term basis.**

**VENTURE CONSORT**

**83.** **The Review referred to in Section IV revealed that the assistance made available by**
**the Commission was of the greatest value in encouraging investors to participate in trans-**
**national syndicates. The administration of the Scheme was also commented upon**
**favourably. Despite this there were a number of suggestions regarding adjustments that**
**could be made, notably by extending assistance to funds that were not members of the**
**European Venture Capital Association. A need was also identified to try to stimulate more**
**support for innovation in traditional areas of activity. A particular problem identified was**
**that the costs for funds participating in trans-national syndicates were significantly higher**
**than for those operating in only one market. There was also a higher degree of risk.**

**In order to counter the problems identified, the scheme was modified by adding a new**
**facility to cover the costs incurred by the syndicate members in establishing the syndicate:**
**cost of searching for syndicate partners and syndicate set-up expenses.**

**Priority was also given to** **innovation,** **particularly in economic sectors that are termed**
**traditional.**

**Accompanying measures (information services etc.) are also foreseen in order to reduce**
**the costs of transnational syndication for all operators.**

**FUND FOR EXPLOITATION OF COMMUNITY R & D RESULTS BY SMEs.**

**84.** **Details of this new proposal by the** **Commission,** **within the context of the Fourth R &**
**D Framework Programme, have been set out in paragraph 69. It has become increasingly**
**clear that major difficulties exist in achieving the optimum exploitation of discoveries made**
**under the Community R & TD programmes. Many of these arise because of shortages of**
**suitable finance and/or** **financial** **guarantees. It is anticipated that this programme will have**
**a beneficial long term effect on the better provision of support for businesses attempting to**
**bring new products and processes to the market.**

**47**

**EUROTECH CAPITAL**

**85.** **A first detailed evaluation of** **the** **scheme will be performed as foreseen by the end of**
**1993.** **It can already be noticed that the programme has succeeded in attracting major**
**venture capital funds committed to transnational high technology projects and covering**
**most of the Member States. The immediate objective is to complete the network by adding**
**more entities in order to achieve the best possible geographical coverage of the**
**Community, hence making fiinds available to SMEs wherever they are located within the**
**Community.**

**THE EUROPEAN INVESTMENT BANK**

**86.** **On 13th December, 1992 the Council approved the establishment of** **a** **new European**
**Investment Fund to be operated by the European Investment Bank with an initial**
**capitalization of ECU 2bn Initially the Fund will issue guarantees in the framework of**
**global loans to banking institutions, but it will later take an equity participation in**
**investment vehicles providing SME** **financing.** **This could in the long term provide leverage**
**of up to eight times the capital guarantied or advanced. In** **addition,** **a decision was made at**
**the European Council in Copenhagen to institute a further financing facility, which would**
**make an additional ECU 1 bn available to SMEs at concessionary rates of interest (a**
**maximum of** **3%** **over five years) in instances where the investment** **will** **lead to the creation**
**of new employment. These new facilities, whilst not solving the complex problems of**
**access to finance by SMEs, will make a significant additional contribution. In addition it is**
**anticipated that the new Cohesion Fund will also increase the supply of risk capital**
**available in assisted regions.**

**48**

**VH** **OVERALL CONCLUSIONS**

**87.** **Financial problems exist for too many SMEs and are tending to worsen. The problems**
**within the Member States are broadly similar although they may differ in magnitude, and**
**the optimum economic development of the Community could be retarded by this**
**development.**

**At the same time there are a considerable number of public and private schemes designed**
**to assist at SMEs with their** **financial** **problems at local, regional, national and Community**
**level. What appears to be absent is any form of linkage between them, which could**
**promote best practice, reduce the danger of** **duplication,** **and obviate any waste of financial**
**resources, at a time when these are not in abundant supply. In order to improve delivery it**
**would seem necessary to clarify policy objectives in relation to SMEs, both at the national**
**level and that of the Community. The time may also be ripe for making an independent**
**comparative evaluation of at least the major schemes so as to define their strengths and**
**weaknesses and to provide a firm basis for the refinement and expansion of existing**
**policies aimed at reducing the size and impact of existing equity gaps.**

