Scottish National Investment Bank: Fairer Scotland Duty assessment

Improving Access to Finance for Socioeconomically Disadvantaged Entrepreneurs

6. Starting a business through successful entrepreneurship has the potential to be a route out of poverty for those who are socioeconomically disadvantaged. Research has demonstrated that for those who establish a profitable business, self-employment translates into increased income, more flexible working conditions, more stable employment and enhanced job satisfaction.^[2] For those who are socioeconomically disadvantaged self-employment can not only offer the opportunity to alleviate financial hardship but also reduces many of the inequalities of outcome that typically accompany poverty. The idea of becoming an entrepreneur therefore holds a particular attraction for those who are socioeconomically disadvantaged.

7. Studies, however, have shown that groups who experience disadvantage in the labour market, and are therefore more likely to experience poverty, also demonstrate substantially lower levels of self-employment than the general population.^[3] Indeed socioeconomically disadvantaged entrepreneurs experience significant challenges when seeking to start a business, challenges that not only determine success or failure but also impact on the future productivity, innovation and profitability of that firm.

8. Responses to both consultations held by the Scottish Government on the Bank as well as the Committee's Call for Evidence on the Bill emphasised the role of the Bank in addressing these inequalities by ensuring that it is an institution that has the capability to invest in anyone with a solid business proposal.

Barriers to Accessing Finance

9. Numerous studies have been conducted with the aim of identifying and better understanding barriers to accessing credit for socioeconomically disadvantaged entrepreneurs. The outcomes from this research has demonstrated that access to finance constitutes a significant challenge for these individuals.^[4] In the first instance, lower levels of personal wealth and fewer opportunities to secure start-up capital from family and friends means that they are more likely to require external sources of finance in order to establish a business.^[5]

10. There are, however, a series of obstacles for socioeconomically disadvantaged entrepreneurs in their attempts to secure capital from external sources such as banks and financial institutions. These barriers exist on both the supply and demand-side meaning that while the inherent characteristics of capital markets and the credit rationing practices of financial institutions create obstacles for socioeconomically disadvantaged entrepreneurs in accessing the requisite finance, individuals from these groups are also less likely to apply for funding in the first place.^[6] Studies have, however, shown that failure to secure finance when businesses have a requirement to do so has a significant impact on the features of what makes a business successful such as its growth, productivity and innovativeness.

11. Alternatively, entrepreneurs may utilise suboptimal forms of finance such as credit cards or bank overdrafts to fund the set up costs for their business which can result in higher repayments coupled with less defined repayment schedules. When determining how to reduce socioeconomic disadvantage the Bank must therefore consider how it addresses both these demand and supply-side barriers. In light of the implications that access to credit has on the ability of socioeconomically disadvantaged entrepreneurs to establish and maintain a successful business, this section will consider what barriers they face in securing capital and how the Bank can seek to improve access to finance for them. It will focus primarily on debt as opposed to equity finance due to its greater prevalence within the Scottish economy and the fact that it is more closely aligned to the characteristics of businesses typically established by socioeconomically disadvantaged entrepreneurs.

Proof of Concept

12. The financial growth cycle theory states that funding the processes required to prove whether a product is marketable, generally referred to as proof of concept, is typically done through insider finance, that is to say it is funded through an entrepreneur's personal wealth or by raising capital from family and friends. Anecdotal evidence provided by Scottish entrepreneurs engaged in the sale and development of specific products reinforces the assumptions inherent in the financial growth cycle theory. Those entrepreneurs who shared their experience stressed that they relied heavily on personal wealth and drew on capital from families and friends to finance development of their product or business idea.

13. The importance of insider finance in funding this stage of the business lifecycle arises largely from a lack of provision available through private investors many of whom are unwilling to assume the risk of investing in a product or idea that hasn't been proven to be a marketable product, a key aspect of what is known as a business being 'investor-ready'. In fact it is this very issue, albeit at a larger scale, that is at the heart of the rationale for establishing the Bank in the first place. As Mariana Mazzucato has highlighted in her work, financial institutions in the UK are typically adverse to investing where there is less certainty of achieving returns or where these returns are realised over a long time horizon. Indeed the Scottish Government has already committed to making the Bank a source of patient strategic finance to address this shortage in provision.

