Need for Bootstrapping in SMEs in the Context of Global Financial Crisis - Coursework Example

Bootstrap finance Contents Bootstrap finance Introduction 3 Need for Bootstrapping in SME’s in the context of global financial crisis 5 Background 5 Impact of the crisis 5 Strengthening investment measures 10 Bootstrapping necessities 10 Reference List 13 Introduction It is important for every business to estimate the development and start up costs involved. As a matter of fact, there is every possibility to start a small business with little capital (Neugebauer and Spies, 2012). Bootstrapping is the activity, which can enable a business to start-up with a small amount of capital. It provides an entrepreneur with the advantage of spending the capital amount as per his capacity. The business functions without any external support and within the means available. Entrepreneurs can, therefore, assist the business to be less wasteful and more resourceful. Bootstrapping enables production of cost effective services and products (Abdulsaleh and Worthington, 2013). Bootstrapping refers to a situation, where an entrepreneur starts business with personal finances and without any help from external sources (Van Auken, 2013). Any individual is said to be bootstrapping if he attempts to develop a company through personal finances or operating revenues of the new organisation. Compared to the venture capital, this activity provides greater benefits to entrepreneurs as they can have reasonable amount of control over a number of business decisions (Van Auken, 2013). At the same time, bootstrapping can create unnecessary risk for an entrepreneur. There are millions of small companies who bootstrapped at some point of time. For instance, the founders of Hewlett-Packard expanded the business from a garage in California. Companies such as, Sony, Motorola, Disney and Microsoft, were also involved in bootstrapping (Neugebauer and Spies, 2012). A number of studies showed that small business enterprises mostly obtain the initial capital from family, personal savings and friends, as opposed to the external sources. The study conducted by Harvard University related to the Inc 500 companies had pointed out that almost 80 percent of them were initiated with personal fund of the founder (Neugebauer and Spies, 2012). The fastest growing firms needed a modest amount of $1000 and the slow growing ones required lesser capital (Neugebauer and Spies, 2012). With an initial infusion of a small amount of capital, there are several businesses that have the capacity to sustain for a longer period of time after development of a product or service, which has the potential to bring in heavy cash flows. Advantages of Bootstrapping There are a number of advantages attached to bootstrapping. These can be highlighted as follows: 1) Saves time required to recognise suitable areas for raising funds. 2) The entrepreneur has the freedom to control business operations without being liable to the external investors. 3) As the business is void of excess money, the entrepreneur is able to spend wisely and manage operations more efficiently; so, the practice of optimal usage of the funds can be continued even in during financially favourable conditions. 4) The business becomes more customer-focussed as a majority of the funds are gathered from the customers, instead of the investors. 5) The company owner can gain huge profit on the event of exit due to absence of investors (Neugebauer and Spies, 2012). Disadvantages of Boot strapping Similarly, there a number of disadvantages associated with the activity of bootstrapping. These can be explained as follows: 1) As the entrepreneurs use their assets in case of bootstrapping, they are more prone to risk of increased debt on failing to continue the business effectively. 2) The business that requires a large amount of capital cannot be supported with bootstrapping. 3) A company takes considerable time to grow, if devoid of any investments. Consequently, the business will not earn any money for an extended period of time. 4) There lies the chance of business failure, if the marketing and product development are not sufficiently strong within a limited period of time. 5) Competitive strategies like, better marketing and out-staffing of the competitors, can push a weak entrepreneur out of the market, even before initiation (Van Auken, 2013). Need for Bootstrapping in SME’s in the context of global financial crisis Background Small business enterprises are a source of economic growth to every nation. They provide opportunities to a large number of people. They are responsible for introducing innovative products and services in the market place as well as generating a number of job opportunities. The financial institutions had supported growth of the small and medium scale industries, until the housing bubble burst in 2007 (Newman, Borgia and Deng, 2013). The small enterprises struggled to gain a foothold in the market after the crisis. They then had least access to credit facilities provided by the banking institutions. Impact of the crisis Fall in liquidity and revenue The global economic crisis has brought along severe complications to a number of countries. There were several survey findings that rightfully confirmed that the global financial crisis had constrained the availability of trade finances to the importer and exporters in the developing countries (Newman, Borgia and Deng, 2013). However, a number of firms stated that the drop in demand was an area of major concern, unlike the trade