**The objective of the Commission in implementing Community policy must be to avoid**
**duplication of national and regional efforts, but instead help to fill gaps in** **provision,**
**investigate new possibilities, and promote best practice . This would particularly apply in**
**relation to the stimulation of the provision of seed and venture capital, the encourage of**
**networking between providers of capital, the better use of the results of Community**
**Research and Development projects, and the continuation of efforts to alleviate the**
**disadvantages suffered in the peripheral and less well developed regions.**

**It is clearly impossible to resolve all the problems related to finance experienced by SMEs**
**though official initiatives, but significant improvements could be made through judicious**
**measures. It has been seen that the difficulties of the generality of firms could be partially**
**eased through their taking action to make more efficient use of their** **financial** **resources by**
**better** **financial** **planning, coupled with an improvement in the standard of information that**
**they provide to their bankers. Where they could be assisted is through the making of**
**management training and enterprise counselling more accessible, together with a greater**
**availability of** **financial** **guarantees for those unable to lodge sufficient collateral.**

**It is important that the problems arising out of difficulties of access to finance should be**
**addressed in relation to all SMEs, right down to the very smallest, but for the optimum**
**economic development of the Community it would seem necessary to concentrate special**
**attention on the problems of the five to ten per cent of businesses that have the capacity,**
**given advice and appropriate financial support, to achieve rapid growth. The majority**
**falling into this category will require long term equity finance, available in the main from**
**Seed Capital, Venture Capital and Development Capital Funds, which is why these sources**
**of** **finance** **have received such a high degree of attention, although of little or no interest to**
**the majority of firms.**

**It follows that priority should be given to the consideration of measures to stimulate the**
**growth and further creation of funds of this nature, particularly those with a bias towards**
**making investments in areas of high technology. One advantage of taking action in this**
**field is that public authorities will not be placed in the invidious position of picking**
**"winners", for which no proven method currently exists. This would be the role of private**
**investors.**

**49**

**What these investors state they require most is aid towards the cost of investigating**
**propositions, together with the development of** **an** **infrastructure which will provide them**
**with better exit routes at the end of their planned period of investment. Whether more**
**ambitious forms of support should be contemplated will require careful consideration,**
**particularly as it would not be right for public** **funds** **to be used in order to reduce those**
**risks which are inseparable from investments of this nature.**

**If carefully planned, and fully coordinated with existing initiatives, the proposed measures**
**should not require a large increment to the current level of public** **funding,** **although there**
**would be an increase in contingent liabilities arising out of the extension of guarantee**
**schemes. Indeed, if given time, they should prove largely self-financing through stimulating**
**an increased production of higher value added products within the Community, have a**
**favourable effect on levels of unemployment, and result in an increase in tax yields, both**
**from those re-employed and the businesses in which they will be working. To take no**
**action would carry the risk of threatening the future competitiveness of the Community in**
**a number of developing areas of industrial and commercial activity. The choice would**
**appear to be clear.**

**50**

**ANNEX A**

**EXAMPLES OF SCHEMES PROVIDING FINANCE FOR SMEs WITHIN THE**
**EUROPEAN COMMUNITY**

**NATIONAL AND REGIONAL**

**1.** **A government sponsored scheme to guarantee loans made to SMEs who lack**
**both a track record and security to offer a bank has existed in the United Kingdom since**
**1981.** **Up to the end of 1991 30,000 loans had been approved totalling £940 million. In**
**recent years the failure rate of businesses receiving such loans has been rising but is still**
**comparable to the failure rate for all businesses. The scheme has always operated at a loss.**

**In the** **1993** **Finance Act certain changes were made in order to widen** **the** **scope so as to**
**make more established companies eligible and reduce the guarantee costs. Premiums were**
**reduced to 0.5% on fixed rate and 1.5% on variable rate loans, but now apply to the whole**
**loan rather than just the guarantied portion (these were 70% normally, 85% in certain**
**inner city areas). The level of guarantee was increased to 85% for all loans, and the upper**
**limit raised from £100,000 to £250,000 for established businesses only.**

**2.** **Mutual Guarantee Systems in Germany have, since their foundation, approved**
**approximately 100,000 guarantees for a total of 8 billion DM, covering loans amounting to**
**11** **million DM. Fifty six percent out of a total of some 4,000 granted annually are applied**
**to the establishment of new businesses. Guarantees are provided for loans, the support of**
**leasing contracts, and investments in SMEs. No dividends are paid, any surplus funds**
**theoretically being transferred to reserves.**

