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SME Financing in Canada, 2003 — Executive Summary

Background

SME Financing in Canada, 2003 is a report on the state of financing for small and medium-sized enterprises in Canada. As part of a five-year joint process involving Industry Canada, Finance Canada and Statistics Canada, this is the second of an ongoing series that will report on SME financing in Canada.

The information gathered in this report originates from a number of groundbreaking Statistics Canada surveys, including the Survey on Financing of Small and Medium-sized Enterprises, 2000 and 2001, and the Survey of Suppliers of Business Financing, 2000 and 2001. The data sets from these surveys focus on the supply of and demand for financing in Canada. These summary tables are available on-line at http://www.sme-fdi.gc.ca/surveys. The report also includes results and data from other sources, including the Canadian Federation of Independent Business, the Conference Board of Canada and Macdonald & Associates Limited.

While the data presented in this analysis will attract and inform a broad audience, this report was initially conceived as a resource for the House of Commons Standing Committee on Industry, Science and Technology. The research was initially intended to provide parliamentarians with accurate and relevant information on the state of SME financing in Canada, and assist them in forging timely and effective public policy.

Highlights of the Report

SME Financing in Canada is presented in four parts:

• Part I examines SMEs' behaviour during 2001 against the backdrop of changes in the economy, focussing on two key forms of financing — commercial debt and leasing
• Part II examines the use of financial instruments within a firm's capital mix (financial structure) and the distribution of their equity shares (ownership structure). This part also examines whether business characteristics (gender/age of business owner or high-growth orientation) influences SMEs' financial structure
• Part III reviews financing issues from a suppliers' perspective and examines the major providers of business financing — domestic banks, other banks, credit unions and caisses populaires, and other market participants such as finance companies. This part focusses on financing to all businesses in Canada and does not distinguish SMEs from other enterprises
• Part IV examines four risk capital instruments used by SMEs (seed financing, start-up financing, initial public offering and quasi-equity financing) at various stages of development, and discusses their economic importance

The following sections highlight key findings of the report.

Part I: Financing Conditions for SMEs in 2001

The Canadian economy slowed in 2001, according to several key macroeconomic indicators — the growth rate of the gross domestic product (GDP), interest rates and consumer spending. It appears that these economic conditions influenced the requests (demand for) and approvals (supply of) commercial debt and leasing.

Commercial Debt

Figure 1 provides an overview of commercial debt financing in 2001. While only 18 percent of SMEs requested commercial debt in 2001, 80 percent of requests were approved. These figures are down from 2000, when 23 percent of SMEs requested some form of commercial debt and 82 percent were approved. While it may appear that the economic slowdown in 2001 lowered demand for commercial debt by SMEs, the effects of similar conditions over a number of observations would be needed to conclude which, if any, economic factors most influenced borrowers' behaviour.

Figure 1
Percentage of SMEs Requesting Debt Financing in 2001

[Description of Figure 1]
Source: Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2001

Leasing

Figure 2 provides an overview of lease financing in 2001. Although only 7 percent of SMEs requested lease financing in 2001, 93 percent were approved. These figures are down from 2000 when 9 percent of SMEs requested leasing and 98 percent were approved. While it may appear that the economic slowdown in 2001 lowered SMEs' demand for leasing, more data collection and analysis will be needed to determine if this is a meaningful trend.

Figure 2
Percentage of SMEs Requesting Lease Financing in 2001

[Description of Figure 2]
Source: Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2001

Part II: Financial Structure of Canadian SMEs

SMEs financed their operations with a wide range of financial instruments in 2000, which can be broadly categorized as formal or informal. Formal types of financing are instruments obtained from external suppliers/sources which are in the business of providing financing. Informal types of financing are obtained from suppliers/sources that are not in the business of financial lending or are funds acquired from the businesses' activities (e.g. retained earnings) or derived from the owners (e.g. personal savings).

In 2000, SMEs preferred commercial financing products (49 percent) over all other forms of financing. However, SMEs also made substantial use of informal personal financing instruments when access to financing was not particularly difficult. As seen in Figure 3, 35 percent of SMEs financed their operations with personal savings, followed closely by the businesses' retained earnings (31 percent). These findings could indicate that SMEs use personal sources of financing to provide a "bridge" until more permanent financing is available, or they may be related to some financial institutions' bundling of commercial and personal banking.

Figure 3
Percentage of SMEs Using Financial Instruments in 2000, by Type*

[Description of Figure 3]
Source: Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2000

* Includes any source used, regardless of whether it was authorized or obtained in a previous year.

A number of factors influence SMEs' financial structure and use of formal and informal types of financing. The most significant factors are sector, size of business (by number of employees), and stage of business. Other business characteristics, such as gender of business owner, appear to be important (but less so than sector), while age of business owner and growth patterns of the firm appear to have less influence. Some key findings in 2000 included the following:

Stage of business development

• 66 percent of start-up SMEs used personal savings of the owner(s), compared with 35 percent of all SMEs
• 29 percent of start-up SMEs used commercial loans and lines of credit, compared with 49 percent of all SMEs

Sector of operation

• Resource-based and goods-producing sectors used more formal types of financing
• Service sectors used more informal types of financing (e.g. 37 percent of knowledge-based firms used retained earnings — the highest rate of all sectors)

