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III. The Finance of SMEs modernisation and innovation
3. Figures showing SMEs finance
1.1. Approach to the problem
It would not be saying anything new to state that the innovation of SMEs is an essential factor for their survival and competitiveness. Nevertheless, there are certain conditions that ensure innovation and competitiveness are linked. Generally, two factors are required for that link: a firm’s project to invest in order to attain productive and commercial capabilities; and innovation capabilities for getting the specific differential which gives it the necessary competitive edge to remain in the market.
Investment and competitiveness are not simple processes. There is a complex connection between the investment process that guides the firm's modernisation through the renovation of equipment, systems and distribution channels, and innovation projects in a strict sense, that develop and/or introduce new products, processes or services.
On the one hand, the modernisation investment process establishes the basic circumstances to compete and provides the conditions that make the innovation process possible. These circumstances can be summed up as financial resources and the productive and marketing environment for learning, developing and introducing innovation policies. On the other hand, innovation projects endow firms with a specific differentiation in products, processes or services that lead to competitive advantage.
Until recently, firms could survive just by modernising and, in some markets, the obstacles that existed allowed backward firms to stay in the market. Today, this is not possible in the long term, and firms require investment funding to modernise as well as innovation capability to compete.
Nevertheless, the financial circumstances necessary for both processes are not always present. In big corporations, modernisation funds are provided by the financial system, while innovation is often self-funded. Moreover, their growth, when there is a qualitative jump, is funded by the stock market. However, in the case of small and medium enterprises, the working of the market poses problems for the funding of modernisation and this makes the innovation process dependent on these difficulties and a downward spiralling effect is caused.
Financial tools to broach both processes are distinct but they reinforce each other in a positive or negative way. Without the modernisation process, innovation would not be possible, or the conditions that made innovation profitable would not be present. Without innovation, competitiveness is quickly eroded and the modernisation process itself is complicated.
1.2. Research Aims
Most firms consider that the financial dimension is a key factor in the development of the innovation process. Though this is well known, there has been little detailed analysis of the factors which could originally give rise to this problem. There is a set of converging factors which increase the perceived risk of investment in SMEs.
The aim of this project is to identify and deepen our understanding of the conditions that block or enhance the processes of innovation and modernisation. In this way we will highlight two kinds of problems: generic problems, related to investment process funding; and specific problems, related to innovation funding.
1.3. Methodology and scope
This project takes as a departure point the definition of the SME according to the EC’s Recommendations of 3 April 1996. This states that the maximum size of a firm that can be considered an SME is: up to 250 workers, with a turnover of less than 40 million Euros and a balance of under 27 million Euros. A larger company may not own more than 25% of an SME.
The methodology used in this report was the personal semi-constructed interview with executives of the Spanish financial system. The purpose of the interviews was, on the one hand, to find out the particular point of view of the interviewee about the investment funding problems of Spanish SMEs in general and, on the other hand, to deepen our understanding of aspects for which they are directly in charge as executives of a finance company. This approach allowed us to obtain diverse opinions of the executives about their own role, and their opinions about the role of other agents involved. For this purpose, we sought to interview a broad set of representative agents that can be summed up as follows:
We carried out 33 interviews with executives in over 26 companies. A full account of the persons interviewed and company names are included in the appendix. Although the research tackles the issue of funding from the point of view of both the firms and of the financial companies, in this part of the paper the approach focuses on the point of view of the financial companies.
In this section we will analyse the investment problem of funding of innovative projects.
It would be helpful to distinguish between R&D and the innovation process. In the former, we are dealing with a stage with significant technological risks and with exploratory aims. In the latter, we are dealing with the introduction of new products and services into the market (or systems and processes for the corporation). The innovation process is closely tied up with the market and, though it has an important technological component, it is oriented to solving relatively structured problems, with little exploration, or open experimentation. In this sense, R&D is a kind of investment that must be funded with self-generated resources due to the risk level and payback period, because it implies a commitment to the business activity. On the contrary, innovation can be funded by debt up to a point. Again, we have to distinguish between debt and capital. As we have seen, both of them are necessary to solve the investment problem and SME growth, but they play different roles.
2.1. CDTI and Innovation Funding by Credit
In the case of debt, CDTI (Industrial Technological Development Centre) plays a main role. However, it does not clearly separate R&D and Innovation projects, and it covers a very broad range of activities.
The CDTI acts with two basic credit lines, one of which is called "direct funding" and uses resources from the CDTI, the European Commission and EUREKA. The CDTI channels these resources which reached 35.000 million pesetas in 1999. This credit line deals with R&D and innovation projects and introduces innovation into the world market. In recent years, the CDTI has faced problems of innovation finance from the view of individual firms, that is, they are not innovations for international markets, but they may be for national markets or markets of distinct sectors.