**A prerequisite for assistance being granted is that any application from a firm should be**
**accompanied by a letter from a bank stating their willingness to take over that part of the**
**risk not covered by a guarantee, which can vary between** **50%** **and 80% of the total sum to**
**be advanced, with an upper limit (subject to some exceptions) of 1 million DM. The**
**average term of guarantee is ten years, although this can run to 23 years in the case of**
**construction projects. A procuration fee of 1% of the guarantied sum is payable on**
**application,** **a further guarantee** **commission,** **normally an additional 1% is payable on**
**completion.**

**3.** **Under another German scheme, mutual guarantee organisations of this type can**
**guarantee 70% of equity investments made by sister organisations known as**
**Mittelstandische Beteiligungsgesellschaften. These are able to invest up to 1 million DM in**
**both new and existing SMEs. Almost 40% of total sums invested are venture capital type**
**financing of innovative projects. Participation is on a silent partner basis and guarantees**
**are not asked from the owners of the** **firm.** **Loans are normally due for repayment after ten**
**years and serve to fill the gap not covered by bank loans. Rates of interest charged are**
**0.5% over inter-bank rates. Banks provide the balance of finance required as working**
**capital at approximately** **1%** **over inter-bank rates.**

**4.** **In Denmark the government provides co-financing, through grants of** **up** **to 50%**
**to newly established businesses, for the cost of new product development, or the cost of**
**penetrating new markets. Other small firms are eligible for repayable loans, to be devoted**
**to the same objectives.**

**51**

**5.** **In the Netherlands** **PPM,** **a private equity participation scheme established in**
**1981,** **guarantees half of any losses made on individual investments, principally in**
**companies with less than 100 employees and for a period of up to six years (12 years in the**
**case of property). Companies receiving PPM supported funds have been shown to have**
**had a substantial and favourable impact on employment.**

**6.** **In 1989 the German Federal Ministry for Research and Development launched**
**the "Investment Capital for New Technology Based Firms" pilot scheme (BJTU) with the**
**aim of supplying indirect assistance for firms in this category. The objective was to create**
**a sufficient supply of risk capital both for their research and development operations and**
**the market entry phase.**

**Two investment models are provided:**

**The co-investment model: in which the Technologie-Beteiligungsgesellschaft** **mbH** **(BTG)**
**makes an investment of up to DM 1 million in a company as a sleeping partner providing**
**the lead investor provides at least the same amount. In the first three years after the**
**investment is made the lead investor can tender its stake to the BTG, which is forced to**
**acquire** **it,** **but at a discount of between 40 and 60%.** **Durinjg** **the same period the** **BTGs**
**stake can be purchased by the lead investor, but at a** **premium,** **which is generally 25%.**
**This model is designed to appeal to profit orientated venture capital companies without**
**refinancing problems, as it enables them to limit their losses but maximise their profits if**
**the investee company prospers.**

**The refinancing model: is offered in cases where funds are suffering refinancing problems.**

**Currently the second option is proving more popular, with calls on funds of DM 50 million**
**as against DM 30 million. To date investments by banks and regional funds have proved**
**more successful than those made by venture capital funds. The German government has**
**expressed its willingness to invest DM 150 million in each fund, to continue its support of**
**investments made for a ten year period, and is prepared to contemplate a** **25%** **loss.**

**7.** **In the United Kingdom some fifty Regional Venture Capital Funds, excluding**
**branches of national financial organisations such as** **3i,** **have been specifically**
**identified (41), the majority having been established during the last ten years. Most are**
**small, having only between five million and twenty million pounds to invest, but have the**
**ability to bring about local syndication of larger deals. They also provide a local focal point**
**for the attraction of money from larger** **financial** **centres.**

**One fund invests only in small and medium-sized companies in its immediate geographical**
**area with existing turnovers of between 700,000 ECU and 6.88 million ECU, with the**
**average capital injection being 400,000 ECU. Funds are normally provided either for**
**expansion or the funding of a management buy out. Companies are selected on the basis of**
**a careful assessment by the fund managers who have wide industrial and commercial**
**experience. Noteworthy is that the amount of time devoted to management support is**
**substantial, involving for example the implementation of improvements in management**
**systems and providing training in strategic management. To date 20 companies have been**
**supported to a total value of 8.8 million ECU. The results have been so encouraging that**
**another fund is being created which will be wholly** **financed** **by private sector capital.**

**Broadly similar schemes have been identified in Sevilla (Spain), Shannon (Ireland) and the**
**Toscana region in Italy.**

**41** **"Financial** **Times", supplement on Venture Capital, 25.9.1992**

**52**

In Belgium the BRUSTART scheme was established in order to provide access to venture
capital to start-ups or growing new companies of less than five years of age operating in
the Brussels region. Loans, which are normally for a period of seven years at market rates
of interest, are provided without guarantees where necessary. The availability of
management advice and support is a specific feature.