finance. The unavailability of the revenues from export created pressure on the cash flow of these enterprises, thereby limiting their ability to fund the trading transactions. Given that SMEs have a lower bargaining power and capital base as compared to the global banks, they were more affected by the crisis. Several SMEs that operated in the auto industry were majorly affected by the financial crisis. They faced severe constraints in terms of reduction in the buyer’s liquidity and export revenues (Newman, Borgia and Deng, 2013). Also during the crisis, the SMEs needed to provide more insurance and guarantees to the stakeholders which were difficult in a down-trodden situation. Demand shock, payment delays and insolvencies The survival and growth of small sector enterprises (SMEs) are largely affected by an increasing number of challenges, which could be mitigated through self-financing activities. The inability to gain proper access to finance has increased incapability of the SMEs to sustain in the market. The problem is further exacerbated by the economic and financial crisis. A double shock is witnessed by the SMEs in the form of tightening terms of credit and fall in demand for the goods and services (Newman, Borgia and Deng, 2013). Countries such as, Chile, Korea, New Zealand, the United Kingdom, the United States and Japan, reported on the low demand margin of SMEs (Newman, Borgia and Deng, 2013). The self-employed had the least businesses expectation. The sectors that witnessed a considerable amount of fall in demand are the automotive supplies, construction, manufacturing, semi-conductors, exports and the wholesale. There was an endemic shortage of working capital due to increase in the delays of trade receivable and inventories. The number of insolvencies, hence, had a rapid escalation. The results of a survey conducted reflect that in Belgium, about 43 percent of the SMEs faced delays in trade (Rösch and Scheule, 2013). In Belgium, the amount of delays in payments for a period of six days increased from 4.8 percent to 29.5 percent. Almost 50 percent of the SMEs in Netherlands had to deal with longer terms of payment from the customers (Fatoki, 2014). The severity of these problems worsened the condition of SMEs and affected the cash flows. The number of bankruptcies heightened with a drastic reduction in sales of the SMEs. The number of insolvencies pertaining to the small sector enterprises in Europe increased by 11 percent between 2007 and 2008 (Newman, Borgia and Deng, 2013). In countries such as, Italy, Ireland, Denmark, Spain and Norway, the rise in corporate insolvencies was more than 25 percent. Moreover, several reports also suggested that solvency issues related to the small firms was 17 percent higher than that of the bigger ones (Hogan and Hutson, 2011). The viable SMEs were undergoing unnecessary bankruptcy owing to dearth in the working capital. Figure 1: Indications of the magnitude of demand shock (Source: D. David and N. David, 2013) Credit conditions The small enterprises are assumed to be facing major problems in securing long-term external finance, which primarily restrained their growth and development. The tightening of the conditions, based on which loan was provided to the SMEs, was adequately visible for all clients of the banks. The stringent conditions for providing credits to enterprises was formulated due to weak liquidity position, inability to access capital, more risk in collateral and expectations associated with the recession of banks. The conditions of the financial institutions in the United States were worse. The rules for lending were not too stringent in France and Germany (Newman, Borgia and Deng, 2013). The lending activity of the banks had declined in general and more for the SMEs as compared to the larger firms. The credit facilities provided by banks to the small and medium scale enterprises increased from $308 million in 1994 to $659 billion in 2008; but the slump was drastic in 2011 (Fatoki, 2014). There was almost 18 percent drop in the bank’s lending facility for the SMEs. The banks attempted to reduce the exposure to risk after the financial crisis. Lending small ventures was considered to be more risky for the banks. Since the SMEs rely on financial institutions for funds, they were exposed to the impact of downturn in the global economy. Banks started charging very high interest rates from the small enterprises. The credit tightening was rigorous and the rates of interest continued to increase, regardless of the central banks’ effort to ease the monetary policy. The economic circumstances drained out all financial sources for the small and medium industries. The second round of financial repercussions was more severe and was difficult to evade. There were a number of foreign owned banks functioning in Africa, which started relocating their liquidity to the home economy (Price, Rae and Cini, 2013). This resulted in the losses to Africa wherein the bank was located. The appetite for risk within the investors to make profit during the period of boom had diminished following the global economic downfall, thereby lowering the possibilities to obtain funds for the SMEs. The situation in a number of countries worsened due to the fast fiscal degeneration of the governments in different countries. This was because of fall experienced in revenues obtained from the exports made (Price, Rae and Cini, 2013). It had become necessary for the government of various nations to borrow; but as there was decline in the risk taking activities of investors, they were left with the only choice of selling debt in the domestic markets. Due to lack of funds available, the governments minimized lending activities in respect to the SMEs. Therefore, instead of being the most dynamic sector, the SMEs were the first to be knocked out by any severe external shock (Price, Rae and Cini, 2013). This particular sector is regarded as the most sensitive segment, which is worst affected by economic recession. Figure 2: Tightening of credit standards for SME’s by banks (Source: Carraher and Van Auken, 2013) The above figure displays the following facts: 1) SMEs had reduced their investments in projects, which were financed by credit. 