For these sorts of projects there is a credit line in collaboration with the ICO, the so-called ICO-CDTI credit line. This credit line introduces funds to the financial system at a lower cost than the market and for a longer term (from five to seven years). The main target is to inject a culture of innovation into enterprises and the banking sector. An example of the kind of project financed would be, instead of buying a conventional clamp, to adopt one controlled numerically, that is more versatile, and could lead to labour for efficient management and to reorganisation of the plant's layout. This would introduce technology and result in a more flexible productive process. The ICO-CDTI credit line has financed projects of about 25,000 million pesetas channelled through bank agreements. It is expected this will have doubled by the end of 2000.
The CDTI’s role in the innovation funding process has several aspects:
Thus the CDTI, in collaboration with the banking sector and the regional financial institutions, can act as a catalyst agent that changes the innovation culture.
2.2. The Problem of Capital Requirements for Innovation Projects
As we have already seen, risk capital avoids innovation projects except those in the highly technology and/or internet sector. The CDTI uses its own resources as well as EC resources but this is usually done through preferential credit. However, due to the level of risk and the maturity terms, this kind of project must be financed with self-generated resources for which preferential credit is inadequate.
The main problem with this type of finance is not the lack of resources of the firm that invests in R&D as much as the reduction of the initial risk in the first stages of the project. Curiously, these require fewer resources. Once the initial phases have been overcome the firms provide resources over the percentage that the CDTI demands. In this sense, grants are needed at the right moment, that is, when the risk is assumed, and not one year later as sometimes occurs. Here grants take the place of capital because the firm does not reimburse these funds.
However, in the initial stages of the firm, the corresponding seed capital stage R&D project and firm project have an important overlap and the resources for an R&D grants could be insufficient. In the cases of internet projects there are ‘business angels’ who are individuals that finance the initial stages of the development of an idea. Then, the project transforms itself into a firm in the market that needs a lot of capital investment in order to grow, when venture capital institutions enter. In some cases of the internet sector, venture capital institutions enter from the beginning. The problem is that this source of capital does not exist for the rest of the SMEs that are not in the internet sector for the reasons mentioned previously.
The alternatives are difficult since public entities of risk capital have avoided these stages and their activity in the past was negative given the difficulties of separating political interests from the entity’s behaviour. In the last few years the figure of privately managed public funds has arisen. The public entity provides the financial resources and defines the fund objectives, in this case small firms with innovative projects, and the private venture capital firm manages the fund. Maybe private management is not always as independent as it would like to be, but there is always an appraisal mechanism that allows revision of the concession by the administration and management reorganisation. Improving the system of monitoring of management of the concessionaire entities must continue in this case.
3. Figures showing SME finance
We are interested in the relative importance of the diverse concepts that we have analysed and, second, their significance with respect to the overall figures about the Spanish financial system (described in the first part).
In terms of the first question, here we analyse the main figures of the different aspects of SME funding. We do not attempt to provide a rigorous analysis from the point of view of the data, since the sources are not homogenous and in some cases we lack data for every year. However we aim to get an overall picture, which allows us to build a certain map of the situation with distinct sources, financial instruments and geographical distribution.
In this case, bearing in mind all the nuances (see section about liquidity) a positive impact on the market risk perception through spread of risk is expected and consequently on the amount of funds for SME financing.
The lack of development in the case of venture capital is very significant because of the circumstances already noted. Even the CDTI mobilises a higher volume of funds with investment capital reaching just 40% of the volume of investment mobilised by the CDTI. Despite the difficulties listed previously, the evolution over the last few years points to a positive tendency for venture capital, although the take off should be delayed until the secondary market develops.
Investment capital is concentrated in Madrid, Cataluña and País Vasco. This may signal trends about the possibilities of investment capital over the next years, if the opportunities in current regions reach a level of saturation. Participation in the rest of the regions in comparison to their GNP share is very low, and this should grow unless new unforeseen obstacles appear.
If we consider the innovation expenditure distribution (note we are not referring to R&D), and that the machinery and equipment acquisition represents 70% and 35% of total innovation depending on firm size (less than 20 employees, more than 20 employees) - we can also evaluate the turn of the investment capital distribution observing the difference between the two distributions.
That is, investment capital distribution must be similar or nearer the innovation distribution.