The Flanders Region Take-Off Fund GIMV has been in operation since 1989. This offers
finance for growth or product diversification to firms established for less than three years.
Firms involved in property or operating small shops are excluded. Entrepreneurs under 35
years of age, who have not previously started **a** firm, have had access to loans for
investments in fixed assets, capital goods and intellectual property from **a** special fund
since 1990.

8. The ANVAR organisation has twenty two regional offices suppling its services to
SMEs in metropolitan France. Its role, as **a** state funded organisation, is to support the
development of innovation in small and medium sized firms. During its twelve years of
operations assistance has been provided to more than 15,000 companies.

ANVAR will supply up to 40% of the finance required for approved projects, without an
upper limit. This is given as an interest-free advance, repayable only if the project is
successful. Provision of this finance provides the resources for the mounting of proper
feasibility studies and the use of outside expertise and consultancy where required.
Evidence of this support in turn gives confidence to other financial backers.

In collaboration with the European Venture Capital Association and the SPRINT
programme it also organises investment seminars where those seeking finance can meet
with financial institutions. In appropriate instances it can also provide assistance for
projects carried out in conjunction with foreign companies or research agencies. Financial
help is also provided both towards the costs involved in technology transfer and the
registration of intellectual property rights overseas.

9. Other examples of guarantee schemes include:

France: Sociétés de Développement Régional - are regional development companies
which are empowered to provide loan guarantees for business start-ups. In addition they
provide long and medium term soft loans and are permitted to hold up to 35% of the
equity capital in an enterprise..

**Italy:** has the Medio Credito Centrale (Central Agency for Guarantees). Taking account of
the additional facilities provided by the Consorzio Fidi and the Co-operativa di garanzia
Italy has the highest number of mutual guarantee schemes in the Community.

**Spain:** has established, with Community assistance, the SOGASA agency for guarantees.
This includes 25 mutual guarantee funds, the Institute for Small and Medium Enterprises
and the Official Credit Institute. The objective is to provide a reguarantee facility.

10. Three Community countries have venture capital type schemes in addition to
those listed earlier:

**France:** Thirteen locally based Sociétés Financières pour l'Innovation are allowed to
participate to the extent of 30% of a firm's capital. In addition a number of schemes (Fonds
Communs de Placement à Risques, Sociétés de Capital Risque and Sociétés
d'Investissement à Capital Fixes) have been introduced in order to make the provision of
seed and venture capital more attractive to private investors.

**53**

**Italy:** Law 317 provides for participatory loans by venture capital funds.

**Ireland:** possesses Early Start Technology Funds, which provide seed capital for high
technology start-ups.

In addition the Spanish government has recently introduced a number of measures to
facilitate the financing of SMEs including:

- preferential credits issued by the Official Credit Institute;

- a credit line of Pes. 100 milliard, to assist SMEs with productive long term investment
in 1993-94, using banks and savings banks as intermediaries.

- Pes. 10 milliard available for reduced rate loans to small firms wishing to acquire high
technology equipment.

In the **United Kingdom** the Highlands and Islands Development Board offers:

- long term loans of between five and twenty years based on the importance of the
investment and the number of jobs to be created;

- loans with an interest rate subsidy;

- the provision of specially built industrial/commercial buildings with a fifteen year
option for the business to buy.

Lancashire Enterprise provides loans against which royalties on sales (once the breakeven
point has been reached) are paid throughout the agreed term, even should repayment be
made earlier. The first year of a loan is normally interest free.

11. **Italy:** offers direct subsidies for investment in new companies under Law 44, although
this only applies to those to be located in the Mezzogiorno.

