Encouraging innovation: A changing framework for the financing of small-to-medium enterprises

Impact Area: Innovation for SMEs
Institution: School of Business, Management and Economics, University of Sussex
Leading Academic: Professor Paul Nightingale

Introduction

Small-to-medium enterprises (SMEs), defined as enterprises with less than 250 employees, make up 99% of all firms in European economies. SMEs are often considered major drivers of innovation and competition, and high rates of market entry by new entrepreneurial enterprises are often associated in policy-makers’ minds with positive economic outcomes. However, SMEs find it more difficult to raise money for growth than large companies, which has made them an area of policy concern in the UK.

The standard economic model informing public policy assumes that entrepreneurs are constrained by a variety of market failures from entering the market, which reduces the number of start-ups and economic growth. This is considered to be a particular problem for innovative, research intensive SMEs, as they lack collateral for debt financing and are harder for funders to evaluate. To foster more innovation, a range of government policies has been introduced to support these firms. Research led by Paul Nightingale, Professor of Strategy at SPRU(Science Policy Research Unit), has involved working with policy-makers to evaluate the most effective schemes to provide finance and other support for SMEs.

Starting within the ESRC-funded Complex Product Systems (CoPS) Innovation Centre (1997-2007) and continuing through EPSRC- and ESRC funded projects within SPRU, the team explored the technologies used in financial institutions to evaluate risks and inform investment, highlighting the technical sophistication of financial services. Innovation in risk management and credit scoring have allowed lenders to know about the firms and improve provision of financing for firms with good credit ratings. In traditional economic models, it is assumed that entrepreneurs know more about the firm than the lender, thereby creating the potential for moral hazard. SPRU’s research questioned this assumption and highlighted the technical sophistication of the models that banks use, which are more realistic than entrepreneurs.

The research has highlighted the extent of unproductive economic churn in the economy, where large numbers of new firms enter and quickly exit the market each year. It suggests that the real policy problem is not increasing market entry for SMEs but supporting economic growth for the small percentage of high-potential firms.

Evaluations of a range of EU/UK policy interventions showed that firms funded with government support do not necessarily outperform unfunded controls unless certain conditions are in place. Many early schemes supporting venture capital (VC), for example, failed to consider the high fixed costs involved in providing equity, the capabilities investors need to manage the firms they invest in or the institutional structures needed for an effective funding escalator to emerge. As a result, the EU has struggled to generate a VC sector on the scale needed for effective investment that delivers sustainable commercial returns. SPRU’s 8-S framework highlighted that a successful VC industry is: small as a percentage of all equity investment, skewed in its performance, skilled, specialised in the sectors it supports, scale intensive, systemic in its links with the rest of the economy and economically significant. It also highlighted that many current policies are very effective, driven by aligning policies with economic incentives. Importantly, this research highlights the large indirect benefits of government support, through things like increases in taxation, compared with the direct returns from investment. Finally, the team highlighted that firms need to align their strategies with their funding environments.

Benefits and impact

Instrumental impact

The team’s impact involved repeated engagement with policy debates to focus on strategies to increase UK tax return by £1 billion through encouraging enterprise and removing £1 billion’s worth of ineffective policy.

The team has had influence in three key areas:

• Post-economic crisis banking reform;

• SME equity provision;

• Developing the conceptual framework used by policymakers to support innovative SMEs

Their submission to the Vickers inquiry was cited in the final report that fed into subsequent banking reforms, new funding mechanisms and policies being developed to support the securitisation of SME loan portfolios. Research fed into the development of a publicly supported business bank that focuses on areas underserved by traditional banks, with £300 million of funding recently announced. These changes have the potential to significantly benefit innovative SMEs.SPRU’s work in hybrid equity schemes (co-funded by government) has highlighted the need for larger-scale funds and contracts that align the distribution of risk and reward with economic incentives. This research has also informed EU policy through the European Research Area Board whose outputs draw on the 8-S model. As a result, there is now increased recognition that viable hybrid funds need to be larger and much more professional, which requires co-funding mechanisms to be aligned with the commercial imperatives of private-sector investors.

The research has achieved the following:

• Move policy thinking away from a market failure so that it is more realistic about the often limited economic impact of SMEs and entrepreneurship

• Informing policy thinking about how best to commercialise university research

• Helped the civil service move away from thinking that the only constraints that SMEs face are financial ones.

References:

Independent Commission on Banking (Vickers Report), Final Report, Recommendations September 2011 ISBN 978-1-845-32-829-0. Page 76, footnote 85, citation to our work on SME financing and the organisational structure of banking.
The “Potential of Venture Capital in the European Union” study for the European Parliament (DG Internal Policies: Policy Department A: Economic and Scientific Policy; Industry, Research and Energy) IP/A/ITRE/ST/2011-11, PE 475.088, February 2012