SME Financing Data Initiative
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Financing Innovative Small and Medium-Sized Enterprises in Canada
IV. Results and Analysis
This section presents findings on the financing activities and experiences of innovative SMEs and non-innovative SMEs. Part a) focuses on accessing financing and Part b) looks at financing terms and conditions for SMEs.
a) Accessing Financing
Innovative SMEs were more likely to seek external financing
Innovative SMEs have greater financing needs than other SMEs. As shown in Figure 1, innovative SMEs were more likely than non-innovative SMEs to seek external financing with 34.5 percent of innovative SMEs seeking external financing compared with only 23.2 percent of non-innovative SMEs.
Figure 1: Percentage of SMEs that sought external financing
Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004
Innovative SMEs were more likely to request debt financing
Among all types of external financing, as shown in Figure 2, innovative SMEs, like non-innovative SMEs, financed their investments through debt more than any other financial instrument with 30.8 percent of innovative SMEs requesting debt financing compared with 18.0 percent of non-innovative SMEs.
Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004
It is worth noting that innovative SMEs were also using other financial instruments to a greater extent than non-innovative SMEs. Innovative SMEs were about four times more likely to request equity financing than non-innovative SMEs at 4.9 percent and 1.1 percent respectively. Equity financing encompasses money from friends or relatives of the business owner, employees of the business, business angels, venture capital firms, and crown corporations or government institutions. Among those innovative SMEs that sought equity financing, 25.8 percent were start-upsFootnote 1 and 65.1 percent had no full-time employees.
There might be two main reasons why more innovative SMEs sought equity financing. First, innovative SMEs tend to be younger than non-innovative SMEs as there were more start-ups among innovative SMEs than non-innovative SMEs (22.1 percent versus 15.2 percent). In the beginning, a firm is unlikely to have sufficient collateral and uncertain prospects to generate the income required to pay back the loan. Start-ups among innovative SMEs had higher request rates (84.6 percent) for debt financing than their non-innovative counterparts (77.9 percent). However, start-ups among innovative SMEs also had lower approval rates (62.5 percent) for debt financing than their non-innovative counterparts (70.6 percent). The second reason more innovative SMEs sought equity financing might be that financial institutions are unwilling to lend to innovative SMEs because they represent a higher risk than non-innovative SMEs, so innovative SMEs have to find other ways to finance their business.
Innovative SMEs were more likely to be turned down by credit suppliers
As mentioned earlier, innovative SMEs were more likely to request debt financing; however, they were less successful in obtaining loans than non-innovative SMEs. As shown in Figure 3, only 54.2 percent of innovative SMEs that requested debt financing received authorisation for credit compared with 83.0 percent of non-innovative SMEs. Innovative SMEs were about twice as likely to be turned down by credit suppliers as non-innovative SMEs (24.5 percent versus 11.8 percent). Moreover, innovative SMEs were about six times more likely to have their loan application still under review at the time the survey was conducted. These findings are consistent with the view that financial institutions consider innovative SMEs more risky than non-innovative SMEs. Higher turndown rates and applications still under review suggest that financing requests from innovative firms may be more difficult to assess and result in lower approval rates.
Figure 3: Authorised and unauthorised debt financing requestFootnote 2
Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004
There were more discouraged borrowers among innovative SMEs
As shown in Figure 4, more innovative SMEs were discouraged (5.3 percent) than non-innovative SMEs (3.9 percent). Discouraged borrowers are those firms that are worthy of receiving financing, but decide not to apply because they think they would be turned down. The higher rate of discouraged borrowers may be due to the fact that some innovative SMEs hear that similar firms have had difficulty obtaining financing, so they refrain from applying for financing.
Figure 4: Rate of discouraged borrowersFootnote 3
Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004
Innovative SMEs tended to rely mostly on chartered banks for debt financing
Close to 80 percent of innovative SMEs approached chartered banks to request new or additional credit compared with approximately 60 percent of non-innovative SMEs (see Figure 5).
