"The Funding Gap"

Due Date: Wednesday November 1st, 2000

The question

"The funding gap" is always quoted as a major issue for dstart up and developingh small businesses. What evidence is there to support this view and what measures have relevant organisations taken to overcome the problem?

Executive Summary

This report critically examine concerned with how young small businesses and start up business fund themselves externally. Firstly we look at the funding ga,p what it is and evidence of its existence. Secondly, how organisations that fund new and small
usinesses have done to help this problem and finally a reivew of their usefulness. This is done in a report style

Abbreviation list

BOE; Bank of England

SME; Meaning small - medium enterprise. For the sake of this report it is taken here to mean both business that are new or business that are still in the developing stage.

DTI: Department of Trade and Industry

Part 1

SME’s are an important contributro to the economy, defined by the Bank of England as 49 employees or fewer1. In 1997 SME’s accounted for over 40% of the economy’s turnover and 45% of total employment in the United Kingdom 2 The chart below reveals a b
akdown of industry where sme are located including area as well. Source; bvca.co.uk

Starting your own busines rasises many difficulties and raising the capital is just one of them, listed below are the main problems encountered. Throughout history, seeking external funds has remained one of the most difficult. Indeed this is not a ne
problem The Macmillian Committee first regcognised the funding issue dubbing it the macmillian Gap in 1931. Today the funding gap can be defined by P Burns & J Dewhurst3 as:

"where the funding requirements of a company are greater than those that can be met by the small scale providers of finance, but not substantail enough to be considered by the large equity providers".

Source; Small Business Finance Report BOE Oct 2000

Evidence of the Funding Gap

The funding gap is prevelant with start ups and new firms. Indeed it is often known that is harder to raise £50,000 for a new firm with no history or collertaal than it is to raise £5,000,000 for a established firm.

Information asymmetrics is often blamed for creating the funidng gap. This is when the entreprenurer generally holds better information regarding the firms performace than the bank for making decisions.

Information asymetrics can lead to two developments. Firstly, adverse selection, The banks cannot distinguish which new firm has the highest returns relative to the degree of risk, they have trouble adopting the price mechanism to help distingusih be
een firms . Secondly, moral harzard, where (in the absence of collertal) use of higher interest rates by banks to offset risk would give firms receiving loans an incentive to alter their behaviour to adopt risker projects.

These two reason reveal why it is harder to obtain smaller rather than larger funds. Banks requuire collertal in responce to these problems. However this often excludes new firms who lack funds despite viable plans. Therefore many fall into the fundi
gap. The central hypothesis is that the market is not cleared through the price adjustments because of the asymetry of information between banks and SME’s. So banks have an incentive to respond to an increased demand for loans by rationing credit fur
er rather than by raising intereset rates.

Also with new start ups having a 50% failure rate4 with the first three years funders can be generally reluctant to fiance such a propsotion.

The funding gap questioned.

The BOE report5 however states that there has been a decline in recent years of the funding gap. 1999 saw a trend away from debt reliance as new source of funding appeared. Below is a chart from6 showing the change of funding sources.

Source: Bank of England see footnote 6.

Empirically their is little evidence for the existence of such market imperfections. However this is only based on partial facts because it is difficult to obtain information on failed start ups . Therefore with information from only surviving firms
is not easy to determine the full picture.

What evidence their is suggests that the most finance constrained businesses are relatively small young located in the manufacturing sector and of below average profitability. This does sound risky and hence it is unclear whether the terms attached to s
h lending are unreaosinable in relation to the extra risk.

On the other