**France:** The Haute-Garonne region offers some 100 subsidies per year to assist with the
establishment of new enterprises. The average advance is ECU 3,500 per application.
Aquitaine offers grants to established companies based on the number of new jobs created.

The amount varies between ECU 1,500 and ECU 3,000 per job, with a maximum limit of
thirty jobs.

12. Most Member States do not offer specific tax incentives wanting to respect the
principle of tax neutrality. Those that do exist include:

**France:** No social security payments are required for a certain period following the
establishment of a new enterprise.

**Greece:** a new enterprise tax exemption for those with gross profits of less than 1 million
drs.

**Italy:** provides a 50% reduction in the amount of tax payable during the first ten years of
its life by a new firm located in the Mezzogiorno;

**Spain:** accelerated investment right offs (up to 80% for new investments), together with
greater ability to carry forward losses.

**54**

**In addition, partial, total or conditional exemptions are granted from local taxes in certain**
**instances.**

**EUROPEAN COMMUNITY**

**1.** **The Seed Capital Pilot Project has a series of criteria. As well as requiring that**
**funds only invest in the creation or development of enterprises which need management**
**and** **financial** **support prior to turning to more traditional sources other investment criteria**

**are:**

**-** **a requirement for external seed capital of not more than ECU** **350,000;**

**-** **existing capital investment of no more than ECU 50,000;**

**-** **annual sales of less than ECU** **100,000;**

**-** **less than 10 employees;**

**-** **a total value of share capital, at the seed funding share price, of not more than ECU**
**1,500,000.**

**These are very much upper limits. The typical investment is more likely to be in the range**
**of ECU 25,000 to ECU 100,000, with the business considerably smaller and less**
**developed than might be indicated by the above parameters.**

**The Warwick Business School report, which surveyed twenty-one of the funds, reported**
**that they had so far raised ECU 36.2** **million,** **and that three quarters of the funds had**
**money for investment of less than ECU 2 million. It is estimated that ECU 18.7 million of**
**the above funding would not have been raised without the support provided by the**
**Commumty, which had added credibility to the projects.**

**In the 18 months since lending operations actually commenced ECU 16.106 million had**
**been invested in 141 enterprises, an average of ECU** **114227** **per project. Fund managers**
**intended to eventually invest in 377 separate projects.**

**For 69% of the projects the funds were able to provide sufficient finance, but the others**
**had raised an average of ECU** **351,000** **from other sources. It appears that this would have**
**been more difficult without the backing or active assistance of a fund. Apparently this**
**Community** **initiative has not only led to the creation of funds which might otherwise not**
**exist, but indirectly helped in the raising from the private sector of twice as much**
**additional funding for those projects that required it.**

**2.** **The Eurotech Capital scheme concentrates on private capital funding of transnational**
**projects in the field of high technology. At present, the Eurotech Capital label has been**
**awarded to** **11** **financial** **entities specialized in high technology investments. Each entity has**
**an investment capacity of at least ECU 50** **million,** **of which at least 20% must be**
**committed to transnational high technology projects, with SMEs being given priority. The**
**funds available currently stand at ECU 170 million.**

**55**

**In order to qualify, projects must comply with the following criteria:**

**•** **To be classed as high-technology projects, they must:**

**fall under a Community or European research and development programme**
**(BRITE,** **EURAM,** **ESPRIT, EUREKA** **etc);** **or,**

**come under a national research programme; or,**

**constitute a significant advance on existing technology.**

**•** **To be classed as transnational projects, they must:**

**come under a Community or European research and development programme;**

**or,**

**have a research phase and an industrial application phase in two or more**
**countries; or,**

**have shareholders from two or more countries.**

**3.** **The objective of the Venture Consort Scheme is the stimulation of** **a** **Single Market in**
**the Community for venture capital through support for new transnational syndicates**
**investing in small and medium-sized companies.**

**All industrial or service sectors are considered as being eligible but a degree of priority is**
**given to the:**

**a)** **encouragement of innovation, particularly in economic sectors that are traditionally**
**termed "traditional"; and**

**b)** **reduction of gaps in the supply of venture capital that currently exist in certain**
**regions.**

**The Venture Consort Scheme comprises two types of facility:**

**a) a non-refundable contribution to a new transnational syndicate to help limit the**
**additional expenses resulting from the transnational nature of the operation (up to ECU**
**13,000); and**

