By Leon Gettler

How can entrepreneurs and SMEs get the capital they need to grow?

Raising capital has never been harder for SMEs. Venture capital has dried up and banks are more cautious.

For many SMEs, the only option might be private equity. But how do they get access to it?

Everyone knows that the global venture capital industry is subject to massive booms and busts. Since the start of the global financial crisis in August 2007, venture capital has gone through hard times. When the GFC was running full bore, capital and risk-taking dried up. Since then it has picked up, but business is still struggling to raise funds.

The latest figures from global consulting and research firm Preqin show that in the first quarter of 2014, there were 1,402 venture capital financings globally with an aggregate value of $15.6b. The good news is that represents the highest quarterly value since the crisis.

However, the number of venture capital financings crashed, dropping from 1,724 deals in the second quarter of 2013 to 1,402 in the first quarter of 2014. And that means one thing: fewer businesses are getting funds from venture capital.

Investment in Australia’s venture capital industry nearly halved from its height in 2008, to A$111m in the 2013 financial year, according to statistics collated by the Australian Private Equity and Venture Capital Association.

The New Zealand Private Equity and Venture Capital Association reported activity of NZ$55m for the full 2013 year, down from NZ$66.1m in 2008.

Shy investors

Entrepreneur and freelancer.com chief executive Matt Barrie has declared that the venture capital industry in Australia is dead, raising fears the brain drain to the US will accelerate. According to Barrie, funding from venture capital firms for technology start-ups has been in sharp decline over the past three years.

He says that in 2012, the entire venture capital industry invested A$40m in total across three funds, a 50 per cent drop from 2011’s A$80m. Funding for the sector reached A$160m in 2010 but had declined by 50 per cent a year later.

At the same time, bank financings of SMEs have fallen. Banks have increasingly shied away from business loans, preferring instead home loans, which are more profitable and lower risk. The New South Wales Business Chamber says 30 per cent of small businesses now can’t get the bank finance they need.

The only force bucking this trend is private equity. Many firms are now on the acquisition trail, looking to build up positions in key industry sectors and then offload those assets through an IPO or trade sale. The five key growth sectors are wealth management, international education, agribusiness, tourism and gas but then, private equity has also bought into mining services, retail and manufacturing. It’s everywhere.

Still, some businesses are reluctant to use private equity because private equity can often take a majority stake in the business, leaving the founder with little control.

That has opened the way for new trends for getting access to capital. Markets have seen, for example, the emergence of crowd-sourced funding, and peer-to-peer lending.

Play to the crowd

Crowd-sourced equity funding is catching on around the world. It was enabled this year in the United States under the JOBS Act. New Zealand, Canada, Italy and the United Kingdom have also enabled crowd-funded investment in the past year.

Crowd funding is an unusual model. It’s about donations rather than investment. Project creators are encouraged to offer rewards for different levels of donation.

The advantage for entrepreneurs is that it offers effective market research to test ideas and the potential for good publicity. And, unlike private equity or venture capital, they don’t have to relinquish ownership or control of the business or take on onerous reporting obligations.

The Australian business community is waiting to see the government’s response to a report by the now defunct Corporations and Markets Advisory Committee (CAMAC) — abolished in the last federal budget.

Because early stage ventures are generally high risk, CAMAC proposed to limit the potential for damage to investors by what is effectively a stop order: there will be limits on both the amount of money that a company can crowd source and the amount of money that individual investors will be able to invest.

Under its proposals, a company could not raise more than A$2m through a combination of crowd funding and small-scale personal offers. A company which raised more than A$2m through small-scale personal offers in a year would not be able to use crowd funding in that year.

For their part, investors could be limited to a A$2,500 investment per annum in any one company, with an annual cap on their investments of A$10,000. CAMAC has proposed that two types of company should be able to utilise crowd sourced equity funding: public companies; and a new class of company or “exempt public companies”.

Because the Federal Budget for 2014-2015 announced the abolition of CAMAC and the transfer of its functions to Treasury, it remains to be seen to what extent and how quickly CAMAC’s proposals will be taken up in Australia. The implementation of CAMAC’s blueprint for a CSEF structure will require legislative amendments to the Corporations Act 2001.

In New Zealand, changes to capital markets regulations made it legal to offer shares through crowd funding platforms from 1 April 2014. A “licensed intermediary” can offer up to NZ$2m in shares per year with an exemption from normal compliance requirements including an investment statement or a prospectus.

Peer to peer (P2P)

P2P lending cuts the banks out of the equation when organising loans. Put simply, P2P lending platforms act like a marketplace. It matches borrowers directly with lenders.

