Scottish National Investment Bank: Fairer Scotland Duty assessment

Improving Access to Finance for Firms with Characteristics that Contribute to Poverty Reduction

Introduction

28. Alongside direct investment in those who are socioeconomically disadvantaged, the FSDA Panel also identified a series of indirect methods through which the Bank could contribute to the Scottish Government's goal of reducing inequalities of outcome arising from socioeconomic disadvantage. In particular, the Panel drew attention to the fact that certain types of SME, by virtue of specific characteristics, can make a significant contribution to reducing inequalities of outcome arising from socioeconomic disadvantage. As such, the Panel proposed that consideration be given to how the Bank can invest in and foster businesses with these characteristics.

29. SMEs, the target market for the Bank's investments, constitute the backbone of the Scottish economy where a substantial proportion of the nation's working age population are employed. The Supporting Analysis published alongside the Implementation Plan observes that 55% of people employed in the private sector work for an SME, which represents a total of 1.2 million people.^[24] The Bank's primary role of investing directly in SMEs and of leveraging in private sector capital will fuel a key driver of job growth in the Scottish economy creating job opportunities that are a vital route out of poverty. Further investigation into the Panel's observations, revealed that where a firm is located and the company model it adopts can further enhance the capacity of that business to alleviate poverty.

Barriers to Accessing Finance for Microbusinesses

30. Microbusinesses are the smallest class of firm operating in the UK and are generally understood to be those companies with 10 employees or fewer. They are a hugely influential and important part of the economy responsible for employing many of those who work in the private sector. The prevalence of microbusinesses mean that they make a significant contribution to job growth in the Scottish economy meaning that they have considerable capacity to reduce socioeconomic disadvantage. Microbusinesses also possess other characteristics that contribute to alleviating poverty that are worth drawing attention to in the context of this FSDA. As well as creating a large number of jobs, they are more likely to employ local people who may be excluded from or unable to access other sectors of the labour market while proximity of staff to business owners also contributes to improved workplace conditions and employment practices. These companies also promote the flow of financial resources into local communities as well as being more receptive to the needs of these communities. Finally, microbusinesses, provide role models and support for future entrepreneurs.

Firm-Level Characteristics

31. Evidence shows, however, that microbusinesses experience a range of challenges in accessing credit either for working capital or to fund their growth aspirations. Microbusinesses tend to have lower capital intensity meaning that the size of loan they usually seek is smaller. The LSBS reveals that the size of loan sought has a considerable impact on the ability of businesses to secure the capital they require from banks and financial institutions. In fact it clearly demonstrates that the smaller the business the less likely it is to secure a loan, a likelihood that drops sharply for microbusinesses and companies with no employees:

a. Success in securing full value of loan sought from bank/building society according to business size: 74% of medium-sized enterprises and 71% of small businesses that sought a bank loan were successful in securing all of the money they asked for compared to 58% for microbusinesses and 47% for companies with no employees.^[25]

b. Rejection rates for loan applications to bank/building society according to business size: 24% of microbusinesses and 44% of companies without employees were rejected for a business loan from a bank/building society. By comparison, just 12% of small businesses and 10% of medium-sized enterprises were rejected.

c. Outcome of application for credit card according to business size: 88% of medium-sized enterprises and 83% of small businesses were successful in securing a credit compared to 71% of microbusinesses. In Scotland, 46% of companies without employees who applied for a credit card were successful.

d. Outcome of application for Government or local authority grant or scheme according to business size: 76% of microbusinesses and 73% of companies without employees secured some or all of the funding they applied for from central or local government. This is more closely aligned with the experience of small businesses and medium-sized enterprises whose success rate was 80% and 64% respectively in securing some or all of the funding they sought.^[26]

32. The implications from the LSBS are unequivocal, the smaller the business the harder it is to secure traditional forms of debt finance from a private lender. Additionally, the LSBS reveals that the public sector plays an important role in redressing the flow of finance towards larger businesses. In seeking to understand why the size of a business has such a marked impact on its ability to secure external funding, academics have tended to focus on banks' target rate of return and the costs associated with assuring and managing investments.

33. These factors render investing smaller sums of money less attractive to banks and financial institutions placing an automatic constraint on socioeconomically disadvantaged entrepreneurs seeking finance through traditional routes. In addition, size also has an impact on the capacity of companies to convey creditworthiness. Small businesses do not have audited financial statements or publicly available contracts with staff and suppliers which means they lack the 'hard' information that banks increasingly require to inform their decision-making on whether to approve a loan application.^[27]

Borrower Discouragement

34. Studies have shown that microbusinesses are not only disadvantaged by the activities of financial markets and the practices of individual institutions but also experience substantial demand-side barriers to securing external investment. Borrower discouragement has become an increasingly significant and pressing area of research for economists in recent years both because of the huge number of businesses that are deterred from seeking the finance that they require from the most appropriate source and the damaging impact that failure to seek finance can have on that business. Studies have shown that there may in fact be twice as many discouraged borrowers in the UK, defined as creditworthy businesses that decide not to seek funding when they have a legitimate requirement to do so, than which actually have their applications rejected. Rejections for applications may be the tip of the iceberg with regard to firms not securing the finance they require to invest and grow.^[28]