**b) a refundable advance to the investee company. The maximum amount of the**
**contribution available to any one investee is 30% of the syndicate's total capital**
**contribution in the investee company, subject to a maximum or ECU 300,000. In principle,**
**the advance will be repayable after five years.**

**4.** **Within the** **PEDIP** **programme, two risk capital partnerships have been established.**
**These concentrate their activities in Northern and Southern Portugal respectively. An**
**interest rate subvention scheme, provided by the ERDF and administered by the Caixa**
**Gérai** **de Depositos, encourages local SME participation in projects deemed essential for**
**the development of the Portuguese regions.**

**56**

**ANNEX B**

**VENTURE AND SEED CAPITAL FUNDING MECHANISMS IN THE UNITED**
**STATES OF AMERICA.**

**Private Venture Capital.**

**The returns sought by private venture capitalists in the US are in the order of** **35%** **per**
**annum for pure venture capital investment and around 20% to 25% for subordinated debt**
**finance. Those sought on product development programmes are typically between two and**
**five times the amount invested. Given the relatively long time scale of many investments,**
**perhaps up to ten years, and the many investments that fail to achieve a worthwhile return**
**means that it is necessary for those US firms that are successful to provide this level of**
**return if the programme is to do more than break even at best. The truth is that the**
**majority of funds established as a result of state initiatives have failed to do so;**

**It is believed that one factor in the recent decline in the number of active venture capital**
**funds in the US is the 30% increase in capital gains tax since 1988. Another, the**
**withdrawal of many corporate financial and industrial groups because of the poor**
**investment results funds had achieved. Whilst over the past twenty years the average**
**annual return to investors has been 15%, with the top quartile earning** **21.3%,** **this conceals**
**the fact that over the last five years average returns have been only 5.8%, with the top**
**quartile of funds earning** **13.1%.** **Due to the difficulties experienced in raising finance total**
**disbursements fell in 1990 to $1.9 billion from $3.4 billion in 1989. This meant that 1500**
**firms, 100 less than in the previous year, received financial support. In addition the total**
**number receiving start-up assistance declined to 259, or 10% of total financial support,**
**with** **74%** **doing to finance expansion or management buy outs.**

**Pension funds, whether public or private accounted for 53% of total US private venture**
**capital funding** **in** **1990, endowments and foundations another 13% and individuals and**
**families** **11%.** **The latter is the fastest growing source.**

**Federal Programmes.**

**Federal programmes comprise:**

**(i) Corporations for Innovative Development** **(CIDs),** **launched in 1979 in order to**
**provide financing for technology based start-ups that were at too early a stage of**
**development to attract funding from conventional sources. CIDs are state sponsored,**
**independent, non-profit making bodies partially funded by the individual States. Federal**
**participation is limited to matching state funding.**

**(ii) Direct funding for research and development is provided through the Small Business**
**Innovation Research Programme (SBIR), established in 1982. Whilst most federal**
**programmes have suffered reductions in their** **finances** **during the 80s those for SBIR have**
**actually been increased. Any federal agency with a budget in excess of $100 million has**
**been required to establish such a programme, setting aside a percentage of its funding**
**specifically for small businesses. The goal has been to increase SBIR grants to 1.25% of**
**the external budgets of the agencies concerned.**

**57**

**(iii) Community Development Corporations were established in 1968, with the objective**
**of mobilising private funds in depressed areas with the assistance of grants in order to**
**encourage the formation of new businesses. This has been a failure with only two CDCs**
**actually formed, illustrating the difficulty of attracting local finance in areas without an**
**entrepreneurial tradition.**

**(iv) The most significant federal financial initiative is the Small Business Investment**
**Company Programme** **(SBIC),** **established in 1958 following twenty years of study into the**
**problems of the financing of small businesses which had revealed that no institutional**
**structure existed to make equity finance available to them. The basic concept was to**
**provide a new financing vehicle for small companies experiencing difficulty in raising**
**equity or loan capital from conventional sources. This was to be achieved by the giving of**
**low interest loans to supplement the private capital raised by the** **SBICs.**

