CandidCapital

With the credit crunch making it even harder for SMEs to raise bank loans, should the government offer incentives to encourage business angels to close the gap?

The credit crunch continues to filter through the banking system, causing the the European Central Bank and the Bank of England to add nearly £300Bn of liquidity to the system earlier this week. The crunch seems to become more severe and more long-lasting as each week passes.

Speaking on Radio 4 yesterday, the American economist Irwin Stelzer chided the government for failing to grip the situation. His recommendation is to let Northern Rock fail but only provided that there's a better deposit insurance scheme in place. However, the government seems determined to let the Treasury select committee complete its deliberations on the matter before taking any resolute action to reform bank supervision. So uncertainty, and the crisis, are set to persist, no matter what's happening in the wider global economy.

Where does this leave smaller UK companies that need loan capital - either for fixed asset or working capital finance? There have already been rumours that the Small Firms Loan Guarantee scheme was to be axed, or at least severly curtailed, during 2008. Which, coming on top of twenty years of steadily-reducing clearing bank appetite for lending to small businesses, is likely to leave SMEs with no source of finance for growth other than equity.

You may say "where's the problem?", since equity finance is the soundest and most stable finance that a business can have. However, that fails to recognise that equity investors have high expectations of what the business can achieve with their money - as well as an expectation of exit which usually means a sale of the business. These expectations cannot be satisfied by many businesses which, though profitable, have growth rates too low for equity investors or whose objectives make an equity realisation hard to achieve.

Walter Herriot, managing director of St John's Innovation Centre in Cambridge, has been lobbying for the creation of a new tier of mezzanine finance for SMEs that could fill this gap. This would make lending, that is effectively unsecured, available to small businesses where equity investment isn't suitable but which have a strong business case. The lender would get an above average level of interest for taking on the additional risk of limited or no security.

So far, for a variety of reasons - of which the most significant has been the reluctance of the clearing banks to get involved, there has been no scheme like this set up in the UK on any scale. Overcoming the reluctance of the clearing banks to become involved could be circumvented by looking elsewhere for a source of funding - enter the business angels.

Business angels have become a major source of early stage finance in the UK - with over £1Bn being invested in EIS qualifying investments in 2000-01 alone (HM Treasury data). The Enterprise Investment Scheme (EIS) was originally set up as the Business Start-up Scheme, evolving (via the Business Expansion Scheme) into its present form in 1994. It allows investors to obtain 30% income tax relief and unlimited capital gains tax roll-over relief on investments of up to £400,000 in qualifying companies (essentially SMEs). All income and capital gains thereafter are free of tax. Clearly the proposed reform of CGT (see blimp's blog Worse in Most Respects) will impact on the scheme to some extent going forward.

Nonetheless, it would seem sensible for the government to consider extending the success of EIS to a lending scheme allowing business angels to take up some of the slack left by the banks' increasing reluctance to lend to SMEs. Given that the Enterprise Capital Fund scheme was set up by the government to mimic the US Small Business Investment Company program, it's interesting to note that SBICs were originally set up to make loan capital available to SMEs and the scheme was only extended to include equity in the mid '90s. Moreover, SBICs have had a patchy track record as equity investors over the past fifteen years compared to their earlier track record as lenders.

19 December 2007

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