Finance pathways for young innovative small‐ and medium‐size enterprises: A demand‐side examination of finance gaps and policy implications for the post‐global financial crisis finance escalator

• Author: David Deakins,Robyn Owen,Maja Savic
• Date: 01 January 2019
• Published date: 01 January 2019
• DOI: http://doi.org/10.1002/jsc.2243

RESEARCH ARTICLE

Finance pathways for young innovative small- and

medium-size enterprises: A demand-side examination

of finance gaps and policy implications for the post-global

financial crisis finance escalator

Robyn Owen

1

| David Deakins

2

| Maja Savic

3

1

Centre for Enterprise and Economic

Development Research, Middlesex University

Business School, London, United Kingdom

2

Entrepreneurship and Strategy Department,

Lancaster Management School, Lancaster

University, Lancaster, United Kingdom

3

Centre for Enterprise and Economic Develop-

ment Research (CEEDR), Middlesex University

Business School, London, UnitedKingdom

Correspondence

Robyn Owen, Centre for Enterprise and

Economic Development Research, Middlesex

University Business School, The Burroughs,

Hendon, London NW4 4BT, United Kingdom.

Email: r.owen@mdx.ac.uk

Funding information

Department for Business, Energy and Industrial

Strategy (BEIS)

Abstract

The paper addresses the persistent finance gaps facing young, innovative SMEs, by examining

the financing pathways of 40 UK businesses in a post global financial crisis (GFC) environment.

Using a unique combination of finance escalator and resource-based view theories four proposi-

tions are tested by examining: (i) early and growth stage development; (ii) innovation R&D

investment horizons; (iii) the management resource base; (iv) finance gaps and their implications.

The paper finds that successful financing strategies are emerging, using a mix of bootstrapping,

collaboration and new emerging post-GFC finance escalator funding, which is heavily reliant on

government interventions. It also pinpoints remaining finance gaps and the need for more cohe-

sive financing and support policy to address these.

KEY SENTENCE

Young, innovative U.K. small- and medium-size enterprises are develop-

ing successful financing strategies, using a mix of bootstrapping, collabo-

ration, and new emerging post-global financial crisis finance escalator

funding, which is heavily reliant on government interventions, but finance

gaps still persist requiring more cohesive financing and support policy.

1|INTRODUCTION

In the aftermath of the 2007–2008 global financial crisis (GFC), many

governments focused their policies on financing innovation as a key

driver for economic recovery (Lee, Sameen, & Cowling, 2015; Lerner,

2010; Mazzucato & Penna, 2014; OECD, 2012; Wilson & Silver,

2013). Numerous studies have examined the supply-side finance

policy offer, but relatively few have considered the demand-side

(Eurostat, 2011; Lee et al., 2015; Mina, Lahr, & Hughes, 2013). Even

fewer have adopted a qualitative approach (North, Baldock, & Ullah,

2013) which is required to understand business financing demand-

side processes, decisions, and deficiencies, despite many requesting

this (ERC, 2014; Lee et al., 2015; Mason & Kwok, 2010).

This article addresses the persistent problem of finance gaps for

early and growth stage innovative businesses through a qualitative

demand-side studyof 40 U.K. businesses, exploring their“pathways”to

external finance and including: first, their external financing require-

ments between 2011 and 2014; second, their processes of accessing

external finance to find out why they succeed or fail; and third,where

they fail, how they overcome this. The study focuses on technology-

based businesses with high-growth market potential and differentiates

between shorter and longer horizon innovation cycles, which may

impact on access (North et al., 2013). Furthermore, a unique pathway

methodology is developed to explore supply- and demand-side factors

by bringing together theoretical elements of the business financing

cycle (Berger& Udell, 1998) using a finance escalatormodel and a man-

agerial resource-based view (RBV) relating to human and social capital

(Barney, 1991).The article aims to explain demand-sidefailure, pinpoint

supply-sidefunding gaps, and provide policyguidance.

The policy rationale for assisting innovativeearlier stage businesses

is supported by two key arguments. First, an established correlation

with economic growth, associated with large-scale econometricstudies

in developed economies (Lerner, 2010; Lerner & Tag, 2013). Recent

international studies (Coad & Rao, 2010; Demirel & Mazzucato, 2010,

DOI: 10.1002/jsc.2243

Strategic Change. 2019;28:19–36. wileyonlinelibrary.com/journal/jsc © 2019 John Wiley & Sons, Ltd. 19

2013; Mina et al., 2013) suggest that their economic contribution is

nuanced, favoring R&D with formal intellectual property (IP) protection

and skewed by a few “superstar”high-growth firms. Since Birch (1979)

highlighted small- and medium-size enterprises (SMEs) as job genera-

tors, governments have been preoccupied with finding and supporting

the high-growthSMEs which generatethe majority of new jobs (OECD,

2002). U.K. policy has been spurred by evidence for a “vital 6%”of

SMEs that generate over half of new U.K. employment (ERC, 2014;

NESTA, 2009b

1

), allied to thepotential role that younginnovative SMEs

could play in this(North et al., 2013). Second, since thediscovery of the

MacmillanCommittee’s (1931) financing gap, it is recognized that young

innovative businesses encounter information asymmetries in the mar-

kets for finance (Hsu, 2004; Hughes, 2009) due to insufficient trading

records and intangible knowledge-based assets. This can make them

too risky for debt finance and prohibitively expensive for equity inves-

tors to undertake sufficient due diligence for the relatively small

amounts of finance they require, providing a rationale for government

intervention(Lerner, 2010; Murray,2007).