For borrowers, P2P lending serves as an affordable alternative to expensive personal bank loans. For lenders with excess money, P2P offers an alternative way to invest with potentially higher returns than other fixed income investments.

P2P lending is well established in the US, with Lending Club and Prosper, and the UK, with Zopa, RateSetter and Funding Circle. It is still in its infancy in Australia and New Zealand, but is expected to grow.

P2P lending is an extension of the sharing economy. Other examples include Airbnb, which provides accommodation, and car-sharing sites such as Uber and Lyft.

Of course, P2P is in its early days and borrowers should not expect big loans. Australia’s SocietyOne for instance, allows people to borrow amounts from A$5,000 to A$30,000 over 1-3 years. There’s no upfront fee, monthly service fee or exit fee, but it’s not much.

Businesses in New Zealand operate under a NZ$2m cap on P2P borrowing in any 12-month period.

Going private

Yasser El-Ansary CA, the chief executive of Australian Private Equity and Venture Capital Association, concedes that venture capital has been doing it tough. He also acknowledges that while there is a lot of money going out, a lot of SMEs are missing out on venture capital backing.

“Part of the dynamic we are seeing in this context is that, over recent years, there has been consolidation in the superannuation fund industry. That’s meant that many of the most significant superannuation funds have had to lift their investment threshold to a very significant level,” El-Ansary says.

“For some superannuation funds that level might be A$50m, A$100m or even in some cases A$200 million.

“In many cases they are not making those investments here in Australia, they are making those investments abroad, typically in the US and in some cases Asia and the reason for that is that the scale is very different. When you talk about venture capital in the US, you are talking numbers that would be multiples of ten or 20 times what we have here in Australia so it becomes quite feasible for an Australian superannuation fund to cut a cheque for A$50m or A$100m into a US fund which might be a total size of A$500m or A$1b.”

That means one thing: many good Australian and New Zealand business will not get support from venture capital.

Where they should look to instead, says El-Ansary, is private equity. Indeed, he says private-equity funding is a better option for many SMEs because it might bring skills and expertise into a business as well as cash. Banks by law have to take a hands-off approach.

“Rather than assuming by default that bank financing is the best option, what I think should happen across the SME market is that more of those business owners should be asking themselves and their trusted advisors, like their accountants, questions around what is the most appropriate funding for my business at this particular point in time,” he says.

“And I think the answer in many of these cases would be: ‘We not only need funding, we need someone to help us take this business to the next level and help drive our strategic focus and our commitment towards achieving growth at certain levels and over certain periods of time’. Banks won’t necessarily be in the best position to deliver on that whereas private equity managers can.”

Securing capital

So how should an SME present its case to secure capital? El-Ansary says they have to be absolutely watertight in their documentation, business model and governance.

“Regardless of whether an SME is sitting down and having a conversation with a bank or sitting down and having a conversation with a private equity manager, the simple facts are that any of those stakeholders looking at the business and looking at putting in capital, either by equity injection or finance and lending, will need to come to grips with the core fundamentals of the business and be very comfortable that the business is built upon solid foundations.”

That means making sure you have robust documentation, and that you’ve got sound information to present to any of those stakeholders to make them aware of the potential opportunities and the potential risks.

“And in the aftermath of the GFC, clearly we have seen a greater focus on governance, risk management, risk identification and risk containment — and that is where some SME businesses don’t invest the time that they should. They are so caught up in running their business and being at the coalface that some of those background issues are left for others to manage and in some cases they are not managed adequately.

“The core fundamental premise that’s important is that the business invests an appropriate amount of time to make sure its governance and control processes are up to speed and they are established to ensure any external stakeholder, whether it’s a bank or private equity manager, becomes comfortable very quickly with the size and shape of this business — and they understand fully what this business represents in terms of opportunity but also what this business represents in terms of risks.”

The core fundamental premise that’s important is that the business invests an appropriate amount of time to make sure its governance and control processes are up to speed…

He says accountants and lawyers can play a pivotal role linking SMEs up with private equity.

“The best approach to take would be to engage in a discussion with your accountant or your lawyer about where your business is at and what sort of options might sit in front of you. From there those professional advisers, lawyers and accountants, should have a good network of contacts to reach into.

“It does very much depend on having access to a good accounting or legal adviser who has a broad network of legal relationships. Many accountants who have worked with dozens and dozens of SME businesses will have a strong network and they ought to have some relationships with private equity managers.”

Leon Gettler is an independent journalist and presenter.

This article was first published in the December 2015 issue of Acuity magazine.