35. Research indicates that microbusinesses are particularly prone to borrower discouragement in comparison to SMEs. A survey into trust in financial institutions in the UK revealed that the smaller the enterprise the less trust they had in banks, a factor which has significant implications for whether a business decides to seek credit.^[29] Knowledge about financial products available appears to be a significant reason for borrower discouragement and one that is particularly prevalent among microbusinesses. 18% of microbusinesses surveyed for the 2018 LSBS that reported being discouraged from applying for finance highlighted not knowing where to find appropriate financial products as a reason why they didn't seek capital. In fact 24% of firms in Scotland listed not knowing where to find appropriate financial products as a reason why they didn't apply for credit, significantly more than in England and Wales hinting at a wider problem.^[30]

Rural Microbusinesses

36. Although more often associated with urban areas, poverty is also a reality for many who reside in Scotland's rural communities. 14% of people in rural areas of Scotland (170,000) live in relative poverty after housing costs.^[31] Fewer job opportunities coupled with high living costs and reduced accessibility are drivers of disadvantage that are often hidden due to associations between the countryside and wealth.

37. Microbusinesses are particularly important to the rural economy due to the fact that 9 in every 10 rural firms are microbusinesses, employing 68% of the workforce in remote rural and 54% in accessible rural Scotland. They also experience distinct challenges in accessing credit compared to their counterparts in urban areas and so it is worth considering some of these challenges separately. The implications of these firms failing to secure sufficient capital are often profound and its impact is rarely confined to the short term. Firms unable to access the finance they require exhibit lower growth, less productivity and substantially less innovation when compared to those who have secured the requisite level of capital. To reduce poverty it is vital that rural businesses have access to the credit that they require to achieve their growth ambitions to increase the proliferation of high quality jobs.

38. Research has demonstrated that peripherally located businesses experience distinct challenges in accessing finance due to 'the liability of distance' making it more difficult for rural firms to offset the impact of information asymmetries. In the first instance, assets, such as property, tend to be significantly cheaper in rural areas which means that business-owners have lower levels of collateral against which to secure loans. The ability of rural business owners to overcome information asymmetries has also been impacted by the retreat of banks from high streets in Scotland making it harder for them to establish a relationship with potential investors. Bank closures were highlighted as a particular issue in responses to the Scottish National Investment Bank Consultation, with respondents highlighting the negative impact that they have on peripherally located businesses. The growing prevalence of Fintech and the premium it places on hard information with which to influence lending decisions could further exacerbate these challenges for rural businesses. It is important that rural firms benefit from the improved access to financial products that Fintech offers the wider business community.^[32]

39. Economists have stressed the importance of the entrepreneurial ecosystem in directing business owners about where to seek finance. These ecosystems are generally underdeveloped in peripheral regions meaning that understanding or awareness of the types of financial products available is lower than it is in urban areas.^[33] Evidence has identified that microbusinesses are more likely to be discouraged from borrowing than larger firms.^[34] The impact of borrower discouragement is significant exerting a considerable impact on the productivity, innovation and growth rate across the lifetime of those that don't seek investment when they need it.

Conclusions

40. It is clear therefore that a significant opportunity exists to reduce socioeconomic disadvantage by supporting the establishment and expansion of microbusinesses in Scotland due to inherent characteristics of these firms which contribute to reducing socioeconomic disadvantage. Evidence shows that accessing credit to fund growth and for cash flow purposes is a challenge for microbusinesses, substantially more so than it is for SMEs, stymieing their positive impacts on reducing socioeconomic disadvantage. These challenges appear to be particularly acute for microbusinesses in rural areas.

Barriers to Finance for Employee-Owned Businesses

41. Microbusinesses are not alone in possessing inherent characteristics that contribute to alleviating poverty. Firms that use specific company models have also been shown to have specific traits that can reduce socioeconomic disadvantage. This incorporates a wide range of company models including co-operatives, b-corps, social enterprises or community interest companies which, in different ways, distribute the wealth they generate. For the purposes of this FSDA, this section looks specifically at employee-owned businesses as an exemplar of an atypical company model that contributes directly to improving the socioeconomic status of its staff.

42. Employee-owned businesses utilise a non-pyramidal company model by sharing ownership of the company across those who work for the firm. The effect of this is to democratise the workplace generating higher wage growth, enhancing job security, improving workplace wellbeing and embedding employee engagement. In addition, studies have shown that employee-owned businesses exhibit higher job growth than SMEs that utilise pyramidal company models. Employee-owned businesses are also rooted in local communities creating stable employers that are at considerably reduced risk of acquisition and relocation or closure by competitors,^[35] a process to which SMEs in Scotland have been particularly vulnerable in recent years and which can be particularly damaging for local economies especially in rural areas.^[36] The power of employee-ownership has already been recognised by the Scottish Government through its Scotland for EO policy which aims to increase the number of employee-owned businesses in Scotland to 500 by 2030.

