Finance for Europe’s growing enterprises

At the heart of the European Union’s tasks in coming years is that of fostering economic growth and job creation – the so-called Lisbon Strategy. Creating the conditions in which entrepreneurs are encouraged to put their ideas into practice allows more small enterprises to be created, and making it easier for small firms to grow is fundamental to success in this strategy. The Competitiveness and Innovation Programme (CIP) (see box) provides a funding mechanism for the EU to help develop the environment in which enterprises can flourish. But finding the funds to get an enterprise started, or to expand an existing small firm, remains one of the biggest challenges entrepreneurs face.

Gap in the market

There are many reasons why firms with decent prospects of building a good business face difficulties in finding finance. Where debt financing is concerned, sometimes banks are reluctant to extend loans to firms that do not have sufficient collateral or to start-ups – firms that are just starting their operations. As for equity financing, the amount of funds which small firms seek may be too small for investors to justify the costs related to making the required investment. And some investment funds and banks may simply not have the in-house expertise necessary to assess and manage investments in small firms.

Over the past decade, the European Commission has developed a set of financial instruments, with the aim of encouraging investors to do more business with small firms. “The results achieved by these instruments over that time have been very impressive; so much so that we have almost doubled the funds that will be available in the coming years,” says James McGing, Head of DG ECFIN’s EIF Programme Management Unit. The financial instruments have been renewed for the period 2007-2013, and with a budget totalling €1.1 billion over that time, are set to enable hundreds of thousands of small companies to obtain finance more easily than they otherwise would. (It is also the case that many small firms are under-prepared for the process of seeking finance, and so fail to convince potential investors of their plans’ likely return. The Commission has also developed initiatives to counter this.)

Tailored approach

There is no ‘one-size-fits-all’ approach to finding finance. Rather, the nature of the business and the stage of the firm’s development are key to the investment approach appropriate at any given point in time. Moreover, there are still significant differences in financial markets, and in established practices, between different Member States, so a firm’s location also plays a role in determining the type of finance suitable.

The diagram shows the different phases of development of a small firm, with the types of investment appropriate to each stage. The mechanism, amount of funds, and the nature of the partner involved varies, but the partners fall into two categories. First, partners who take a stake (equity) in the business, becoming partowners, who therefore share in its success, but stand to lose their entire investment if the business fails. Second, partners who simply lend money to the business, with the expectation that they will be paid back with interest, although they bear a risk that the business will fail and they will get little or none of the principal back. Conversely, if the business is very successful, the lender will still only receive back the principal plus interest. In some financing methods, the two categories are mixed, or loans can be converted into equity.

In 2007-2013, the Commission will implement three parallel financial instruments: the Risk Capital Facility, in the area of equity finance; the SME Guarantee Facility, in the field of loans; and the Capacity Building Scheme, to enable the financial sector to work more with small firms. The budget allocated to the first two will amount to around half a billion euros each, with the remainder of the €1.1 billion budget dedicated to capacity building. The European Investment Fund (EIF) has been mandated by the Commission to implement the instruments.

Risk capital

The Risk Capital Facility (GIF) will invest in venture capital funds which focus on small, high-growth firms. A condition for GIF investment is that all a fund’s investment decisions are made on the basis of commercial market principles. Nonetheless, the EU’s stake in such funds enables them to raise their profile and attract investors more easily. Funds which specialise in eco-innovation will have the possibility of proportionately higher EU shares in their capital.

The phases of financing for growing firms

The GIF builds on the achievements of its predecessors, which have invested some €309 million since 1998 in 39 funds, leading to investments in a total of 357 small firms. The leverage effect, acting as a catalyst for investment funds raising money, is strong, as the EU investment in these funds amounted to just 17% of their combined total capital. In 2007-2013, there will be ‘seed and early-stage’ (GIF 1) and ‘expansion stage’ (GIF 2) interventions from the GIF. Overall, the venture capital instrument will now cover much of the life cycle of small, dynamic firms, and will also be able to work with business angels, supporting their investments.

Loan guarantees

The SME Guarantee Facility enables banks to increase their portfolios of loans to small firms, and extend loans to entrepreneurs and companies with higher risk profiles, or at lower cost, or with less security, than they might otherwise have done. It also supports micro-credits – loans of up to €25 000 – where banks’ costs may discourage them from entering this market. In short, the facility means that the EU shares some of the risk of lending to small firms, in return for a commitment from the banks concerned to increase the scope of their lending to small companies.

Since 1998, the EU has provided guarantees to banks and financial institutions to a value of €441 million, covering loan portfolios totalling almost €28 billion. The institutions to whose 74 loan portfolios the Union has extended guarantees have lent funds to a total of more than 330 000 small firms.

Capacity building

The Capacity Building Scheme has two strands, providing grants to financial-sector operators to develop their know-how and abilities to invest in small firms. The Seed Capital Action will enable venture capital funds to recruit additional staff specialised in working with firms in the early stage, i.e. before start-up, when the risks are high and many investment funds steer clear. The Partnership Action will help financial intermediaries and banks to develop stronger credit appraisal techniques and procedures. In particular, it will aim at improving banks’ capacities to assess commercial prospects in the field of eco-innovation.

Spreading the benefit

The leverage effect of both the guarantee facility and the GIF ensures EU funding benefits a far higher number of small firms than any system of direct grants could. The increased budget allocated for the next seven years will enable more small companies throughout the EU to benefit than ever before.

“Our research shows that, on average, each investment in a company saves – or creates – 1.3 jobs. When we take into account the income tax paid by these workers, the net investment by the EU is paid back within a few short months,” concludes McGing. “And that makes these financial instruments amongst the most cost-effective of any public measures to support job creation.”