**In its early years the programme was characterised by over eagerness, with** **under**
**capitalised funds being supported, many of which subsequently failed. As a result the**
**supporting legislation was modified and SBICs now have to have a minimum capital of $1**
**million in order** **to** **be approved. After its initial problems the programme has achieved a**
**number of important objectives: it introduced the private sector to the concept of financing**
**small businesses; the overall level of demand and the potential for investment was**
**demonstrated; it provided an entry vehicle into venture capital investment for many banks;**
**and the SBICs served as a training ground for future venture capitalists. On the debit side**
**it is rumoured to be suffering from over cumbersome administrative procedures.**

**By the second half of the 80s overall cuts in federal programmes had their effect, sharply**
**reducing the number of new SBICs because of uncertainty regarding the future availability**
**of low interest government finance. This has also lead to some reduction in numbers but**
**about 350 still exist, deploying no less than $13 billion in private capital.**

**(v) The Loan Guarantee Scheme offered by the Small Business Administration should not**
**be overlooked as it was not only the first, but is rather more generous than some if its**
**imitators, covering** **90%** **of the amount of approved loans.**

**Suggestions have been made, notably in the US Senate on 16th June, 1992, that a further**
**scheme called the Small Business Capital Access Programme should be introduced. This**
**would operate on a portfolio rather than loan by loan basis, with the guarantees being on**
**the total portfolio held by a financial institution. This would be similar to a programme**
**established by the State of Michigan which has led to 950 loans being made since** **1986,** **to**
**a total value of $48.5 million dollars, and with the lending exceeding the state governments**
**obligations by a ratio of** **20:1.** **In the case of the new proposal schemes would also be**
**operated by the individual states, with they and the federal authorities each guaranteeing**
**3.5%** **of the loan portfolio**

**State Programmes.**

**Most of the larger State backed funds have a bias towards assisting firms in the high**
**technology sector. They may be contrasted with the Maine Capital** **Corporation,** **which**
**although established in 1980 has only $2 million of available funds obtained from private**
**investors and a matching federal grant. This provides equity capital for all SMEs, with the**
**exception of start-ups, with the prime objective of creating employment. This undoubtedly**
**reflects the problems faced by a large and sparsely populated state with a number of**
**declining industries such as ship building and fishing and much seasonal employment in the**
**tourist industry, demonstrating the importance of matching funding objectives with local**
**conditions.**

**58**

**Recent Proposals:**

**In his State of the Union Address on 17th February 1993 President Clinton made certain**
**new proposals in relation to improving the** **financial** **circumstances of** **SMEs:**

**a) a permanent investment tax credit on equipment of 7% in 1993 and 1994 and 5%**
**thereafter.**

**b) capital gains tax relief for investors in small businesses, allowing an exclusion of** **50%**
**of the gains earned on stock investments in companies capitalized at less than $25 million**
**when held for at least five years.**

**c)** **an increase in the level of funds available under the** **SB** **A loan guarantee programme.**
**At the same time it is proposed that the level of guarantee be reduced to 75% from 90% in**
**order to encourage greater scrutiny, by lenders, of loan proposals.**

**59**

**ANNEXC**

**THE FINANCING OF SMEs IN JAPAN.**

**The government has established three** **financial** **institutions to furnish SMEs with funds for**
**their business operations and to promote specific policy objectives. This** **financing** **is meant**
**to complement that available from private banks**

**(i) Special loans system: The Small Business Finance Corporation and the People's**
**Finance Corporation provide special low interest rates (2.5% in 1989, but as high as 6%**
**for much of 1991) to be used for specific purposes, such as improving industrial**
**structures, preventing** **pollution,** **saving energy etc.**

**(ii) Loans aimed at improving the management of small scale enterprises: The People's**
**Finance Corporation provides financing for improving the management skills in small**
**enterprises. This commenced in 1983 to assist the Management Improvement**
**Dissemination Programme conducted by the Societies of Commerce and Industry and the**
**Chamber of Commerce and Industry. Small enterprises can borrow money under this**
**scheme without having to provide collateral, or have a guarantor.**

**(iii) The System of Credit Guarantees and Credit Insurance: This is officially known as the**
**Public Credit Supplementation System and assists SMEs to borrow money from private**
**banks by acting as official guarantor and providing insurance. Requests for a guarantee are**
**initially submitted to a Credit Guarantee Association, which are located in 52 cities**
**throughout Japan. Should the requirements of the Association be met, funding will be**
**guarantied, enabling the applicant to borrow from a private bank. In turn, the Association**
**will insure the amount guarantied with the Small Business Credit Insurance Corporation.**

