By Simon Heath, partner at Heligan Corporate Finance
In the UK, SMEs account for 60% of all private sector employment and generate over 50% of UK GDP, contributing around £2.8 trillion annual revenue. SMEs are the vast majority of companies, representing 99% of the total number of businesses in the UK. They are important, critical even, to the prosperity of the UK.
Despite the challenges that have been foisted upon them with increases in the National Living Wage, rising tax and compliance burdens, escalating employment legislation and endless regulatory red tape in the post-Brexit world combined with an inflationary economy and rising interest rates, SMEs are nimble and flexible, finding a way to survive.
Merely surviving isn’t aspirational, so how do SMEs drive growth?
Most shareholders and management teams want to develop and grow their businesses, with aspirations to create a market-leading brand in their respective markets. Growth requires a strong product or service, an addressable market with significant opportunity and a clear strategy that can be implemented. This takes investment.
Balance sheet growth alone is often limited by access to capital, particularly for CAPEX intensive companies, so funding is becoming increasingly important to support future growth ambitions. As businesses expand, there is a requirement for additional working capital, capital expenditure and to support a greater cost base through additional recruitment and professionalising a business, all requiring cold hard cash.
Traditionally, a phone call to the relationship manager at the bank would provide the access to finance but times have changed and the high-street banks are not as approachable for SME lending. The risk profile of traditional lenders has changed and they are more focused on working with larger clients, outside of secured facilities such as asset backed lending.
There are two principal routes to funding depending upon the maturity of the business, either through the sale of equity in the business or provision of a debt facility. Beyond the traditional debt markets there has also been an expansion in alternative funding solutions focused on supporting growth.
Equity markets
Venture Capital (“VC”) and Private Equity (“PE”) investors offer access to capital in exchange for buying an equity stake in the business. VC investors target early-stage companies that can’t access debt markets, whilst PE investors focus on more mature, revenue and profit generating companies. In return for the investment the funder would require equity, which is a shareholder’s most precious asset, but often the funders bring an alternative mindset that can accelerate growth plans and professionalise a business. Shareholders can then assess the trade-off of a partial equity sale today versus a larger future company, and whether that equation generates a greater combined return.
Generally in the SME market, PE investors consider there to be a greater intrinsic risk given the lack of scale, diversification and corporate governance. Consequently, investors often seek a majority equity position to retain ultimate decision making, particularly where there may be underperformance. VC investors are predominantly minority investors with fewer control rights and protections, albeit 20% equity participation is an important threshold for a meaningful shareholding and Companies Act protections.
Debt markets
The larger, traditional funders have generally chased bigger clients and outside of providing debt banking facilities, consider the SME market to be significantly higher risk, particularly for cash flow lending. Asset backed lending is deemed lower risk given any lending is secured against company assets or supported by personal guarantees. The ABL market continues to be active but there are limitations on what can be lent and generally considered working capital facilities rather than funding for growth capital.
There are however, challenger banks, that have developed an SME lending strategy, such as Allica Bank or Metro Bank. They have taken the opportunity to replace the ‘Big 4’ with debt solutions that can meet SME shareholder needs for growth. These challenger banks are innovative and less risk adverse, recognising the importance of early engagement and support of SMEs can deliver long-term and more profitable relationships.
Alternative funding solutions
There is a plethora of alternative funding solutions to traditional high street banking. These solutions can range from pure debt to quasi-equity, short or long term, amortising or bullet structures. The advent of debt funds which have a longer-term horizon given they are often funded by pension funds, allows more flexible terms and tenure. The debt funds can also create structures that include warrants or ‘equity kickers’ to share in the upside but reduce the cost of debt, freeing up important cash flow for investment.
In addition to debt, there are government backed initiatives, whether grant-funding or more direct investment that can support SMEs on their pathway to growth. Probably the most high profile is the British Business Bank which was established to fill any void left by the nervous PE investors. They support through the company lifecycle, from start-up through to mature businesses and tailor their support to meet shareholder objectives. In total, the BBB has deployed £39 billion of debt and capital into the SME market.
UK Research & Innovation (“UKRI”) and Innovate UK are two government organisations that are focused on research and development grants for commercialising innovative products and services, but there is a wider ecosystem of regional and national grant schemes designed to actively encourage growth across the SME market. All SMEs should regularly track the grant landscape as it is dynamic with new available packages regularly being deployed.
If there is so much capital available, why is it so difficult to access?
Whilst there is an ocean of capital available, the biggest challenge is that debt and equity funders have become increasingly risk adverse, particularly equity funders which given they are supposed to be risk capital investors is inherently contradictory. Access to debt and equity enjoyed a post-Covid bounce, but subsequently there has been a flight to quality following the growing awareness of UK economic vulnerabilities.
Beyond these macro-economic factors, artificial intelligence has also thrown a spanner in the works, potentially disrupting the traditional approach to business across an array of sectors. For example, Software-as-a-Service (“SaaS”) companies have seen their business model disrupted or even replaced, and what was seen as a rock-solid recurring revenue market has the potential to be replaced by agentic AI at minimal cost. Technology innovation, such as AI, can therefore impact investor and lender sentiment.
It is therefore increasingly important for SMEs to improve the investability of their businesses through strengthening management teams and splitting responsibilities, enhancing corporate governance and management reporting alongside diversifying its customer base, product and service offerings, all in order to professionalise the company and mitigate traditional risk criteria.
Taking best practices in respective industries and being proactive in identifying risks and implementing a mitigation strategy, even if only delivered in part, will improve confidence across the debt and equity funders and make the likelihood of accessing this valuable capital greater.
In addition to improving the quality of the business, debt and equity funders will want to understand the return on investment in microscopic detail. How will the new capital be deployed, how will this investment generate additional sales or improved margins and ultimately how does the investor or funder can repaid.
These strategic points feed directly into the company’s business plan and forecast model and is used as the basis of any investment or lending. Often companies undervalue the importance of the business plan and model which is where advisors come in to help secure the growth financing.
Conclusion
A healthy SME sector is not only desirable but essential for a fully functioning economy and ultimately, society.
There needs to be a multi-pronged framework of support to encourage the risk-taking entrepreneurs to drive additional growth and that includes available access to capital to recruit the next employ or purchase new equipment.
There is also an onus on SMEs to better prepare for capital and de-risking their proposition. It is only when there is an open debt and equity market combined with well-run businesses, that the capital liquidity will start to flow.
Government also needs to be central to this framework. Creating an environment that rewards entrepreneurship and aspirations for growth, reducing administrative and regulatory burdens, implementing grant and loan schemes to accelerate SME growth plans, combined with a macro-economic policy that stimulates growth.
Ultimately, companies blossom in growing economies with limited governmental friction where entrepreneurship is applauded, and success is celebrated. By limiting access to capital, whether intentionally or indirectly, it will cause harm and threaten the SME market, the beating heart of our economy.
*Simon Heath is a Partner at Heligan Group LLP, a UK financial services group with clients across the SME market, offering a range of corporate finance, risk intelligence, investment and wealth management services. Prior to Heligan, Simon worked at KPMG UK LLP for 18 years in their corporate finance division.
