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

7. High-Growth SMEs (GSMEs)

Characteristics of an average GSME in 2000: Share of Businesses: 12 percent of the 1.4 million SMEs Total Equity: averaged $254 500 Demand for Financing: 31 percent of GSMEs requested debt; 80 percent were approved Prominent Sectors: 17 percent of manufacturing SMEs, followed by 16 percent of KBI firms Business Size: 22 percent of medium-sized businesses (100–499 employees) Regional Presence: consistent across Canada, ranging from 11 percent of SMEs in Quebec to 13 percent in Alberta

A small subset of SMEs contribute disproportionately to Canada's economic growth — high-growth SMEs (GSMEs).⁵⁷ A common characteristic of these firms is their ability to sustain above-average growth rates over long periods. GSMEs are not only responsible for a significant proportion of new job creation, they are also major contributors to innovation.

Formal versus informal types of financing

Formal Types of Financing in 2000

• 50 percent of GSMEs used commercial loans and lines of credit (similar to the 49-percent national average)
• 32 percent used commercial credit cards (compared with the 26-percent national average)
• 20 percent used leasing (higher than the 16-percent national average)

Informal Types of Financing in 2000

• 47 percent of GSMEs used trade credit to suppliers (higher than the 39-percent national average)
• 37 percent used the personal credit cards of the owner(s) (higher than the 33-percent national average)
• 35 percent used the personal savings of the owner(s) (similar to the national average).
• 13 percent used loans from friends and relatives of the owner(s) (compared with the 10-percent national average)

Key Findings for High-Growth SMEs (GSMEs) in 2000: GSMEs' financial structures reflected the high use of formal instruments (50 percent of GSMEs used commercial debt, 20 percent used leasing) and informal instruments (46 percent used trade credit, 35 percent used personal savings) GSMEs used more risk capital than other SMEs – two times the angel investment and six times the VC investment Sectors include: 17 percent of manufacturing firms were high-growth (high use of commercial debt and trade credit) 16 percent of KBI firms were high-growth (high use of retained earnings, risk capital, and savings)

Figure 30 shows that GSMEs, compared with all SMEs, have either equal or higher rates of use of both formal and informal types of financing. However, as discussed below, use of formal and informal debt does not come at the expense of financing through ownership capital. GSMEs have an equally high use of risk capital, which is likely related to GSMEs' sector of operation and high-growth potential.

Figure 30
Types of Financial Instruments in Use by GSMEs in 2000*

Sectoral Influence on the Financial Structure of GSMEs

Knowledge-based industries accounted for 16 percent of firms in this sector, compared with 12 percent of SMEs overall. As discussed in Section 3.2.1 of this part, KBI SMEs were among the least debt-intensive of all sectors in 2000, and tended to rely on the internal resources of the business (i.e. retained earnings) or external equity financing.

Figure 31
Sectoral Distribution of GSMEs, 2000

High-growth firms do not operate exclusively in high technology sectors. As seen in Figure 31, 17 percent of GSMEs operate in the manufacturing sector. This is consistent with the findings of an Ontario Ministry of Economic Development and Trade study⁵⁸ of Ontario's high-growth firms. This study found that GSMEs' financial structure reflects the fact that a significant portion of these firms operate in manufacturing sectors. Discussed in Section 3.1.2 of this part, manufacturing SMEs were among the highest users of both formal and informal debt, and had a particular preference for flexible financial instruments such as commercial credit cards and leasing, both of which are prevalent in GSMEs' capital mix.

GSME Ownership Capital in 2000

• $120 500 in average owner's equity in GSMEs
• 57 percent was owned by the business owner/operator (below the 86 percent for all SMEs)
• 5 percent was owned by foreign and domestic venture capitalists (higher than the 0.3 percent for all SMEs)
• 4 percent was owned by foreign and domestic private investors (compared with the 1 percent for all SMEs)

Beyond formal and informal debt, GSMEs use more external equity than other SMEs. This difference is most evident in the ownership held by the business owner/operator. Whereas 86 percent Canadian businesses' equity was owned directly by the business owners, this proportion was 72 percent for GSMEs, indicating a much higher propensity to accept equity. In fact, angels and venture capitalists invested nearly $2 billion in GSMEs in 2000 — twice the amount of informal (angel) investment and six times the amount of venture capital than was invested in SMEs overall.

Other Statistics Canada studies on innovative and small firms in Canada have found that many smaller firms in knowledge-intensive environments (home to many GSMEs) rely on risk capital and retained earnings rather than debt financing. One of these studies suggests that debt-intensive capital structures constrain growth opportunities and R&D, whereas equity offers more flexibility and investment support.⁵⁹

These data begin to build a picture of GSMEs' contributions to the economy and touch on whether market imperfections (gaps) impair GSMEs' access to appropriate types and levels of financing.⁶⁰ Of particular concern, in light of the findings regarding initial public offerings of company stock discussed in Part IV, is the presence of risk capital providers with access to sufficiently large pools of investment capital to support the expansion of GSMEs over the longer term. Timely access to risk capital can be a critical factor in determining whether a firm optimizes its full market potential and develops products in a rapidly changing environment, fails, or is sold and its Canadian operation wound down. Continued monitoring is required to ensure that such gaps do not impede these firms' growth prospects, especially in light of their disproportionate contribution to the Canadian economy.

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57. GSMEs (also known as gazelles) are defined in this analysis as having cumulative annual growth rates in sales of 50 percent or more over a three-year period, from 1997 to 2000.

58. Ministry of Economic Development and Trade (1999) The Universe of Ontario's Leading Growth Firms, Government of Ontario.

59. John Baldwin, Guy Gellatly and Valérie Gaudreault (2002) Financing Innovation in New Small Firms: New Evidence from Canada, a report prepared by the Micro-Economic Analysis Division of Statistics Canada.

60. Industry Canada has also undertaken a separate major study on GSMEs, covering a 15-year period (1985–1999), that is expected to provide revealing complementary results. These results are expected to be available later in 2003.