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Informally Financed SMEs

Small Business Financing Profiles - September 2006

Dr. Allan Riding, University of Ottawa
Brad Bélanger, Industry Canada

Table of Contents

Highlights in 2004
... of informally financed SMEs

Incidence of informal investment was higher among firms in the manufacturing, wholesale/retail and knowledgebased sectors.
Firms in which business angels invested were more likely to have owners under 40 (25 percent) than firms financed by family or friends (22 percent) or other firms (13 percent).
On average, firms that received angel financing reported higher revenues (40 percent) and total assets (25 percent) than other firms.

... of the financing of informally financed firms

26 percent of angel-financed firms sought external capital compared with 19 percent of firms without informal financing.
Angel-financed firms were more likely to have their applications for debt approved (85 percent) than firms financed by friends and family (70 percent).
Firms financed by friends and family were more likely to draw on all available sources of financing at the business start-up stage, whereas firms financed by business angels were less likely to cast as broad a net.
Angel-backed firms tended to be more substantial and better capitalized than those financed by friends and family.

This profile looks at small and medium-sized enterprises (SMEs) that received financing for risk capital through the informal marketplace in Canada. The informal marketplace is composed of two types of investors: family or friends, and business angels (individuals who invest their personal funds at arm's length in businesses owned and operated by individuals unrelated to them). This article examines the differences between these two types of investors and the impact of their investments on SMEs.

This work is based on research drawn from the comprehensive database of the SME Financing Data Initiative. The project is among the first efforts to study the demand side of the informal investment market in Canada.

Findings for this profile were taken from financial statement information from more than 800 respondents of the Survey on Financing of Small and Medium Enterprises, 2004 in the following categories:

equity financing from friends and family;
equity financing from business angels;
current loans from friends and family;
current loans from angels;
loans from friends and family received during start-up; and
loans received from angels during start-up.

Incidence and Importance of Risk Capital in Canada

Risk capital comes from both the formal market, which is essentially venture capital companies managing third-party capital, private equity and initial public offerings (IPOs) on public markets, and the informal market, which comprises business angel investments and investments from friends and family.

Risk capital is increasingly recognized as an important source of financing, particularly for SMEs with high growth potential that are seeking substantial amounts of capital for expansion in return for a share of the business. However, risk capital is a financing strategy suitable to only a small proportion of SMEs. In 2004, just 1.2 percent of all SME owners sought risk capital.

Among the various sources of risk capital, informal investments are the single largest source of external equity capital for Canadian SMEs. Among all SMEs reporting on financing activity that took place in 2004, 23 percent of requests for equity financing were made to friends and family, and 22 percent to private angel investors. Only 7 percent of requests for equity financing were made to the formal side of the risk capital market, venture capital firms.

Definitions

For the purposes of this analysis, small and medium-sized enterprises (SMEs) are defined as firms with fewer than 500 employees and less than $50 million in annual revenues. Excluded are non-profit or government organizations, schools, hospitals, subsidiaries, co-operatives, and finance and leasing companies (SME Financing Data Initiative).

Informal investors are individuals who invest personal funds in businesses owned by someone else. There are two types:

"Love money" is personal funds invested by friends and family.
Business angels are typically well-educated, high networth individuals who invest their personal funds at arm's length in businesses owned and operated by individuals unrelated to them. The angels are frequently entrepreneurs or former entrepreneurs. They have much to offer to new firms, both in financing and in knowledge and experience in operating a business.

Caveat on the data
The majority of informally financed firms in the sample examined in this profile received informal investments before they were questioned for the Survey on Financing of Small and Medium Enterprises, 2004. Their responses may relate to financing that was received before 2004.

Supply of Informal Investments and Venture Capital in Canada

In 2001, the aggregate flow of investment funding from business angels in Canada was at least $3.5 billion, averaging approximately $117 000, invested in about 30 000 businesses. Friends and family members who invested in small firms collectively comprised a substantially larger pool of investment capital, with an aggregate flow of investment capital of more than $5 billion during 2001 (Riding, 2005). Together these accounted for nearly twice the venture capital invested by venture capitalists.

Incidence of Informal Investment

In 2004, business angels played a financing role in more than 200 000 SMEs, or about 15 percent of the 1.36 million SMEs in Canada. By comparison, friends and family have been involved financially in more than 328 000 Canadian enterprises, almost 25 percent.