14. While the reticence of private investors to make credit available for proof of concept testing is understandable, it does inherently handicap socioeconomically disadvantaged entrepreneurs in proving to themselves and others that they have a viable business proposition. Significantly lower levels of personal wealth coupled with fewer opportunities to raise the necessary capital from family and friends mean that they are heavily reliant on external sources of funding in order to make their business idea a reality. The lack of financial products available to fund proof of concept and the requirement this places on entrepreneurs to self-fund this phase means that those who are socioeconomically disadvantaged are often simply unable to access the finance that they require to develop the product or business idea that offers them a route out of poverty.

Firm-level characteristics

15. While the Financial Growth Cycle model developed by Udell and Berger highlights the importance of insider finance to the start-up phase across all types of business, private investors in the UK including banks and building societies do offer credit for new and emerging businesses entering an established market. Data pertaining to the experience of Scotland's socioeconomically disadvantaged entrepreneurs in securing capital has not been collected at sufficient scale or in enough detail to provide reliable evidence of specific obstacles that they experience in accessing finance. Detailed research into the specific characteristics of businesses established by those who face socioeconomic disadvantage has, however, found that they typically exhibit specific features.In particular, firms established by socioeconomically disadvantaged entrepreneurs tend to be and remain small^[7] and are clustered in specific sectors such as retail, hospitality and care.^[8]

16. By analysing the experience of businesses within these sectors in accessing finance through information made available in the UK Government's Longitudinal Small Business Survey (LSBS) it is possible to gain insight into the experience of socioeconomically disadvantaged entrepreneurs in securing capital from private investors. This analysis demonstrates that sectors where businesses created by socioeconomically disadvantaged entrepreneurs are typically clustered have a lower probability of securing a loan from a bank or financial institution compared to other types of business, particularly high-tech and knowledge intensive companies:

a. Success in securing full value of loan sought from bank/building society according to business type: 42% of loan applications for businesses in the care sector were successful in receiving the full value of the loan they sought. Comparatively, 83% of primary industry businesses, 61% of manufacturers and 68% of small and medium-sized enterprises (SME) operating in professional, scientific or technical sectors received the full value of the loan they sought.

b. Reasons for being rejected for loan from a bank/building society according to business type: Although businesses operating in the retail sector had a relatively high approval rate for loan applications, a large proportion of those rejected were done so on the basis that the lender was 'not interested in their sector or business type'.

c. Outcome of Application for Government or local authority grant or scheme according to business type: Businesses operating within the retail, hospitality and care sectors have some of the highest rates of securing loans or grants from public sector sources. Last year 75% of retail, 87% of accommodation and food sector and 88% of care businesses were successful in securing some or all of the funding they sought from this source.^[9]

17. Results from the LSBS clearly demonstrate that specific sectors of the economy, particularly where businesses started by socioeconomically disadvantaged entrepreneurs are clustered, experience challenges in accessing finance. Significantly, the public sector plays a key role in addressing the shortfall in finance for these sectors from private lenders. Interestingly, the LSBS reveals that the proportion of businesses which have an application rejected on the basis that their proposals lack commercial viability is lower within these sectors than it is among those types of business that are typically more successful in obtaining finance. It is also worth drawing attention to the findings of the recent IPPR Scotland report entitled 'How Productivity could Deliver Inclusive Growth in Scotland' which highlights the importance of ensuring that productivity gains are shared across all sectors of the economy in Scotland and makes specific mention of sectors where low paid staff are clustered.

Information Asymmetries and the Requirement for Collateral

18. Socioeconomically disadvantaged entrepreneurs experience additional challenges in accessing finance arising from information asymmetries. Financial institutions are using increasingly digitised and data-led methods to inform their decision-making around whether to invest in specific businesses. Newer and smaller firms are particularly vulnerable to the influence of information asymmetries due to a lack of 'hard' evidence against which banks and financial institutions can determine the degree of risk associated with lending to a specific business.^[10] Where investors lack sufficient information to assess the viability of business proposals they will seek to secure the value of their investment against tangible assets, collateral, which can be seized in case of default. Since those who are socioeconomically disadvantaged own fewer assets that can be used to secure loans, such as property, they are significantly more likely to be rejected by traditional private sector lenders.^[11]