In terms of the relative importance, within the Spanish financial system (data included in Part I), of the cost now shown, relating all of this with specific methods of financing SME processes, the conclusion can only be that it is of marginal importance. This can be interpreted two ways. On the one hand, that there is an important margin for growth in the development of mechanisms designed to help the financing of SME modernisation and innovation. On the other hand, that the tools mentioned act as a catalyst rather than a direct financer of SME requirements. Their main role is to mobilise other resources, transform attitudes, influence behaviour, rather than to directly channel resources to SMEs.
First, from the point of view of context, it is important to note that the phenomenon of globalisation, rapid technological change and the growing sub-contracting of activities by large enterprises give SMEs a key role. This leads them to need capital linked to high growth rates and technological renovation. This is a new problem that requires new solutions.
Neither should it be forgotten that the two different types of long term funding, self-generated resources and debt, have qualitative differences with reference to risk, the terms and relative volume. The integration of these three variables creates a level of compromise with the business and a type of relationship with a qualitatively distinct nature. These are questions that require different treatment. However, analysts, institutions and firms often incorrectly treat them as substitutive resources and this has negative consequences for all the agents involved.
In regard to the processes of investment finance with outside capital it is worthwhile noting four characteristics:
1. Credit Access
The first problem when dealing with SME debt in the medium to long term and the investment programme is that many companies find it difficult to get credit access because it is nearly impossible for them to meet the bank’s demanded guarantees. The difficulty is closely linked to firm size, age and credit terms. These factors are very inter-related.
The level of guarantees demanded by the banks affect objective and subjective factors that determine the risk level of a project. Firm size is related to both factors. MGC act in both ways. They operate at the subjective level through specialising in SMEs problems within the local environment. This allows them to increase their knowledge about the enterprise and its environment, and through the direct assessment to SMEs with the financial project design. On the other hand, they operate directly in the size factor through the diversification of risk on reciprocal guarantees system.
MGC activity is highly concentrated into two areas, the Comunidad Valenciana MGC and the Elcargi situated in the País Vasco. The importance of the MGC in both cases is closely linked to the support of the local authorities. This indicates that a more aggressive support (not direct intervention) policy in other regions is very important. This shows that there is currently a territorial concentration of this activity due to the underdevelopment of the mutual guarantee system in Spain. There is a lot of growth potential for this activity over the next few years.
2. The Credit Terms
The second problem encountered is the terms. Again, we have to distinguish between objective and subjective factors. In terms of subjective factors, those that affect risk perception can be significant such as the success of the growth of ICO financial credit lines for SMEs started in 1993 with the so-called "bank intermediation credit lines".
In fact, bank funding and enterprise habits have changed over the years with regard to the terms. Financial companies have been obliged to accept higher rates of risk because they are forced to compete in an increasingly competitive SME market due to the ICO financial credit lines. However, once they have entered the market, experience and learning have changed the risk perception over the last few years.
3. Liquidity and Volume of Available Resources
The third problem in SME funding is the volume of resources available. One of the general problems in SME funding is the difficulty of channelling funds towards enterprises because of the risks related to the size of the firm. This reason alone limits the supply of funds.
Securitization aims to reduce credit risk and unlock financial companies’ own resources in order to increase the supply of funds for the SMEs.
From the point of view of individual enterprises, the situation remains the same because access to credit is the same and has the same conditions.
The profits of the securitization scheme are obtained at the financial system level, allowing financial companies to channel more funds to SMEs and under better conditions than the credit market.
Securitization in Spain started to develop in 1998 at the same time as the legal framework. The estimations are between 1,5 billion pesetas and 2 billion pesetas in 1999 of registered transactions with the CNMV.
Big banks have started to decentralise and to give flexibility to the management of credit concession to SMEs to a greater extent than Savings banks and smaller banks. This has been based on:
In this way they free up managers’ capacities for value added tasks and allow them to have great autonomy without losing control, through policies and systems. The conclusion is that under these conditions better knowledge of the firm is available for the bank .The direct impact is a diminution of the risk perceived.
Nevertheless, the result of the interviews carried out shows that there is a general tendency towards decentralisation and specialisation for the sake of flexibility and risk diminution. The differences are found in the methods adopted and evolutionary stages of each company. It is considered extremely important to improve the quality of the relationship with the SMEs and to exploit better information technologies.
In regard to processes of investment with self-generated capital three characteristics stand out:
5. Undeveloped Venture Capital markets
Venture capital is not able to take off in Spain due to the following reasons:
6. Venture Capital avoids SMEs and shelters in Larger Consolidated Corporations – with the exception of the Internet Phenomenon.
Factors like size, age and innovation character of the investment increase the perception of risk by the investor and it is only compensated by:
The situation means that venture capital avoids projects in the primary stage as seed capital and start-up capital of small firms. In this context technological (high tech) projects and in particular the internet, are an exception to the explanation above because they fulfil the requirements of high profitability and rapid growth potential. This is because of the global nature of these projects.
