Small and Medium-sized Enterprise Financing in Canada — Part II: Financial Structure of Canadian SMEs

2. Stage of Business Development

Key Findings about SME Start-Ups: 2 out of 5 new firms do not survive beyond their second year of operation The majority of start-up financing originates from the owner's personal savings, lines of credit or credit cards Only 29 percent of start-up SMEs are financed through commercial loans or lines of credit from financial institutions, compared with 49 percent of established SMEs Similar variations in financial structure for start-ups and established businesses are found by region, sector and business size

The Challenge of Access to Financing for Start-ups

Business creation and development typically involve several stages of financing and a variety of debt and equity instruments. These instruments vary depending on the type and growth prospects of the business and on prevailing market conditions.³⁵ Often, however, high failure rates among new entrants (see insert) represent a degree of risk that falls outside the risk appetites of many financial institutions. For example, Thompson Lightstone (1997) found that rejection rates by financial institutions for business start-ups exceeded 40 percent, compared with 13 percent for SMEs overall.³⁶ An earlier study by Riding and Haines (1994) found that new firms represented fewer than 5 percent of financial institution clients. As a result, start-ups use informal sources of external financing, and tend to rely more on the personal credit and savings of the business owners.

The "Revolving Door"; of Entrants into the SME Marketplace The reality of the marketplace is that the majority of new entrants do not survive beyond start-up, leading many to refer to the marketplace as a "revolving door."; In fact, a recent Statistics Canada report found that failure rates among new entrants were extremely high; 40 percent exited the market by their second year. The study found that the survival time for new businesses was approximately six years on average. While it is clear that new entrants face many challenges during their formative years, the likelihood of survival does increase as firms mature. Source: Baldwin, John, Lin Bian, Richard Dupuy (2000), Failure Rates for New Canadian Firms: New Perspectives on Entry and Exit. Statistics Canada.

Formal versus Informal Types of Financing Used during Start-Up
Figure 21 shows the financial instruments used by start-up SMEs.³⁷ There was a stark contrast between financing trends for start-up firms and the trends for overall SME financing in Canada (see Figure 18).

Figure 21
Types of Financial Instruments Used by Start-Up SMEs

Formal Types of Financing used During Start-up

• 29 percent of start-up SMEs used commercial loans and lines of credit (compared with 49 percent for all SMEs)
• 12 percent used leasing (compared with 16 percent for all SMEs)
• 8 percent used commercial credit cards (compared with 26 percent for all SMEs)
• 5 percent used government loans or grants (compared with 7 percent for all SMEs)

Informal Types of Financing used During Start-up

• 66 percent of start-up SMEs used the personal savings of the owner(s) (compared with 35 percent for all SMEs)
• 23 percent used the personal lines of credit of the owner(s) (compared with 21 percent for all SMEs)
• 19 percent used the personal loans of the owner(s) (compared with 14 percent for all SMEs)
• 12 percent used loans from friends or family of the owner(s) (compared with 10 percent for all SMEs)

The overall pattern of SME financing discussed earlier in Section 1 centred on commercial lending, trade credit and retained earnings. For start-up firms however, the financial capacity of the owner, rather than that of the business, is a more significant determinant of the firm's financial structure.

Regional and Sectoral Picture of Start-ups

Start-up businesses had a similar regional and sectoral variation to that discussed for all SMEs in Part II, Section 1 and Section 3. If a particular region or sector has lower usage rates of a particular instrument among SMEs overall (see Table 11), comparable start-up firms tend to follow similar financing patterns (see Table 10). The difference for start-up firms is one of scope. Start-up SMEs tend to use formal sources of financing far less than established businesses. One example from Table 10 shows the following start-up rates of usage of commercial loans and lines of credit, regionally and by sector.

Regional usage of commercial loans and lines of credit by start-ups:

• 37 percent of Atlantic Canada's start-ups used commercial loans or lines of credit (compared with 54 percent for all SMEs in Atlantic Canada)
• 26 percent usage by start-ups in Ontario (compared with 44 percent for all Ontario SMEs)
• 45 percent usage by start-ups in Manitoba/Saskatchewan/Nunavut (compared with 61 percent for all SMEs in that region)

Sectoral usage of commercial loans and lines of credit by start-ups:

• 62 percent of agricultural start-ups used commercial loans or lines of credit (compared with 72 percent for all agricultural SMEs)
• 40 percent usage by start-ups in manufacturing (compared with 51percent for all manufacturing SMEs)
• 8 percent usage by start-ups in KBI sectors (compared with 21 percent for all KBI SMEs)

Impact of Size of Business on Type of Financing Used by Start-Ups³⁸

Business size influences the financial structure of start-ups. The following two examples from tables 10 and 11 compare established SMEs' with start-up firms' use of commercial loans, lines of credit, and the personal savings of the business owner(s).

Use of commercial loans and lines of credit among start-ups by size of business:

• 21 percent of start-ups without employees used commercial loans and lines of credit (compared with 34 percent of established firms in that size category)
• 32 percent usage by start-ups with 1–4 employees (compared with 50 percent)
• 42 percent usage by start-ups with 5–19 employees (compared with 66 percent)
• 45 percent usage by start-ups with 20–99 employees (compared with 69 percent)
• 71 percent usage by start-ups with 100–499 employees (compared with 86 percent)

Use of the personal savings of the owner(s) among start-ups by size of business:

• 64 percent of start-ups without employees used the personal savings of the owner(s) (compared with 36 percent of established firms in that size category)
• 69 percent usage by start-ups with 1–4 employees (compared with 32 percent)
• 66 percent usage by start-ups with 5–19 employees (compared with 33 percent)
• 66 percent usage by start-ups with 20–99 employees (compared with 17 percent)
• 37 percent usage by start-ups with 100–499 employees (compared with 11 percent)

Size of firm is a major determinant of SMEs' use of formal types of financing — use of commercial loans or lines of credit is positively correlated to the size of business. This pattern is reversed in the case of informal financing; reliance on the owner's personal savings is more common among smaller firms. As will be discussed in Section 4, smaller firms' greater reliance on informal types of financing occurs independent of the business' age. Both start-ups and established smaller businesses make more use of informal financing than larger firms do. However, it is not possible to conclude from a single observation whether this presents an accurate picture, or whether these findings are influenced by sectoral or economic factors. These differences may suggest a substantial gap in the financing market for early-stage formal financing, but more data is needed on the relative impact of the various factors (e.g. risk of business failure, lack of an established credit history, absence of sufficient assets to pledge as security for financing or other sectoral or economic factors).

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35. For a more detailed discussion of the spectrum of risk capital financing options employed by Canadian SMEs throughout their growth cycles, see Part IV.

36. Thompson Lightstone & Company Ltd. (1997), Small and Medium-sized Businesses in Canada: An Ongoing Perspective of their Needs, Expectations and Satisfaction with Financial Institutions. A report prepared for the Canadian Bankers Association.

37. For the purposes of comparison, start-up SMEs are defined as businesses started from scratch by the owner(s) prior to the first sale of products or services, at any time between 1996 and 2000. Established SMEs are those firms started prior to 1998, and data on these businesses are only available by size of firm. All SMEs include both start-ups and established firms.

38. Size of business, as defined by number of employees, reflects the size of firm in 2000, rather than at the time of business start-up.