Figure 5: Type of financial institution approached
Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004
As a result, fewer innovative SMEs approached credit unions or Caisses populaires (primarily found in the province of Quebec in Canada, francophone equivalent of a credit union) for new or additional credit than non-innovative SMEs (15.1 percent versus 24.0 percent). Results also show that more innovative SMEs chose the transactional approach and fewer the relational approach to obtain financing than non-innovative SMEs.Footnote 4
Innovative SMEs were less likely to be approved for debt financing by credit unions or Caisses populaires than chartered banks
As mentioned earlier, innovative SMEs were less successful in obtaining loans than non-innovative SMEs. Moreover, Figure 6 indicates that credit unions or Caisses populaires were less likely to approve debt requested by innovative SMEs than chartered banks (33.3 percent versus 56.8 percent). It is worth noting that the approval rates did not differ much between chartered banks and credit unions or Caisses populaires for non-innovative SMEs at 81.3 percent and 83.3 percent respectively.
Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004
A new line of credit was the most popular credit instrument choice among innovative SMEs
As shown in Figure 7, more than 60 percent of innovative SMEs requested a new line of credit from credit suppliers compared with 32.9 percent of non-innovative SMEs. A similar proportion of non-innovative SMEs requested a term loan (33.3 percent). Innovative SMEs, on the other hand, were about 1.5 times less likely to request term loans, 4.7 times less likely to request mortgage loans and 1.3 times less likely to request an increase in the credit limit of current lines of credits than non-innovative SMEs.
Figure 7: Type of loan requested
Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004
Close to 80 percent of innovative SMEs intended to use the financing requested for working and operating capital
Working capital is the backbone of any business. It is used for financing the day-to-day operations of the business, such as the purchase of inventory or paying suppliers. Without enough working capital, business could lose their flexibility and credibility with financial institutions, suppliers and customers. Figure 8 indicates that 78.9 percent of innovative SMEs intended to use the financing requested for working and operating capital compared with 54.6 percent of non-innovative SMEs. A similar proportion of non-innovative SMEs intended to use the financing requested for fixed assets (50.3 percent). It is worth noting that innovative SMEs were about six times more likely to use the financing requested for research and development than non-innovative SMEs (16.6 percent versus 2.8 percent).
Figure 8: Purpose of debt financing
Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004
Equity financing accounted for the highest share of the total financing authorised for innovative SMEs
Innovative SMEs received higher average amounts of lease and equity financing but lower average amounts of debt financing than non-innovative ones (Table 3).
It is worth noting that for each financing instrument, the median amount was much lower than the average amount. This indicates that a small number of firms received large amounts of financing (see the maximum amount received by innovative and non-innovative SMEs for each type of financing instrument), which brings the average up. For example, the median amount of debt financing authorised for innovative SMEs was CAD 20 000, indicating that 50 percent of innovative SMEs received less than CAD 20 000 and 50 percent of innovative SMEs received more than CAN$ 20 000, whereas the average amount of debt financing authorised for innovative SMEs was CAD 51 181. The average amount of equity financing authorized for innovative SMEs did not differ much from that authorized for non-innovative SMEs (CAN$ 466 315 versus CAN$ 447 183); however, the median amount of equity financing for innovative SMEs was only about one-third of the median for non-innovative SMEs. This finding could, a priori, be somewhat surprising given, as noted previously, that innovative SMEs use other financing instruments to a greater extent than non-innovative SMEs. However, the lower amount of equity raised can be explained by the fact that there are more start-ups among innovative SMEs, and they rely more on money from friends and relatives for their financing needs.
As illustrated in Figure 9, debt financing accounted for the highest share of the total financing authorised for non-innovative SMEs, but equity financing accounted for the highest share for innovative SMEs. Lease financing accounted for 22.8. percent of the total financing authorised for innovative SMEs compared with 8.0 percent for non-innovative SMEs. Although the average amount of equity financing received by innovative and non-innovative SMEs did not differ much (CAD 466 315 versus CAD 447 183), the amount of equity financing received by innovative SMEs represented 44.3 percent of the total financing received, whereas the amount of equity financing received by non-innovative SMEs represented only 8.7 percent of the total financing received. This indicates that innovative SMEs are more dependent on equity financing than non-innovative SMEs.
