80 the context of corporate insolvency law

Debtors and patterns of borrowing

The above discussion gives an idea of the main sources and credit devices available to borrowers but not of the patterns of borrowing that tend to be encountered in companies. Such patterns are liable to vary according to a number of factors such as the company’s needs, size, commercial sector and plans but, bearing this in mind, some generalisations can be made. In doing so it is helpful to distinguish the practices of small and medium enterprises (SMEs) from those of larger companies.

Certain research on SMEs45 reveals that small businesses tend to rely heavily on internal funds for both operating and investment purposes.46 Internal sources of finance thus seem to be more attractive than external borrowing. Around 38 per cent of SMEs would appear to seek external finance in a given two-year period, however,47 with a greater proportion of borrowing by firms of above-average growth rate.48 Of the SMEs surveyed by Cosh and Hughes for 2002–4, 81 per cent of those who had sought finance externally went to their bank;49 38 per cent had sought credit from hire purchase or leasing businesses; 19 per cent went to partners or shareholders; 15 per cent approached factoring businesses; 14 per cent went to venture capitalists; 6 per cent looked to trade customers and around 20 per cent had sought to raise funds by other routes (namely through private individuals or other sources).50 As for the amount of finance raised by SMEs, the same survey revealed that banks provided 56.9 per cent of this;

45See Cosh and Hughes 2007; Bank of England 2004. See also J. Freedman and M. Godwin, ‘Incorporating the Micro Business: Perceptions and Misperceptions’ in A. Hughes and

D. Storey (eds.), Finance and the Small Firm (Routledge, London, 1994); S. Fraser,

Finance for Small and Medium Enterprises (Warwick University Centre for Small and Medium Enterprises, 2004) (‘Fraser 2004’).

46See Cosh and Hughes 2007, p. 50; figures for 2004 indicate that the total of external funds sought in 2004 was £1.4 billion.

47Ibid. (years 2002–4); Cosh and Hughes 2000 (for years 1997–9). See, however, Fraser 2004 and the survey indicating that 80 per cent of SMEs had used one or more sources of external finance in the previous three years.

48See Cosh and Hughes 2007, p. 51. In recent years SMEs have become less reliant on external finance: the 38 per cent figure for SMEs seeking external finance in 2002–4 is down from 65 per cent in 1987–90.

49On the advantages of borrowing from banks (expertise, purity of interests, access to advice, interests in stable markets and resources etc.) see B. G. Carruthers and T. C. Halliday, Rescuing Business: The Making of Corporate Bankruptcy Law in England and the United States (Clarendon Press, Oxford, 1998) ch. 4.

50Cosh and Hughes 2007, pp. 51–3, noting that, compared to the 1997–9 survey, there had been a slight increase in resort to banks and a significant increase in approaches to venture capital firms.

hire purchase/leasing firms, 15.9 per cent; partners and shareholders, 6.5 per cent; factoring businesses, 5.5 per cent; other sources, 7.3 per cent; other private individuals, 2.6 per cent; venture capitalists, 4.4 per cent and trade customers, 0.9 per cent. These figures show a decline in bank finance compared to a similar 1997–9 analysis (from 61.2 per cent to 56.9 per cent), a doubling of factoring (from 2.6 to 5.5 per cent); a more than tripling of venture capital funding (from 1.3 to 4.4 per cent); and a drop in hire purchase/leasing sources (from 22.7 per cent to 15.9 per cent).

Banks thus remain the main providers of credit for SMEs, with more borrowing by term lending than through overdrafts. In the early 1990s the Bank of England expressed concern at the dependence of small businesses on overdraft facilities for purposes other than working capital: for example, to finance long-term business expansion.51 There has been, since that time, a drift away from overdraft borrowing in favour of term loans. Term lending in 2003 amounted to over £38.9 billion and borrowing on overdrafts was around £9.1 billion. By the end of 2003, overdrafts made up only 23 per cent of small firms’ borrowings compared to 25 per cent at the end of 2002.52 The Bank of England has, nevertheless, acknowledged that the overdraft will ‘always be important to small businessmen as a flexible source of working capital’.53

Certain kinds of borrowing seem, additionally, to be size dependent. Findings reported in 2007 suggested that micro-companies use venture capital, HP/leasing and factoring significantly less frequently than larger firms and resort to banks more often.54

A significant source of SME working capital has been factoring and invoice discounting and, as noted, financing through factoring more than doubled between 1997–9 and 2002–4.55 An area of modest uptake

51 Se e Ba nk o f England, Finance for Small Fi rms , Si x th Rep or t (Bank of E (‘Bank of England 1999’) p. 17.

52Bank of England 2004, p. 11.

53Bank of England 1999, p. 18. In 2002–3 the overall level of overdraft lending rose marginally on the previous year: see Bank of England 2004, p. 11.

54See Cosh and Hughes 2007, p. 55.

