With the help of a bickering bunch of businessmen and bankers, the DTI has produced an excellent best practice guide on capital investment.
The Department of Trade and Industry official who chose the businessmen and bankers who produced the department's best-practice guide on capital investment, Money & Machines, did too good a job. According to one account the early meetings of the steering group were characterised by bickering, precisely reflecting the continuing spat that was going on between the two sides outside in the real world. The industrialists accused the bankers of short-termism and lack of financial support for small and medium-sized businesses. The bankers gave as good as they got.
'There was a fair bit of antagonism,' says Malcolm Kelly, managing director of Warwick-based valve manufacturer Integrated Hydraulics. 'We started off throwing stones at one another but gradually we got to understand each other's problems, the banks making the case that they are custodians of the public purse. We on the other hand are industrialists and entrepreneurs and we tend to gamble a bit more.' Having worked their way from confrontation to rapprochement the bankers and industrialists haven't resolved all their differences but they have come up with a document which gets the issues out in the open and offers some practical advice. Stuart White, head of small business at the Midland Bank, who also sat on the steering group, thinks it should at least get everyone on the same wavelength.
'The guide's first two chapters are for the banker because they say how the business owner arrives at the required figure and the second two chapters are for the benefit of the business owner - they say what the bankers are going to want when they have finished their evaluation of the investment.' The guide is being published at an opportune moment. The indications are that small and medium-sized businesses - roughly speaking those with turnovers between £1 million and £10 million and up to 500 employees - are investing heavily again after several very lean years when they didn't want to take the risk. They were afraid that the economy might collapse again leaving them stranded with new machinery that had nothing to do.
The latest industrial trends figures from the Confederation of British Industry, generally regarded as an accurate measure of industrial health, show that both small and medium-sized companies are now significantly more optimistic about the levels of investment. In both categories the 'balance' of companies expecting to invest more over the next year than they did in the previous 12 months has been positive since the beginning of last year. For the previous four years - from April 1989 - the balances had all been negative.
Keith Lewis, managing director of the west Midlands-based Newby Foundries, a typical medium-sized business, confirms what the statistics show. He and other industrialists in the Midlands have clearly been much more confident about investing recently.
'For the first time for a long time we're seeing stable conditions that are going to give a bit more long-term confidence,' says Lewis. 'People are seeing the likelihood of a more stable trading environment and they've seen the likelihood of more stable low interest rates and low inflation. Packaged together these will stimulate confidence about capital investment and the regeneration of industry.' That is a major contrast to the uncertainties which have dogged business, particularly small business, when the economy has been more up and down.
'Historically,' says Lewis, 'industry's problem has been stop/go. We've had busy order books for about 18 months then we've gone into a decline. Usually we're caught on the wrong side of the hump. We've started to invest then suddenly somebody's pulled the skids out from under us, there hasn't been the business activity and people have got equipment that they've invested in but can't get any payback on. Smaller companies have caught a cold at such times because the banks have started to pull up the drawbridge, started foreclosing just at the time they need support. They're fair-weather friends.' This, from the businessman's perspective, is the crux of the matter. Small and medium-sized companies often feel that when the going gets tough, which is precisely the point at which they need to feel the security of the bank around them, their friendly bank manager can't be seen for dust.
These negative feelings are still evident even now that there is more stability and confidence around. The belief of businessmen that the banks are fair-weather friends is a symptom of another even more basic belief - that bankers don't think like businessmen. They don't have the same kind of mind-set or share the same values, say the critics. It is as though they see themselves as somehow being set apart from the rest of business, tending to the financial needs of business but not part of it.
Lewis compares the attitudes of British bankers with those of their counterparts in Germany and Japan.
'The German banks tend to run more as a partnership with industry and look at it as an investment and a risk in the same way as we do. Our banks tend to stand at arm's length. They'll find you the money and where trading is good and your profits are good they're quite happy, but as soon as they see any sign of problems they're always prepared to leave you holding the baby.' This sense that the banks do not have an identity of interest or even of approach with business is widespread. But if businessmen think that bankers don't understand what makes them tick, the feeling is reciprocated. At bottom, say the bankers, businessmen simply don't understand how banks work. What they need to appreciate is the brutal arithmetic of banking. In simple terms, if the bank lends somebody £10,000 at 3% over base rate and the company goes bust the bank loses its £10,000 and any administrative costs (though it may be able to realise collateral to offset at least some of the loss). If, on the other hand, the bank lends a businessman £10,000, the business takes off and a year later he's a millionaire, the bank still only gets 3%. It may have to share failure but doesn't share pro rata in success.
Analysts point to other difficulties. One of the most obvious is 'information asymmetry', which is really just a way of saying that, where small business is concerned, the information that prospective borrowers and lenders have is not comparable. The assumption is that the business owner has more and better information about the performance of his business than the bank does. The banks, aware of this, counter their disadvantage by being extremely cautious and sometimes by charging higher rates because of the higher perceived risk. Bankers and businessmen, then, may seem to be galaxies apart, but the people who sat on the DTI steering group think the exercise should give them a chance to get closer.