43. Employee-ownership has become an increasingly popular business model in recent years in Scotland and there are now estimated to be more than 100 employee-owned businesses operating in Scotland. The value of employee-ownership to both the company and its staff has become increasingly apparent in recent years which has precipitated the development of a supportive ecosystem to assist interested companies explore the transition to becoming employee-owned. Despite the existence of this network, challenges remain for those SMEs that want to become employee-owned particularly in relation to raising the external capital required to fund an employee buy-out (EBO). Even if they don't require the full value of the business upfront, owners who wish to exit their business will typically seek a substantial initial payment upon exit which many see as either their pension pot or working capital to fund their next venture. Employees often lack the means to come up with this initial capital which can be a barrier on companies becoming employee-owned unless they are able to secure external funding in order to facilitate the EBO.^[37]

44. There are, however, a range of challenges that business wishing to pursue an employee-owned company model experience when wishing to access external capital in order to fund an EBO. Given the role played by employee-owned businesses in supporting the development of a wellbeing economy, responses to the Committee's Call for Evidence on the Bill have proposed that consideration be given to how the Bank can support the proliferation of employee-owned businesses.

Supply-side Barriers

45. Many of these barriers are broadly similar to those experienced by microbusinesses not least the value of loans sought in order to fund the buy-out which do not generally do not deliver the rate of return thresholds sought by many banks and financial institutions. A qualitative survey exploring access to finance for employee-owned businesses revealed the attitudes of banks towards funding EBOs and found scepticism about whether investing in employee-owned businesses would deliver the rate of return they required.^[38] This survey also identified that transition to an employee-owned business meant that the company would assume a different credit risk and that banks would be unable to take past performance into consideration when making a decision on whether to lend.^[39] To offset this credit risk, financial institutions typically seek to extract significant personal guarantees from directors as collateral against which to secure their investment which is often too great a level of risk for that director.^[40]

Demand-side Barriers

46. Demand-side barriers also explain why employee-owned businesses are disadvantaged in accessing finance. A survey conducted with established employee-owned businesses and those considering the transition to becoming employee-owned revealed that many are suspicious of using loans and, particularly, equity funding to finance an EBO due to a fear of rent-seeking behaviours and the impact of outside interference. Although they are gaining in popularity, misinformation about employee-owned businesses and the process for establishing them is pervasive meaning that many entrepreneurs fail to consider this as an exit route due to a lack of awareness that it is an option or misconceptions about it implications.

Conclusions

47. The experience of employee-owned businesses shows that private financial institutions are less comfortable investing in those businesses that utilise company models which differ from those operated by firms that they are more used to giving credit to. Much like with microbusinesses, however, there are also appear to be demand-side obstacles that prevent these companies coming forward for investment when they have a legitimate need to do so. Both these demand and supply-side barriers need to be addressed if the wealth distribution models of these companies is to have a significant impact on reducing socioeconomic disadvantage in Scotland.

Addressing these Barriers

48. It is a by-product of the credit rationing processes adopted by banks and building societies that organisations such as microbusinesses and company which utilise atypical company models that contribute to reducing disadvantage are also disadvantaged in their efforts to and discouraged from securing credit. As part of the obligations placed upon it by the Fairer Scotland Duty the Bank should also give consideration to how it can work with partners across the public sector and beyond to help improve access to credit for these organisations. The findings of this FSDA also demonstrate that the following conclusions are also relevant to the Bank in respect of improving access to finance for those businesses that contribute to alleviating poverty. The Bank, once established should:

a. consider how it can contribute to an investment landscape which actively removes barriers to accessing finance for microbusinesses and organisations with inherent characteristics that contribute to reducing poverty. 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.

As is the case in respect of access to finance for socioeconomically disadvantaged entrepreneurs, the LSBS is unable to shed light on the number of organisations with inherent characteristics that contribute to reducing poverty who experience barriers in securing credit despite representing an investible proposition. This FSDA therefore suggests that a full analysis is conducted into the gap in provision of capital for these businesses to inform the steps that should be taken to mitigate this gap.

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.

Please refer to conclusions on improving access to finance for socioeconomically disadvantaged entrepreneurs

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.

The Bank's ultimate aim is to resolve market failures by encouraging banks and financial institutions to invest in areas where viable businesses are being prevented from scaling up due to a lack of sufficient capital to support their growth aspirations. An important part of achieving this will be the role that the Bank plays in de-risking investment in specific types of SME by providing private investors with the information that they require to recognise the opportunities rather than the risks of investing in specific types of business. The Bank's role as a market intelligence actor therefore holds the potential to have an impact well in excess of its investment activity. The BBB already has a mandate to collate and publish information about the SME market at the UK level but having an actor capable of analysing information and extrapolating trends specific to the Scottish economy could give banks and financial institutions the confidence to invest outside of traditional lending patterns. In addition, consideration should be given to other areas where information asymmetries exacerbate inequalities of outcome arising from socioeconomic deprivation where the Bank, in its role as a market intelligence actor can address these.