Figure 9: Share of authorised financing
Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004
Innovative SMEs were three times more likely to request equity financing from a venture capital firm
Figure 10 shows that innovative SMEs tended to approach business angels and friends/relatives to request equity financing. They were about three times more likely to approach a venture capital firm than non-innovative SMEs. Typically, innovative SMEs have few physical assets, often base their strategic plans on new technologies and have higher than average business risks. Because of these high risks, it is difficult for innovative SMEs to access debt financing. Venture capital firms, on the other hand, finance high-risk firms in which traditional financial institutions are unwilling to invest. Although venture capital involves a time horizon of many years and many failures, the potential returns on a winning venture portfolio are very high. Moreover, there are more start-ups among innovative SMEs than non-innovative SMEs and Canada's venture capital firms emphasize early-stage financing.Footnote 5 The amount of financing provided by angel investors and venture capital firms represented 90 percent of total equity financing received by innovative SMEs compared with only 42.3 percent received by non-innovative SMEs.
Figure 10: Type of financier approached for equity financingFootnote 6
Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004
b) Financing Terms and Conditions
Financing terms and conditions of innovative SMEs reflect their high-risk profile: loan terms were shorter and interest rates were higher
Table 4 shows the average interest rate and the average length of term of authorised credit that Canadian SMEs had in 2004. Innovative SMEs paid higher interest rates for short-term loans, term loans, new lines of credit and increases in the credit limit of current lines of credit. For term loans, innovative SMEs had slightly higher interest rates for shorter terms (46 months versus 62 months). A better comparison can be made by adjusting the length of loan terms to the same period, to 60 months. This adjustment shows that the interest rate paid by innovative SMEs was 0.5 percentage points higher than that paid by non-innovative SMEs (6.8 percent versus. 6.3 percent).
Fewer innovative SMEs were requested to offer collateral or to meet co-signing requirements as a condition of obtaining financing
Fewer innovative SMEs were requested by credit suppliers to provide business or personal assets as collateral to obtain financing. As shown in Figure 11, 31.1 percent of innovative SMEs were requested to provide business assets as collateral to obtain financing, compared with 42.3 percent of non-innovative SMEs. Similarly, 33.1 percent of innovative SMEs were asked to provide personal assets compared with 42.6 percent of non-innovative SMEs. These findings could reflect the fact that innovative SMEs often lack collateral that can be used to secure bank loans. Since financing assets pledged as collateral is less risky, innovative SMEs have more difficulties in obtaining financing.
Figure 11: Type of collateral requested
Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004
Over 50 percent of innovative SMEs were asked to provide business financial statements or formal applications for credit applications
A business financial statement was the most frequently requested document for a credit application. As Figure 12 shows, 55.9 percent of innovative SMEs were requested to provide a business financial statement for credit applications compared with 61.8 percent of non-innovative SMEs. Formal applications were also a common document requested by lenders: with 56.0 percent of innovative SMEs requested to provide a formal application for credit compared with 52.9 percent of non-innovative SMEs.
Figure 12: Documentation required as part of the application process
Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004
Footnote 1 A firm age of between zero and one year is defined as a start-up; a firm age of more than one year is defined as a non-start-up.
Footnote 2 The estimates are based on reasons why funds were not authorised for innovative SMEs (i.e., withdrawal of application, application still under review, request was turned down). The estimates have high coefficients of variation and margins of error; therefore they may not be very reliable.
Footnote 3 Kon, Y. and D.J. Storey, 2003. "A Theory of Discouraged Borrowers." Small Business Economics, Vol. 21, No. 1, 37-49. The authors define discouraged borrowers as good firms requiring financing that choose not to apply to credit suppliers because they feel their application will be rejected.
Footnote 4 Financial institutions have two ways in which they manage their activities related to SMEs: the transactional approach, which favours the use of technology and is preferred by large financial institutions; and the relational approach, which leaves more room for judgement on the part of the account managers and is often used in smaller lending institutions (Berger, A. and G.G. Udell, 2005. A More Complete Conceptual Framework for Financing of Small and Medium Enterprises. World Bank Policy Research Working Paper 3795).
Footnote 5 According to figures from Thompson Financial 2008, total VC investment in Canada was CAD 1.69 billion in 2004 and over 50% of total VC was placed as early-stage investment (CAD 881 million).
Footnote 6 Estimates related to type of financiers approached by innovative SMEs have higher coefficients of variation and margins of error. Therefore, the estimates may not be very reliable.