The report starts from two basic assumptions: first, that the reason many initial applications for investment finance fail is because the investor doesn't explain the project well enough; second, that the finance providers may fail to grasp all the benefits that the investment will bring to a firm. Start to address those weaknesses - by businessmen, for example, learning how to prepare workmanlike business plans for the bankers to scrutinise, something many of them seem curiously reluctant to do, and by bankers immersing themselves more in manufacturing - and at least some of the misunderstandings and some of the antagonism may disappear.
There's a lot of work and improvement needed on both sides, says Midland's Stuart White.
'It's all about effective two-way communication. The business owner needs to be far more skilled in communicating what it is he's doing and how he's doing it and the bankers need to be far more skilled in communicating what it is they are expecting of their customers in return for making the loan available.
'The message of Money & Machines from the customer's perspective is: do your homework. Not only should they be looking at what equipment they should be buying, but at how it will be used, what the cost of funding it all will be, and what contribution it will make to the bottom line. They need to do their own evaluation, do a SWOT (strengths, weaknesses, opportunities and threats) analysis and make sure it's beneficial for the business.' The tragedy up to now, says White, is that while small and medium-sized businesses have always presented their products to their customers in an exceptional manner they don't seem to appreciate the need to sell their 'business' to their bankers in the same way.
From the banker's point of view, he suggests, the best advice is: make sure that the most appropriate type of finance is provided.
'In other words don't give them an overdraft to buy a machine (overdrafts are for working capital); don't lend them money over 10 years if the useful life of the machine is only six, because it will stop contributing to its own upkeep. Where necessary the banker may have to be a little innovative in finding a financial package that makes it possible for the business to be successful while at the same time giving the bank some comfort.' Is all the extra effort justified? The chances are we won't know until the next bout of economic squalls hit us. That's when new friendships will really be tested.
Money for Capital Investment
The different forms of funding to mix and match
There are five main sources of money for capital investment, suggests the DTI guide Money & Machines. Often a company will want to mix and match, putting together funds from different providers.
Internal funds: some firms fund their investments almost entirely from retained earnings. Where companies are looking for external finance their internal funds may still be used for things like working capital, or for small (less than £100,000) or short-term (less than two years) investments.
Debt finance: overdraft finance is not usually the most appropriate way of funding capital investment. Overdrafts are better for working capital needs. Term loans offer a repayment period related to the life of the project and to cash-flow projections. Long-term loans are normally for projects with a lifetime of 10 or more years, medium-term loans are usually for three to 10-year projects. Mortgage loans, secured against specific assets, are mainly used for buying property.
Hire purchase and leasing: both are often used to buy capital items. The availability of this sort of finance will depend on your creditworthiness and whether or not the asset can be sold if you do not keep up the payments - best then for a marketable asset with a long life. This form of finance is extremely flexible.
Equity and development capital: often sought by companies with plans for growth or with a high level of debt. Equity investors take a minority stake in the business and take little part in the management. Banks tend not to take equity stakes and businesses are reluctant to take the equity route because of fears about losing control.
Factoring and invoice discounting: regarded as a flexible form of working capital but not as a way of raising money for capital investment. In factoring, the debts are sold to the source of funds who also collects the debts.
Exploding the myth that banks fail the smaller fry
Evidence that the banks are failing small and medium-sized businesses in the provision of finance is largely anecdotal. There have been plenty of horror stories in the press, but researchers are by no means convinced that the problem amounts to what economists would call a market failure in the provision of finance.
Professor David Storey, director of the Small and Medium Sized Enterprise Centre at Warwick University, says that, in most circumstances, there is no market failure.
'Not everybody gets the money that they want at the price that they want, but then not everyone gets Rolls Royces at the price they want and you don't regard that as having been a market failure in the provision of Rolls Royces simply because everyone doesn't get one. Research suggests that in most circumstances most viable businesses should get appropriate access to the finance. Comparatively few people are denied and in most circumstances those people who are denied are simply deemed to be uncreditworthy. In most circumstances most businesses get most of the money they want.' There are some partial exceptions, notably the funding of high-technology businesses.
According to Storey, 'The most recent research, as yet unpublished, says that when you talk to business owners in the high-technology field those businesses which are most likely to have reported constraints on their growth through lack of access to finance are the most technologically sophisticated.' Part of the problem appears to be that bankers feel they are out of their depth when it comes to high technology. Ironically, research shows that if one takes a sample of 50 high-technology companies and 50 low-technology ones, the high-technology ones will significantly outperform the low.
Navigating the right court for a sea change
Navico, a Margate-based maker of navigational and communications equipment for boats, has a turnover of more than £6 million and has grown rapidly over the past three years. It has spent several hundred thousand pounds on new capital equipment like the surface mount placement machines that are used to put components on circuit boards. Much of the investment comes from retained earnings but Navico uses lease-purchase deals where the investment is in a visible solid asset which has a resale value. It uses a flexible overdraft but not term loans.
Co-founder Alan Wrigley says the company has a good relationship with its present bank, National Westminster, but had a much less satisfactory one with NatWest's predecessor, whose services were dispensed with a year ago.
'We were forced to change banks. Banks work in a cyclical pattern and they seem to lag behind what's going on. When the economy is down they're still lending. But then, when the economy starts to pick up they're suddenly reacting to all the losses they've picked up from elsewhere. The result is that, just as you're trying to expand, they don't want to help.' The pleasantest surprise for Navico, says Wrigley wryly, is that the bank official sent along from NatWest really seemed to understand manufacturing.