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For SMEs, forget bank loans to fund growth. Now equity investment is the only show in town, but the full ecosystem is yet to emerge

September 24, 2017

In or about 2005, at meetings of the Alliance of Business Lawyers of which my firm was the Irish representative, I would describe the capital stack in SMEs here to my European colleagues. Invariably they were confused by the preponderance of bank debt in the capital structures of what were micro businesses by their standards. The banks’ exposure to this risk didn’t make sense to them, and because it was all that I knew, I was bemused by what I took to be misunderstandings of vagaries between the different economies represented at the conferences we were attending.

 

When we fast forward post-crash to analysing the elements that caused the banking crises, and look at what are going to be the likely practical outcomes for SMEs, we can say with a degree of certainty (in general terms), that lending was made to companies on the following basis (and in this order);

  1. the security they or their promoters could offer,

  2. the ability to make repayments based on their current trade.

When the economy cooled, lenders were left with two extremely unfortunate outcomes; company turnover reduced thereby impacting on borrowers’ ability to meet repayments, and asset values reduced thereby undermining their security and putting in jeopardy the recovery of the funds lent. Because this funding procedure was so widespread, the impact of the slowdown was amplified and we had the banking crises that does not require further description here.

 

Simply speaking, company balance sheets were not sufficiently robust to withstand the adverse trading conditions, and hence the slew of insolvencies and job losses.

 

Fast forward to 2017, and all the numbers suggest the economy is charging along. However, as Fine Gael found to their cost in last year’s election, there was little in their recovery that gave succour to the electorate. This is because the SME sector which provides 70% of the employment in the state only accounts for 50% of its gross economic value, and the weakness in this sector was reflected by the political implications of their attitudes to this significant sector in this economy.

 

So, how has the State reacted to the requirement for funding? There are many aids for SMEs, which range from grants and investment from County Enterprise Boards and Enterprise Ireland, to funding for specific regions and objectives from the likes of Údarás na Gaeltachta. In addition, significant funding is available from the Ireland Strategic Investment Fund (ISIF) and the Strategic Banking Corporation of Ireland (SBCI) via investors and funding managers (in the case of the ISIF), and the established banks and asymmetric funders (in the case of the SBCI).

 

While these sources of equity funding are most welcome, there is an argument they are unsuitable for many family centred micro business who are inevitably the most unattractive undertakings to finance. Among the reasons for this is the nature of the business is probably sufficient to generate an income, and in many cases a significant income, for one family, but little extra. Also because there is no obvious time for a liquidity event that will deliver an exit for the equity investor the timeline of the investment is unclear..

 

Historically these companies would have benefitted from the peculiar Irish funding environment where their performance would have made them a lending target for their bank. In this brave new world though, while there is no doubt these company promoters will do everything they can to keep the business going, when it gets beyond them there is very limited access for lenders to recourse for the funds lent, and with the exception of two forms of funding this is no longer available as a typical lending product. The two types of funding widely available are invoice discounting and leasing. Where these are not suitable for the company seeking funding, the alternatives are few and far between and this is the weakness in the current system.

 

As will always be the case, the market will resolve these matters, and there will be a confluence of the requirements of companies liking for money, and investors seeking a return on their funds. The elements involved here will be that;

  1. the company promoter will cede some control of their company to the investor, and in the event of their non-performance potentially the entire company, and

  2. the company promoter will properly pay for the investors risk in terms of an annual coupon on funds lent or otherwise invested, and

  3. standard investment terms will emerge in terms of company valuation on investment and exit, voting arrangements to reflect control of the company, promoter remuneration provisions etc.

  4. pro forma documentation to reflect the arrangements in standard investment terms in the form of shareholder agreements, loan documentation, share purchase agreements etc. will evolve so as to reduce the transaction costs to remove this as an obstacle to investment.

As the economy improves, rather than stakeholders wringing their hands wishing money was available to pay for the additional working capital requirements of businesses, it makes sense to look at the position on the ground and work towards putting solutions in place so as to ensure the environment for SME growth improves to include these vital elements. The sooner this happens the better for all concerned.

 

A little like the requirements for housing, if the situation surrounding access to funding for SME’s does not change shortly if the SME sector remains tenuous, it is likely the electorate will take out their frustrations, and therefore sooner than later there may be political implications to the need for this to be addressed.

 

If you have any queries on this please contact Barry Lyons on 01 539 0060 or by email at blyons@lyonssolicitors.ie .

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