2) The demand for short-term loans and working capital had fallen in few countries. 3) The lending policies of banks were tightened for all the enterprises and not solely for the SMEs. 4) The cost and spread to all clients were substantially increased in several financial intermediaries and banks. The European Central Bank increased their spreads dramatically for small loans in 2008. The motive behind the exceptional rise in interest rate spreads was partially intended to ease the effects of monetary policy (Kumar and Maheswaran, 2014). SME’s demand for credit The reduction in the demand of credit for acquisition and investment purposes was quite significant. The entrepreneurs related to several SMEs were more frustrated with the stringent credit conditions in comparison with the fall in demand for their goods and services. Almost 56 percent of the small enterprises in Australia had experienced rigidity associated with borrowing of funds (Mason, Michie and Wishlade, 2012). In 2008, the condition of Netherlands had worsened as one out of every five SMEs was seeking additional funds. On the contrary, Canada had reported that one out of every four SMEs operating in the country was underfinanced. Also, 80 percent of SMEs in Spain had experienced problems in accessing financial support (Malmström, 2014). Then again, in countries such as, New Zealand and Finland, more than 10 percent of the small and medium enterprises faced complications while obtaining investment funding and working capital (Divakaran, Shariff and McGinnis, 2014). The situation indicated that the entrepreneurs were not willing to increase their levels of debt, despite delays in payment and steep fall in the sales. The reaction was quite rational as the enterprises had to confront severe credit conditions imposed by the creditors and banks. Figure 3: Demand for credit in the United States (Source: Barakova and Palvia, 2014) Strengthening investment measures Many SMEs had withheld their plans of investment due to the bleak prospects and falling sales. The demand for long-term borrowing had significantly decreased. In order to help the SMEs to retain their competitive edge in medium-term and remain ready for the upturn, the governments tried to incorporate certain measures (Price, Rae and Cini, 2013). The measures were primarily undertaken in the form of strengthening the capital base and developing product capacities of the SMEs. The governments decided to provide the SMEs with tax incentives and specific funding provisions like, grants or credits. Nonetheless, the extent to which the government originally intervened and made the desired changes is uncertain. As a result, it was important for the SMEs to take appropriate decisions related to financing in order to sustain in the market. The economic situation had forced the small and medium industries to be self-dependent. Bootstrapping necessities The financial crisis had affected the small and medium industries significantly. The credit conditions formulated by banks were greatly stringent. It was worthless to pay huge rates of interest for the small enterprises. Hence, bootstrap finance was the most suitable mode for funding the SMEs. The small and medium enterprises began to be increasingly dependent on the bootstrapping activities as a means for meeting the need for resources. Most small business managers handled the need for resources by way of using means other than external financing. They applied different kinds of financial bootstrapping methods, thereby effectively meeting the need for funds without relying on long-term external capital from the debt holders or new owners. The global recession had left the start-up entrepreneurs with no other option, but to self-financing through usage of own assets (Manolova, Manev and Gyoshev, 2013). Bootstrap financing was consequently the only option for the SMEs to avail. This financing technique had helped the SMEs to overcome the problems encountered following the crisis. The small and medium enterprises were able to derive several benefits from the bootstrap finance. These can be listed as follows: 1) Improved cash flow- Setting up the small and medium enterprises was the best choice for the entrepreneurs as they did not need to depend on the banks for availing credit. The entrepreneurs only had to initiate business with the least amount of funds and assets. With an initial hiccup, the SMEs had managed to grow significantly through self-financing measures (Price, Rae and Cini, 2013). 2) Retain more control- The entrepreneurs who suffered during the economic downfall experienced more autonomy in business. They were devoid of financial worries and took decisions that favoured business. They had the freedom to incorporate the best decisions for improving product and customer relations (Moradi-Motlagh, Valadkhani and Saleh, 2014). 