The need for governments to address the persistent gap in early

stage innovation financing was heightened during the post-GFC envi-

ronment. Business finance became more expensive and difficult to

obtain in manycountries due to bank credit rationingand the retreat to

more secure later-stage equity investing (Eurostat, 2011; Wilson &

Silver, 2013), leading to widely held observations that difficulties in

raising external finance for young innovative SMEs were particularly

exacerbated and to a proliferation of government interventions. In the

United Kingdom, many considered that the finance escalator (NESTA,

2009a) for these businesses was broken (Gill, 2010; Lee et al., 2015;

Mason, Jones, & Wells, 2010; North et al., 2013). This paralleled

U.K. Coalition Government’s(2010–2015) efforts to rebalance the

economy (HM Treasuryand BIS, 2011), with greater focus on advanced

manufacturing and high value export services where young innovative

SMEs were perceivedas an important driver to post-GFC growth.

The article comprises three main sections. First, a theoretical dis-

cussion in relation to innovation, finance, and the business develop-

ment cycle, how this relates to the evolving post-GFC U.K. finance

escalator model and the crucial role that management experience and

the business resource base including external support and networking

can play. Second, the research methodology and key findings are set

out. Finally, the implications of the findings for policy, theory, and fur-

ther research are discussed.

2|DEFINING INNOVATION

SME innovation can broadly be defined as the commercial exploita-

tion of ideas (DTI, 1998), which various studies have quantified in

terms of the scale and distribution of new or improved products, ser-

vices, and a range of business processes including improvements in

organization, structure, marketing, and activities such as R&D, training,

and acquisition of machinery and equipment linked to innovation

(e.g., BIS, 2013, 2014). However, as North, Smallbone, and Vickers

(2001) suggest, the degree of innovation in terms of its potential mar-

ket impact is crucial to this article.

This suggeststhree key innovation drivers of economicgrowth that

underpin this article. First, significant technological advances in sectors

associated with R&D expenditure, “high technology,”and patent and

trademark registrations (Bullock & Millner, 2003; Pavitt, Robson, &

Townsend, 1987; Thwaites & Wynarczyk, 1996). Second, innovation

ranges from “internally significant”where innovations are new only to

the firm itself to “externally significant”innovations which profoundly

impact on global markets, economies, and societies (OECD, 2005).

Third, the degree of innovation intensity relating to cost and duration

of the R&D innovation cycle, which progresses through initial concept,

proof of concept (PoC), prototyping, market testing, to establishing a

market presence.These factors will have varying impacts on the attrac-

tion of externalfinance, explored in the supply-sidediscussion.

3|DEMAND-SIDE FACTORS: FINANCING

PATHWAYS, A RBV

Fundamental to this article, we examine external financing require-

ments and explain theoretically why young innovative businesses may

succeed or fail to access the external finance that they require. Where

they fail, we examine factors that contribute and discuss whether

such failure can be explained through demand-side factors.

Pecking order hypothesis (PoH) (Myers & Majluf, 1984) is a com-

mon explanation for business selection (priority tendencies) for using

different types of finance, favoring internal finance over debt finance,

with equity finance and loss of ownership share being least favored,

notably by family-owned businesses (Hiebl, 2013; KPMG, 2014).

PoH may be influenced by business resource-based factors such as

managerial experience, knowledge, and the role of external advice and

information (Hirsch & Walz, 2011). Berger and Udell (1998) subse-

quently provided a balancing supply-side hypothesis by incorporating

asymmetric supply-side theory into a business finance life cycle

model, suggesting that as businesses become more established and

less opaque to financiers, a wider range of financing options become

available. Their theory underpins the finance escalator, providing a

dynamic external financing supply map for each stage of the business

development cycle. First, demand-side factors are assessed.

From a demand-side perspective, the SME externalfinancing path-

way for innovation can be viewed as stage specific, within the course

of the business cycle (Churchill & Lewis, 1983), and resource based in

assessing external finance requirements and seeking access. External

finance is defined as outside the existing investor base (typically foun-

ders, family, and friends) and retained surplus for reinvestment. This

requires a fusion of the pathway steps taken to consider financing

requirements and the RBV which seeks to explain why actions are

taken. Koryak et al. (2015) review entrepreneurial leadership and SME

growth, suggesting that the elements of growth capabilities involving

management leadership, team diversityof human capital, organizational

skills, strategicnetworking and venturing, anddynamic absorptive capa-

bilities are key factors in growth, but that more needs to be known

about how they operate,particularly in relationto accessing finance.

1

ERC (2014) noted that NESTA's original data excluded microbusinesses (<10

employees), updating U.K. evidence for 2008–2013, and found a “vital 1%”of

“growth champions”with 0–50 employees generated 36% of net new

employment.

20 OWEN ET AL.