Size of business

• 36 percent of self-employed SMEs used personal savings. Smaller businesses used informal financing instruments, such as the business owner's savings or personal credit facilities
• Medium-sized firms used formal commercial instruments and the business' resource (e.g. 86 percent used commercial loans and lines of credit, compared with 49 percent of all SMEs)

Part III: Financial Services Sector — Providers of Business Financing

This section adopts the perspective of authorization size rather than size of business (by number of employees). As a rough proxy, authorizations of less than $1 million represent lending to SMEs. Over the past decade, technical innovation, globalization and increased competition from foreign suppliers have spurred rapid structural changes in the financial services sector. As a result, the financial services sector has become increasingly dominated by large financial groups that provide a variety of services, such as deposit taking, insurance, trusts and securities. These players operate alongside "monoline" or "niche" companies that focus on one or a few business lines, such as credit cards or Internet/telephone-based retail banking. This market structure influences SMEs' access to financing, especially for businesses in specific regions and sectors.

Figure 4 illustrates financial suppliers' market share of all commercial debt authorized and shows smaller authorization amounts (under $1 million) as of December 31, 2001. The figure shows that domestic banks continue to be an important supplier of commercial debt for all authorization sizes. Other large institutions focus more on the larger authorizations (over $1 million); smaller authorizations typically represent a small percentage of their overall commercial debt portfolio.

Figure 4
Authorizations of Commercial Debt by Financial Service Providers as of December 31, 2001

[Description of Figure 4]
Source: Statistics Canada, Survey of Suppliers of Business Financing, 2001

Credit unions and caisses populaires focus more on smaller authorizations (under $1 million) (see Figure 4), which account for close to one fifth of the market. This is an important feature of the SME financing market, since SMEs typically seek financing in smaller authorization amounts.^{Footnote 1}

Understanding the sources of SMEs' commercial debt provides a window to issues of accessibility, particularly related to SMEs operating in certain regions and sectors. Many financial service providers are regionally-based (see Figure 45). For example, credit unions typically serve the western provinces and caisses populaires tend to serve enterprises in Quebec; domestic banks are distributed across Canada, but are most prominent in Ontario and the Atlantic provinces. Therefore, the potential of more consolidation (mergers and acquisitions) among financial service providers may have implications for SMEs' access to financing.

Part IV: Profile of Risk Capital Financing

Risk capital is only one of many financing instruments available to Canadian SMEs. However, this instrument is not a panacea for economic development or for all SME financing challenges. Risk capital is often a more appropriate financing instrument for high-growth-potential and start-up SMEs, particularly for those in knowledge-based industries (KBI). Risk capital investors' stringent criteria mean that fewer than 2 percent of firms will access this form of financing. However, these firms tend to be dynamic and innovative and represent the most interesting investment opportunities.

As businesses grow, they typically require several stages of financing, involving a combination of financial products. Risk capital follows the same pattern; what is appropriate at one stage of development may not be appropriate at another stage.

Figure 5 shows risk capital financing through the various stages of a firm's development. During the seed and start-up stages, technology-driven high-growth SMEs are often almost entirely dependent on risk capital from the owner's personal resources and informal investors (family, friends, private individuals or business angels) to finance their initial operations, such as research and product development. In the seed stage, equity financing is initially obtained from entrepreneurs or from family and friends. Subsequently, financing may be supplemented by seed capital investment from informal private investors and, in a few cases, (e.g. high-growth-potential firms), by seed financing funds and venture capitalists. For high-growth-potential start-ups, informal investment and/or early-stage venture capital investment are the main sources of external financing. In the expansion stage, SMEs generally require increasing amounts of equity to maintain R&D and product commercialization and to expand marketing and sales activities.

Figure 5
Types and Amounts of Risk Capital Financing by Stage of Development — Technology-Driven Businesses

[Description of Figure 5]
Source: Western Technology Seed Investment Fund

As companies continue to expand, they often require growing amounts of equity investment — amounts that are normally only available through initial public offerings (IPOs) on stock exchanges. Not only do IPOs supply growth capital, they provide exit avenues for venture capitalists and other early-stage investors. Timely exits allow investors to recuperate their original investments, realize their gains and reinvest in new, innovative, early-stage firms.

Venture Capital Activity in Canada in 2001 and 2002

Despite the tightening investment climate since 2001, the Canadian VC industry showed signs of vigour and enjoyed a stronger-than-expected year in 2002, investing $2.5 billion in 677 firms (see Figure 6). While this figure represented a sharp drop from the $3.8 billion invested in 2001 and the $5.8 billion invested in the peak year 2000, it was in line with the level of investment in 1999, $2.7 billion.

Figure 6
Canadian VC Activity, 1998–2002

[Description of Figure 6]
Source: McDonald & Associates Limited, 2002.

Initial Public Offerings (IPO)

Canadian firms have low post-IPO survival rate

Very small issues by small or very small companies (under $1 million in net assets) with short track records have an extremely small chance of succeeding. Of the 153 companies with gross proceeds under $1 million that launched an IPO between 1991 and 1995:

• 53 percent were unsuccessful, either because they were written off, had negative net assets or ended up with net assets worth less than their transaction values
• 28 percent survived over five years and had a positive book return with net assets worth more than the proceeds of the IPO
• 6 percent survived over five years with net assets exceeding $10 million, and these could be considered real successes.

1. Loans of less than $1 million is a proxy definition that the Canadian Bankers Association uses for loans to SMEs.

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