19. Returning to the 2018 LSBS and this time using size of firm as a proxy for businesses established by socioeconomically disadvantaged entrepreneurs, the results show that the smaller the firm the less likely it is to secure capital from private lenders. Take, for example, commercial mortgage applications, where real estate is used as collateral for a business loan. The LSBS shows that the smaller the firm the less likely they are to be successful in applying for a commercial mortgage. Whereas 86% of medium-sized businesses secured all of the funding they applied for through a commercial mortgage, the equivalent figure was 52% for microbusinesses and just 28% for companies without any employees. Given that, alongside credit cards, commercial mortgages are the most commonly sought type of business finance from banks^[12], the implications inherent in this disparity in access to credit are significant. In fact socioeconomically disadvantaged entrepreneurs in Scotland appear to be at a particular handicap in their pursuit of external finance relative to other European countries due to a preference among UK banks to use property as collateral against which to secure business loans.^[13]

Borrower Discouragement

20. A study exploring barriers to entrepreneurship for poorer communities conducted in disadvantaged parts of Leeds demonstrated that demand-side barriers could be equally as impactful as those on the supply-side in restricting access to credit for socioeconomically disadvantaged entrepreneurs. The outcomes of the study identified concerns about accessing the requisite finance as a key restraint on people from poorer communities seeking to become entrepreneurs with almost a third of those who were surveyed listing it.^[14] These findings have since been supported by a more generic study exploring access to finance for businesses in disadvantaged urban neighbourhoods. This study concluded that perceptions around their ability to access finance was the only significant barrier that firms located in disadvantaged communities actually faced in securing capital and that these views were pervasive among business owners.^[15]

21. The 2018 LSBS explores the reasons why companies without employees are deterred from seeking finance which provides some insight into what discourages entrepreneurs and potential entrepreneurs from disadvantaged communities in their pursuit of external capital. Fear of being rejected (45%), not knowing where to find appropriate finance (25%) and poor credit history (19%) all feature prominently on this list.^[16] It is evident that there are a range of factors at play which deter entrepreneurs and potential entrepreneurs from socioeconomically disadvantaged backgrounds from coming forward for finance to start a business and that these are acting to depress demand coming from these individuals.

Access to working capital

22. Once a company has been successfully established the next point at which entrepreneurs typically require credit is when they are seeking to scale up. Scaling up can broadly be defined as a short period of high growth for a company when its operations expand significantly relative to its size at the beginning of the high growth period. Although scale up companies are usually thought of as operating in the technology and digital spaces, firms across all sectors of economy have periods of rapid expansion that requires capital to facilitate. The evidence shows that companies owned by socioeconomically disadvantaged entrepreneurs tend to remain microbusinesses which suggests that they struggle to achieve their growth ambitions.

23. Access to working capital has been identified as a key challenge for socioeconomically disadvantaged entrepreneurs in Scotland. In effect, covering the costs of fulfilling a specific order in the intervening period between conducting that job and payment for completing it is a particular challenge for those firms where the owner doesn't have personal savings or the ability to borrow from friends and family. The implications of not being able to secure the working capital that they require to cover the costs of delivering an order are significant and can result in businesses not being able to take on contracts that will allow them to expand thereby acting as a brake on the growth aspirations of that company.

24. Data published by the British Business Bank (BBB) appears to show a substantial shortage in provision of financial products across the UK designed specifically to enable firms to access the working capital that they require. In 2018, 40% of firms who sought finance did so in order to access working capital and of those businesses,^[17] 37% stated that their reason for doing so was to cover a short term gap until funds were received from customers.^[18] Despite the prevalence of businesses that have a requirement for working capital and the clear advantages of utilising supply chain finance over other types of product, the uptake of these types of financial products by businesses across the UK is low. While over half of SMEs surveyed by the BBB were aware of these products, significantly fewer knew who to approach in order to secure this type of loan. Considering Scotland specifically, the results of the 2018 LSBS show that only 1% of SMEs had applied for supply chain finance in the previous 12 months, the lowest percentage of any of the UK nations indicating a particular shortage in Scotland.^[19] Either there is insufficient provision of this type of finance in Scotland or demand for this type of loan is not being adequately generated.

Conclusions

25. The LSBS reveals that there are a number of barriers that socioeconomically disadvantaged entrepreneurs experience in accessing the credit that they require to build a successful business. On the one hand, they have less capacity to self-fund when establishing or expanding their business yet the credit rationing practices adopted by financial institutions create obstacles to securing that funding externally. In addition, socioeconomically disadvantaged entrepreneurs are more likely to be discouraged from seeking business finance which means that they are less likely to come forward in the first place.