By Industry Sector...

Figure 1 shows the incidence of financing by informal investors across each sector of industry in 2004. The results indicate that business angels are involved in firms across all sectors but are most likely to be associated with enterprises in the manufacturing, wholesale/retail and knowledge-based sectors, and least likely to participate in the tourism and professional services sectors. Investments from friends and family cross all sectors; however, their investments are more prevalent in the manufacturing and wholesale/retail sectors. Professional services and the agricultural and primary sectors are least likely to attract investment by friends and family.

Figure 1
Percentage of Informally Financed SMEs by Sector

Figure 1: Percentage of Informally Financed SMEs by Sector

Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004.

By Region...

Figure 2 shows the relative frequency of investments by friends and family and by business angels across each region. The findings illustrate that investments by business angels and by friends and family are found in all regions; however, business angels are especially active in Quebec. This finding may warrant further investigation.

Figure 2
Percentage of Informally Financed SMEs by Region

Figure 2: Percentage of Informally Financed SMEs by Region

Note: Information regarding the Territories has been suppressed to meet the confidentiality requirements of the Statistics Act and/or for data quality reasons.
Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004.

Attributes of Informally Financed SMEs

SMEs that have received investments from business angels differ in several ways from other firms (see Figure 3). First, angels are more likely than average to invest in SMEs owned by younger people. Twenty-five percent of angel-financed firms have owners who are under 40 years of age; this compares with 22 percent of firms financed by friends and family, and only 13 percent of other firms.

Figure 3
Business Demographics by Informal Investment History

Figure 3: Business Demographics by Informal Investment History

Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004.

Business angels are also more likely to invest in businesses that are majority-owned by women. In Canada, during 2004, 17 percent of angel-financed firms were majority-owned by women. This compares with 14 percent of the firms in the other two categories — majority male and male/female partnerships. Other research has found that female business owners are less likely than male business owners to apply for venture capital (Orser, Riding and Manley, in preparation). The research has also found they are concentrated in service sectors, which this analysis shows is less attractive to risk capital investors.

Finally, firms owned by individuals whose first language is French were more likely to receive investments from business angels. This is in keeping with the previously noted finding that a relatively high proportion of angel-financed firms are in Quebec (see Figure 2).

Other business demographic characteristics of SMEs financed by angels and by friends and family differ very little from each other and from other firms (see Figure 3). The propensity of angel-financed firms to engage in exporting, at 11 percent, is similar to that of firms financed by friends and family (13 percent) and to other firms (10 percent). SMEs in these three categories are equally likely to invest in R&D (approximately 28 percent of firms).

Financial Performance

Both angel-financed SMEs and those financed by friends and family are larger than other SMEs. On average, firms that received angel financing reported revenues that are 40 percent greater and total assets that are 25 percent greater than other firms. Firms financed by friends and family report both revenues and total assets averaging 23 percent more than other firms. This suggests that informal investment has indeed spurred growth for these SMEs. Table 1 outlines average values of various measures of financial performance for each of the three categories of SMEs.

Table 1
Financial Statement Figures for 2004
	Angel-Financed SMEs	SMEs Financed by Friends and Family	Other SMEs
* Figures give the average values of various measures of financial performance for SMEs. They may not add up exactly due to rounding and the absence of some income statement or balance sheet data. Source: SME Financing Data Initiative, Statistics Canada, Survey on Financing of Small and Medium Enterprises, 2004.
Sales	$754 498	$666 545	$532 150
Total Revenue	$811 151	$718 399	$581 807
Current Assets	$244 743	$218 371	$193 253
Total Assets	$619 925	$609 094	$493 866
Current Liabilities	$187 806	$157 662	$108 509
Total Liabilities	$375 919	$326 781	$259 454
Retained Earnings	$116 861	$137 661	$135 750
Owner's Equity	$136 225	$150 069	$102 921
Total Equity*	$244 006	$282 313	$234 412

Table 1 also shows that angel-financed SMEs report higher levels of financial leverage (use of debt). For firms financed by angels, the ratio of total debt to total equity is higher (1.54) than firms financed by friends and family (1.16) or other firms (1.11). Perhaps this is because of the accreditation role that business angels can play. The presence of an external partner may provide comfort to lenders and allow angel-financed enterprises to carry a higher level of debt financing than other SMEs.