**Should there be a default on the loan the local Association will repay the bank the**
**outstanding balance. It will in turn receive between 70 and 80% of the loss from the Small**
**Business Credit Insurance Corporation. Should the Association, which has now become**
**the debtor, recover any part of the loan it will have to repay between 70 and 80% of the**
**amount recovered to the** **SBCIC.**

**(iv) Financial Assistance System for Small Business Reinforcement: Many SMEs need to**
**restructure because of changes in the market place, the development of new technologies,**
**or even in the case of a retailer, the opening of a Superstore in the locality. This scheme**
**was established in 1980 in order to assist in just that type of situation. This is a tripartite**
**venture between national and local government and private** **financial** **institutions, the latter**
**having official funds channelled to them through the Credit Guarantee Associations. The**
**private institutions then add their own funds, with the total being specifically available to**
**provide** **fundinjg** **for the restructuring of small firms. In this way a high level of gearing is**
**apparently achieved.**

**60**

**ANNEX D**

**RESULTS OF A STUDY BY THE EUROPEAN ENTERPRISE CENTRE** **AT** **THE**
**CRANFEELD** **SCHOOL OF MANAGEMENT INTO THE ATTITUDE OF**
**SMALLER FIRMS TOWARDS FINANCING AND FINANCIAL INSTITUTIONS**
**IN EUROPE**

**The report represents the views of 739 companies from Britain (156), France (168),**
**Germany** **(151),** **Italy (129) and Spain (135), out of 6000 approached. Although this means**
**that the sample may not be statistically balanced the number of companies surveyed**
**probably means that the indications given are significant, although not conclusive. The**
**results may be summarised as follows.**

**OWNERSHIP AND CONTROL**

**In most of the companies the manager or their family owned a substantial proportion of**
**the equity. This was most popular in Italy and least popular in Britain. Only** **12%** **had some**
**voting equity owned by venture capital companies. Most were in Britain (43%) and France**
**(40%).** **A further** **21%** **reported that some of their equity capital was owned by other types**
**of** **financial** **institution, with Britain at 39% and France with 27% again being the countries**
**where this was most common.**

**FINANCING STRUCTURES**

**These were fundamentally different in each country. Taking gearing (total debt divided by**
**shareholder's** **funds) as the yardstick this was generally lowest in Britain and France, with**
**British** **firms** **having the highest proportion of** **short** **term debt, particularly overdrafts, only**
**25%** **ever used long term loans. German companies had the highest proportion of long**
**term debt and preferred short term loans to overdrafts, with only 47% ever using the**
**latter. Britain had the highest proportion of compames with no debt** **(31%)** **and Spain the**
**lowest (10%).**

**One notable feature was that the smaller the company, whichever the country in which it**
**was located, the greater its reliance on overdraft finance.**

**61**

LEASING AND HIRE PURCHASE

Leasing and hire purchase were popular in all countries other than Italy where it only
represented 6% of total debt. In France, where it was most used it accounted for 19% of
total debt.

**RAISING** FUNDS

In all countries smaller companies felt that long term loans were less easy to obtain than
did larger companies. This is consistent with their use of overdraft finance. Most
companies believed equity finance, from any source, was in short supply and difficult to
obtain. Generally, most companies in **all the** countries (67-78%) thought it difficult to
obtain from institutions.

Most popular was the use of internal funds, followed short term loans. Equity finance from
financial institutions was consistently the last choice, a preference particularly marked in
smaller firms.

**COSTS AND COLLATERAL**

Variations existed from country to country in the views expressed about the costs of
different forms of finance, but there was no evidence that smaller firms faced higher costs.
There were however significant differences in the incidence of the provision of security
against loans from country to country. Most British (74%), German (82%) and Italian
(56%) companies provided collateral against their loans. Fewer companies did so in France
(41%) and Spain (47%) .

**INFORMATION** **AND ADVICE**

"Knowledge of business by all providers of finance was seen as "average to poor" in most
countries. Helpfulness of advice was also only rated as "average". Opinions about
institutional providers of equity were little different from those about providers of
overdraft and loan finance.

ISSN 0254-1475

#### **COM (93) 528 final**

# **DOCUMENTS**

## **EN**
### **10 [ 08 ]** Catalogue number : CB-CO-93-561-EN-C ISBN 92-77-60179-5

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