Even if the problems of a secondary market are overcome in the future, there is still a kind of SME which will keep having problems in terms of capital access due to the fact that they will never become big enterprises. These SMEs, due to their limited growth potential, do not promise high profitability or attractive maturity terms for venture capital.
The profitability required of the projects will be lower and a higher number of projects will fulfil the required conditions if the second market and the related portfolio diversification is able to reduce the risk perception enabling liquidity, increasing the competence in the market and increasing prices for better risks. However, in a global sense, this is a problem that requires in addition another sort of solution.
The opportunity cost incurred during evaluations of small projects means that investors tend to think in terms of large projects as shown in the figures for past years. The development of the secondary market can relieve this problem because the market can work as an evaluator on its own, reducing the evaluation cost for the investor in this kind of project. Naturally, this factor is closely linked to the ease of exit provided by the second market.
In regard to the processes of investment finance it is important to differentiate debt and self-generated capital:
When dealing with the specific problem of innovation finance it is important to distinguish between debt and capital. In the case of debt, the CDTI plays a key role by modifying the decisive factors of the risk perception of banks and enterprises through the ICO-CDTI financial credit lines.
The risk is limited by an understanding of the innovation problem and the possibility to rely upon a technical risk evaluation company. It permits SMEs’ requirements to be treated appropriately, improving the information and understanding of the factors which are decisive for the perception of risk.
Nevertheless, the CDTI continues to have a massive problem of presence in the SME market. Most SMEs are not able to access the CDTI and this institution could not manage their requirements alone. In order to overcome this problem, the co-operation of the banking sector as a diffusion and distribution network and of the autonomous authorities through their financial institutions are needed, as well as the creation of a network of technical risk evaluation companies.
As a last resort, it is necessary to create a much stronger network which is able to involve the SME sector as a whole. This implies the decentralisation of the CDTI’s role and the involvement of other kinds of agents such as specialised consultancy.
9. The unsolved problem of capital needs in innovation projects
The conclusions about capital indicate that the problem cannot be solved unless a secondary market is developed and that it will remain unsolveable for the part of the SMEs sector which is not in transition to larger ones.
Again, the CDTI’s contribution is significant through its own funding resources and subsidies but this does not solve the capital needs problem. Specific funding of innovation is linked on the one hand to the venture capital problems and they should be resolved in this context, but they also have specific connections to the first stages of the innovation project (not to be confused with the corporation project). In these first stages, the risk is very high and the resources are small. Experience shows that, once this stage is overcome, where the product or service has been defined and the pure technical risk has been evaluated, then the risk is sharply reduced and funds flows more easily. At this point, flexible and rapid subsidies received on time in relation to the innovation cycle can be very important and more useful than current soft funding.
This means financing an idea so it develops and becomes an investment in its commercial stage. In this case, we face a capital need, though small, which will be covered by the subsidy and that is treated as a debt matter by the CDTI. We consider that, despite the positive results about CDTI activities, there should be some changes in this aspect.
10. We highlight the importance of the institutional framework and the requirement to generate multiplier effects.
In a previous section we showed the lack of SME investment and innovation finance when comparing it with the large amounts within the Spanish financial system. Taking this into account, the important thing is not the absolute quantity of resources mobilised but the effect created by the practices applied. So, at the margin of the increase of quantities assigned to each one of the tools mentioned, it is important to highlight the significance of three qualitative aspects: agent specialisation, the improvement of the process of learning, and, finally, the consolidation of the distinct agents and tools.
In the first place, it is worth stressing that, as has been argued in other parts of the report, information and knowledge, as well as their correct management, have a central role in changing the subjective risk perception. In this field, specialisation is essential, as much as for the banking institutions as for venture capitalists and administrative agents.
The need for a process of specialisation from distinct agents is essential in order to respond to the challenges of rapid technological change and globalisation.
In the second place, the process of learning by private and public agents in relation to the market and among themselves is an essential factor for the development of an adequate institutional framework. This means that the institutional framework cannot be imposed voluntarily, but is the fruit of a mature consensus between different agents. This does not imply that the process does not require stimulus that is the responsibility of the administration, orientating intervention or presenting possibilities through a regulatory framework freely accepted by private agents.
Finally, one of the factors of success for the modification of conditions of the working of financial markets is the articulation of the distinct public and private agents who intervene in the market to the point of constituting an articulated and coherent institutional framework. This synergetic effect could operate through multiple relationships:
All these examples show the way in which the institutional framework changes market operations and increases the impact of the different interventions by the function of complementarity.
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