55Ibid., pp. 53–5. Factoring, as noted above, is the purchase by the factor and the sale by a company of book debts on a continuing basis, usually for immediate cash. The sales accounting functions are then provided by the factor who manages the sales ledger and the collection of accounts under the terms agreed by the seller. The factor may assume the credit risk for accounts within agreed limits (non-recourse) or this risk may be retained by the seller. Invoice discounting is the purchase by the discounter and the sale by the company of book debts for immediate cash. The sales accounting functions are retained by the seller and the facility is usually provided on a confidential basis. See Hewitt, ‘Asset Finance’. Fraser (2004) suggests that more than half of SMEs use invoice

82 the context of corporate insolvency law

from SMEs, however, is equity financing, where the evidence is that around 6 per cent of external financing to small businesses in the 2002–4 period involved equity56 and earlier work suggested that only a third of businesses were even prepared to consider equity financing.57 There are reasons why smaller enterprises face constraints in using equity to raise finance.58 First, markets may be reluctant to supply funds in return for equity because they see a willingness to give up equity as a sign of either the equity seller’s low confidence in levels of anticipated returns or their having exhausted their ability to raise debt finance. Second, raising equity may be expensive for smaller firms, compared to their larger brethren, because the transaction costs will be relatively high for small investments. Third, investors will want to research the risks involved but, for smaller investments, the costs of such research will be proportionately higher than with larger deals and this may prove offputting – as may the higher risks posed by smaller companies.

Funding in the UK by the venture capital/private equity industry grew by 28 per cent in 2005 to £6.8 billion (from £5.3 billion in 2004)59 though figures for 2002–4 suggest that venture capital supplied only 4.4 per cent of total SME finance from external sources.60 Of total informal venture capital investment, business angel activity, on official figures, makes up only a small proportion.61 Raising funds through the provision of venture capital often involves investments in high-risk ventures (typically with new companies) and the investor will usually demand a significant equity stake in the enterprise. The expected return is accordingly of capital gain rather than merely income from dividends. Venture capital is frequently used as a

discounting and two in five use factoring. In 2008, £16.4 billion was advanced against invoices in the UK: see n. 244 below.

56Cosh and Hughes 2007, p. 56.

57British Chamber of Commerce, Small Firm Survey No. 24: Finance (July 1997).

58See Cosh and Hughes 2007, p. 48.

59See British Venture Capital Association (BVCA) Annual Report 2006 (London, May 2006).

60See Cosh and Hughes 2007.

61In 1998–9 around £20 million was invested by business angels in UK companies: Bank of England 2001, p. 5. In 2005 about £29 million was invested in 180 businesses by participating members of the trade association: see BVCA Annual Report 2006. The amount of informal lending by business angels is, however, difficult to quantify since most such angels act anonymously. One estimate is that the UK has 18,000 business angels investing around £500 million annually: see C. Mason and R. Harrison, ‘Public Policy and the Development of the Informal Venture Capital Market’ in K. Cowling (ed.), Industrial Policy in Europe: Theoretical Perspectives and Practical Proposals

(Routledge, London, 1999). See also A. Belcher, Corporate Rescue (Sweet & Maxwell, London, 1997) pp. 133–4.

source of finance for management buyouts (MBOs) and may well involve the supply of business skills as well as funds.62

Credit arrangements such as overdrafts, bank loans, trade credit, leasing and hire purchase can be resorted to by firms of all sizes. Large companies, however, are able, in addition, to secure credit by making use of the capital markets and trading in a huge variety of financial instruments and forms of debt.63 Thus, use can be made, inter alia, of bonds, loan stock, syndicated loans, mezzanine finance, notes and securitisation. A bond64 involves a contract in which the bondholder lends money to a company and the company agrees to make a series of interest payments (‘coupons’) until the bond matures – commonly in between seven and thirty years’ time. They are usually secured by either fixed or floating charges against the firm’s assets. Bonds are tradeable in secondary markets in a variety of arrangements and larger, creditworthy companies are able to use not only domestic bond markets but the foreign bond and the Eurobond markets. Foreign bonds are bonds that are denominated in the country of issue where the issuer is non-resident65 and Eurobonds (or ‘international bonds’) are bonds that are traded outside the country of the denominated currency. ‘Syndicated loans’ are bank loans that spread credit provision across a number of banks, with the originating bank usually managing that syndicate. These loans are normally tradeable in a secondary market. ‘Mezzanine’ debt offers a high risk / high return mix and may be either secured or unsecured but it will rank below senior loans. It constitutes hybrid financing when it offers lenders a mix of debt and equity and is described as subordinated, intermediate or low grade because it ranks for payment below straight debt but above equity.66 It is a device that is useful to companies when bank borrowing limits are reached and the firm cannot, or is unwilling to, issue further equity. The term ‘mezzanine finance’ has, in recent years, tended to be used to refer to high yield / high risk debt that is private rather than gained through a publicly traded bond. Such privately based financing has grown rapidly over the last twenty years and has proved especially attractive to fastgrowing companies in the communications and media sectors.67

62See Belcher, Corporate Rescue, pp. 131–3.

63For a concise outline see Arnold, Handbook of Corporate Finance.

64The terms ‘bond’ and ‘loan stock’ are often used interchangeably.

65So that in Japan, bonds issued by non-Japanese companies and denominated in yen (for example, for interest and capital payments) are foreign bonds: see Arnold, Handbook of Corporate Finance, p. 430.

66Ibid., p. 415. 67 Ibid., p. 416.