Did you know that 99% of companies in Europe are SMEs? And that they employ two out of three employees, and create 85% of all new jobs?
Did you also know one of the key obstacles to growth for SMEs is the difficulty in raising funding?
Although the EU has been coming up with action plans to help SMEs overcome these obstacles, there is still a big gap between the needs of small businesses, and the financing that is currently available from financial institutions.
In this post we’ll look at why SMEs struggle with the current funding process and what a possible solution looks like.
Why is it a problem?
Ever since the 2008 crisis, raising money has been increasingly difficult for SMEs. Every year, the regulators tighten the rules, and banks become more risk averse. Sadly, this seems to be a trend that won’t be reversed any time soon.
And yet, 90% of the businesses worldwide are small businesses, representing 50% of employment. According to the World Bank, 600 million extra jobs need to be created by 2030. These will primarily be created by SMEs — but that will be hard if said businesses are unable to grow.
SMEs are vulnerable to funding shortages due to lack of resources and lack of access to outside capital. According to EIF’s latest working paper, 1 in 4 SMEs reports difficulties in accessing finance.
Why is financing such an obstacle for SMEs right now? Here are a few reasons.
Conditions are strict
It’s getting harder and harder to get financing from traditional financial institutions — especially since the Coronavirus pandemic. SMEs put in applications and are often rejected, because financial institutions look at traditional metrics rather than SME-appropriate metrics.
Most businesses that do get approved need to have a business with underlying assets and an understandable business model, or need to take certain guarantees in private. That means businesses that are running riskier projects or intangible products have a much harder time raising funding.
Loans are expensive
Bank loans that do get approved are often very expensive because the banks consider the risks to be high. Banks are not adapting to the business models of this decade, and businesses are the ones paying the price.
According to a survey by Banking Circle, 35% of SMEs are not happy with the interest rate they’re offered, and 28% were put off by the heavy arrangement fees. High interest rates turn financing into a burden rather than an enabler, and results in SMEs spending too many resources paying off debt rather than focusing on growing the company.
Funds take a long time to be released
According to the same Banking Circle survey, only 3% of those seeking funds obtained their finance within a week. Just over half get it in two weeks, and for some it takes five to six months. As we know, weeks matter a lot in the life of an SME, and can be the difference between surviving or not.
Bank funding usually takes too long, forcing companies to look elsewhere or urgently cut expenses such as headcount in order to survive.
Information is lacking
Many entrepreneurs are not well informed about financing tools and rely too much on local banks. This means that after receiving several rejections, they often give up and stop looking elsewhere, accepting the fact that they won’t grow.
For those who do their research, it still takes a long time to find out where they need to go. Too many SME owners lack the financial expertise and spend more time than they should on funding.
Financing does not meet SME needs
When an SME application loan does get approved, the loans are not personalised to their specific needs. SMEs are more likely to have cash flow issues, and for example, might prefer monthly payments rather than larger payments twice per year. By nature of their business, they require more flexibility when it comes to paying.
Banks offer rigid repayment terms leaving SMEs without much room to grow on their terms.
If they don’t get a bank loan approved, founders often have to consider other funding options — neither of which are too attractive either.
Bootstrapping restricts growth and results take a long time. Raising money through equity investors can be a good option, but it means giving up control of the company. Crowdfunding and peer to peer lending is another good option, but interest rates often remain high for SMEs.
A solution: alternative, non-dilutive funding
One solution for subscription-based SMEs looking for funding is a type of funding called revenue-based financing, or also called non-dilutive funding. With this method, SMEs can turn their monthly subscriptions into assets and use them as collateral to raise money. With this funding type, they can essentially turn their MRR into ARR, and receive financing based on more appropriate SME metrics such as churn rate and customer acquisition costs.
The two main benefits with this funding method is that SMEs can raise money without having to offer annual discounting to boost revenue (which is what investors use to value a company), and they also don’t need to resort to offering equity and diluting the company shares. It’s a win-win funding method that helps SMEs grow, without sacrificing revenue or ownership of the company.
The funding gap for SMEs is only getting wider as banking restrictions get tighter and risk appetite decreases. If 99% of the European population couldn’t get a mortgage, our governments and financial institutions would be moving quickly to fix the problem. And yet, this is not happening with SMEs, the most important business segment that employs the vast majority of the population. If financial institutions and governments can’t fix the problem, then it is up to alternative solution providers to help SMEs grow.