3) Increase in profit- The profit margins of the SMEs increased through the bootstrap financing measures. There were greater cash inflows, following a meagre amount of investment. These enterprises had become hardly dependent on banks. Hence, the SMEs were able to grow successfully, without the help of external financing, at the verge of economic downfall (Moro and Fink, 2013). 4) Interest payment- The SMEs that had utilised the method of bootstrap financing did not have to pay interest for the loans taken, thereby enabling the entrepreneurs to save considerable amount of funds. Entrepreneurs who have employed this mode of financing during the economic crisis were required to be less liable to the banks and other financial institutions (Moro and Fink, 2013). 5) Increase in exports- The resources generated from the business and investors were utilised by the owners in order to earn revenue. The revenues were in turn utilised for expansion of the business. Hence, generation of revenue through exports were no longer a problem for the SMEs after the bootstrapping activities were initiated (Moon and Sohn, 2010). The global economic crisis had forced the SMEs to utilise bootstrap financing for starting and retaining the business. In this manner, the SMEs were able to overcome the financial and economic crises. It enabled the small and medium scale companies to revive from the initial down-trodden situation. The SMEs no longer needed to depend on the banks and other financial institutions for funding new ventures. There are a number of companies who bootstrapped while commencing business and were able to transform into a huge enterprise with proper usage of the funds. Hewlett-Packard can be cited as the best example in order to portray success of a bootstrapped firm. The economic crisis had forced a number of firms to opt for the self-financing activity, which in turn greatly reduced their debt and interest margins. Therefore, through bootstrap financing, the SMEs had flourished without depending on the banks (Visscher, Thompson and Haley, 2008). Reference List Abdulsaleh, A. M. and Worthington, A. C., 2013. Small and Medium-Sized Enterprises Financing: A Review of Literature. International Journal of Business and Management, 8(14), p36. Barakova, I. and Palvia, A., 2014. Do Banks’ Internal Basel Risk Estimates Reflect Risk? Journal of Financial Stability, pp. 67. Carraher, S. And Van Auken, H., 2013. The use of financial statements for decision making by small firms. Journal of Small Business & Entrepreneurship, 26(3), pp.323-336. David, D. and David, N., 2013. The role of finance in the development of technology-based SMEs: evidence from New Zealand. Journal of Entrepreneurship, Business and Economics, 1(1/2), pp. 82-100. Divakaran, S., Shariff, M. and McGinnis, P. J., 2014. Private equity and venture capital in SMEs in developing countries: the role for technical assistance. World Bank Policy Research Working Paper, pp. 6827. Fatoki, O., 2014. The Financial Bootstrapping Methods Employed by New Micro Enterprises in the Retail Sector in South Africa. Mediterranean Journal of Social Sciences, 5(3), pp. 72. Hogan, T. and Hutson, E., 2011. Understanding the start-up funding process in venture capital-backed and non-venture capital-backed firms. Entrepreneurship, Growth and Economic Development, pp. 69. Kumar, D. and Maheswaran, S., 2014. Are major global stock markets efficient? An application of the martingale difference hypothesis with wild bootstrap. American Journal of Finance and Accounting, 3(2), pp. 217-233. Malmström, M., 2014. Typologies of bootstrap financing behavior in small ventures. Venture Capital, 16(1), pp. 27-50. Manolova, T. S., Manev, I. M. and Gyoshev, B. S., 2013. Friends with money? Owner’s financial network and new venture internationalization in a transition economy. International Small Business Journal, pp. 45. Mason, C., Michie, R. and Wishlade, F., 2012. Access to finance in Europe’s disadvantaged regions: Can ‘new’financial instruments fill the gap? EoRPA Regional Research Consortium Paper, pp. 12(6). Moon, T. H. and Sohn, S. Y., 2010. Technology credit scoring model considering both SME characteristics and economic conditions: The Korean case. Journal of the Operational Research Society, 61(4), pp. 666-675. Moradi-Motlagh, A., Valadkhani, A. and Saleh, A. S., 2014. Rising efficiency and cost saving in Australian banks: a bootstrap approach. Applied Economics Letters, pp.1-6. Moro, A. and Fink, M., 2013. Loan managers’ trust and credit access for SMEs. Journal of Banking & Finance, 37(3), pp. 927-936. Neugebauer, K. and Spies, J., 2012. Borrowing locally, operating globally? Financing and trading patterns of firms during the economic crisis, pp.47. Newman, A., Borgia, D. and Deng, Z., 2013. How Do SMEs with Single and Multiple Owners Finance Their Operations Differently? Empirical Evidence from China. Thunderbird International Business Review, 55(5), pp. 531-544. Price, L., Rae, D. and Cini, V., 2013. SME perceptions of and responses to the recession. Journal of Small Business and Enterprise Development, 20(3), pp. 484-502. Rösch, D. and Scheule, H., 2013. Forecasting Mortgage Securitization Risk under Systematic Risk and Parameter Uncertainty. Journal of Risk and Insurance, pp. 1-24. Van Auken, H., 2013. Influences on frequency of preparation of financial statements among SMEs. Journal of Innovation Management, 1(1), pp. 143-157. Visscher, P. M., Thompson, R. and Haley, C. S., 2008. Confidence intervals in QTL mapping by bootstrapping. Genetics, 143(2), pp. 1013-1020. Read More