Addressing these Barriers

26. Given the legal obligations arising from the Fairer Scotland Duty, it is evident that the Bank, once it becomes operational, will be required to consider how it can contribute to reducing the clear barriers that exist to accessing finance for socioeconomically disadvantaged entrepreneurs. The Bank cannot do this in isolation and must collaborate with partners across the public sector and beyond to implement those measures that will be successful in helping to mitigate these barriers. Action is necessary across the full range of demand and supply-side barriers identified above to ensure that all entrepreneurs with a viable business proposal, irrespective of their socioeconomic status, have the ability to access the capital they require to realise their ambitions. In order to achieve this, this FSDA suggests that the Bank, once established considers how it can:

a. contribute to an investment landscape which actively removes barriers to accessing finance for socioeconomically deprived entrepreneurs. The Bank should consider the development of financial products that are tailored to the needs of these businesses where they are not already available through other bodies. Where necessary the Bank should conduct or commission robust and transparent analysis of the gap in provision of credit for these businesses to inform its role.

Through the LSBS it is possible to see the scope but not the scale of the handicap experienced by socioeconomically disadvantaged entrepreneurs. While the LSBS is able to reveal what the barriers are it is unable to provide insight into the number of entrepreneurs with a viable business proposition who are unable to access the finance they require on account of their socioeconomic status. Without understanding the full gap in funding that exists for socioeconomically disadvantaged entrepreneurs any steps that the Bank takes in conjunction with public sectors partners to reduce these obstacles will ultimately be replaced by other credit rationing practices which could cause disadvantage in other ways. This FSDA therefore suggests that a full analysis into the gap in provision of credit for socioeconomically disadvantaged entrepreneurs is undertaken to inform the steps that should be taken to address this issue.

b. support relevant partners across the public sector to improve awareness among entrepreneurs about the types of financial products available to them when seeking to start or scale up their business, and develop core skills required to make their business a success. In addition, the Bank may wish to communicate its suite of financial products to other lenders so that they are fully aware of the finance available and can refer entrepreneurs and businesses seeking such support, where appropriate.

Evidence shows that entrepreneurs are increasingly using information online to support their decision-making about what financial products to use and the most appropriate organisation to seek investment from. A 2018 study by the BBB revealed that in just one year there was a 4% increase in the number of business owners using the internet for this purpose indicating that entrepreneurs are diversifying their sources of information. This suggests that there could be an opportunity for the Bank and its public sector partners to capitalise on increased reliance on online resources to identify and compare financial products.

Despite more entrepreneurs researching their options, direct interaction with banks remains the most popular method for business owners to find out about securing investment in their firm with the vast majority going to their existing bank.^[20] Further research into this by the BBB has revealed that 41% of firms that obtained funding chose their provider on the basis that they had an existing relationship with them.^[21] Loan application rejections have a significant influence on borrower discouragement with almost half of those who aren't offered the full amount of credit sought either giving up or putting plans on hold.^[22] In fact just 13% of SMEs that had not been offered the full amount of funding they sought indicated that they had spoken to another provider.^[23] These figures suggest that a policy intervention is necessary to reduce borrower discouragement among those entrepreneurs who have not been offered all of the money that they applied for to encourage them to consider other providers or forms of finance

c. positively contribute to market intelligence and formation of evidence-based decisions by improving understanding in the market place of access to finance issues, especially arising from information asymmetries on some firms, for example, those companies that contribute to reducing socioeconomic disadvantage, including establishing and publicising the accessibility of those categories of firms to lending by financial institutions.

Please refer to conclusions on improving access to finance for firms that contribute to poverty reduction.

27. The benefits that could be derived through success in reducing these barriers and ensuring that socioeconomically disadvantaged entrepreneurs can access the credit that they require are potentially significant not just for individual entrepreneurs but for poverty in Scotland more broadly. Evidence has shown that a key driver of entrepreneurialism in disadvantaged communities is knowing someone who has started a successful business. Increasing the number of companies established by individuals from poorer communities through improved access to credit could prompt a growth in entrepreneurship from the socioeconomically disadvantaged.