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Sources of business financing and financing practices: A comparison among U.S. and Asian countries
EXECUTIVE
FORUM
SOURCES OF BUSINESS FINANCING AND FINANCING PRACTICES:
A COMPARISON AMONG U.S. ANDAsIANcouNTRIEs CHONG LI CHOY National
University of Singapore
INTRODUCTION Lack of financing has traditionally been cited as a major problem facing small and medium businesses across the world. Indeed, this is probably still a major complaint of many such firms today. At the same time, there is little doubt that much money is available for investment in high-growth business ventures, but too few small and medium businesses qualify for such financing. Banks, too, are keen to lend money to businesses, but they are certainly not keen to have businesses default on their loans. Thus, there is always a conflict between the need of small and medium businesses for financing and the need of banks and investors to ensure the safety of their loans and investments. The pertinent question that needs to be answered is: “How does one increase financing opportunities and venture successes at the same time?’ This would certainly be ideal both for the ventures who needs financing but do not qualify, and for the financers (investors and lenders) who cannot find sufficient quality business ventures in which to invest or to whom they would lend money. This forum outlines an ongoing research project that compares the similarities and differences in the sources of financing for business enterprises in three East Asian countries and the United States. It is evident that business financing is influenced by the environment and often does more than just finance the business concerned. Certain financing practices in East Asia, as well as in the United States, that may have achieved the ideal of increasing financing opportunities and venture successes simultaneously, are also discussed. I wish to thank Dr. Ian C. MacMillan for his encouragement and valuable assistance in the preparation of this paper, which was written during the author’s stay as a research fellow at the Sol C. Snider Entrepreneurial Center of the Wharton School, the University of Pennsylvania. Address correspondence to Ian C. MacMillan, Sol C. Snider Entrepreneurial Center, 402 Vance Hall, 37th and Spruce Streets, Philadelphia, PA 19104-6374. Journal of Business Venturing 5, 271-275 0 1590 Elsevier Science Publishing Co., Inc., 655 Avenue of the Americas, New York, NY 10010
271
272
c.L.CHOY
SELF-FINANCING Throughout the world, self-financing is probably the most important source of start-up capital. The financing is normally accumulated from the wealth or savings of the entrepreneur. It can also derive from personal loans from banks or other sources, or from the mortgage or sale of personal properties or assets. In China, self-financing is normally possible only for people who have some additional income derived from the sale of their products or services in the marketplace. Interestingly enough, most of these people are rural folk who have their own agricultural products to sell in the marketplace. Family support is also particularly important in China, particularly in farm families that are able to meet the basic needs of the family member who stops working on the land to become an entrepreneur. Another important group with disposable funds is managers whose incomes would allow them to save some funds. Of course, those who have previous businesses or work on their own may also invest their profits or earnings in a new venture.
THE INFORMAL SECTOR AND CONNECTIONS Across the world, the ability of entrepreneurs to raise financing for their businesses can depend very much on their network of relationships or connections with people who can help obtain funds. This is true of almost every society, although there are obviously considerable differences among societies. Family members and friends are the most common sources of financing. In Chinese and Japanese societies, where the family is more closely knit (as is also true of many communities in the United States), borrowing from family members or just getting money from them to start a business is very common. Connections and loose friendships can also lead to other sources of financing outside one’s family members and immediate circle of friends. In China, where relationships seem to take precedence over rules, the right connections can mean the availability of scarce funds from government banks and even venture funds. One might also obtain a business license in the same manner, which almost inevitably leads to profits because of the scarcity of products in the market. Even in the United States, the right connections can lead to financing from “angels,” the informal venture capitalists. Other sources of financing for new enterprises from the informal sectors are moneylenders and tontines or huays (an informal banking system which is described below). Of course, there are such sources of funds as goods supplied on credit terms, and advanced payments for goods and services yet to be supplied. The relationship of the entrepreneur with the persons involved in the granting of such credit or advances is again crucial; these are important sources of funds everywhere, including China.
TONTINES OR HUAYS The huay is an informal system of banking commonly found among Chinese and other Asian communities. It normally involves a group of persons who each subscribe to one or more shares in a common fund through the payment of a fixed (usually monthly) subscription. Each month, beginning with the first month and continuing through to the last, depending on the number of shares subscribed to, a member or tbe owner of one share will be allowed to utilize all of the funds collected for that month. In order to get access to the fund for each month, all eligible members who are interested have to make a bid with a premium that the member is willing to pay the group (as a form of interest) for using the fund first.
BUSINESS FINANCING: U.S. VS. ASIAN COUNTRIES
273
The member who makes the highest bid will then have access to the fund for that month. Unless the member has more than one share, this will be the last bid allowed for that member. When all eligible members have completed their turns in getting the funds, the huay terminates. Evidently, the last person who gets to use the fund will not need to pay any premium (or interest) for its use. He or she will also benefit most from the premiums paid by other members.
BANKS Once again, throughout the world, loans from banks for business financing are generally available to those with a good track record. Most businesses that can show evidence of their capability to repay loans will normally qualify for bank loans. Generally, businesses in the growth stage face few problems when borrowing from banks. However, in China, banking practices are also considerably affected by political circumstances and administrative rules, as well as other social factors, such as personal relationships. Many countries currently have small-business development banks or similar institutions to help small businesses. Taiwan, for instance, has such a development bank. While softer and easier loans may be helpful to some new businesses, the combination of too few small businesses qualifying for bank loans coupled with too many small businesses defaulting on their loans is still the main problem. A Taiwanese innovation designed to solve this dual problem, and the solutions that can be found in the Japanese banking system, are particularly interesting here.
BANK LENDING TIED TO CONSULTANCY The work of the Small Business Integrated Assistance Centre in Taiwan is extremely interesting. This entity helps small and medium businesses, particularly those that are faltering, to transform their management and business practices so that they can qualify for bank loans. These faltering businesses are normally referred to the centre by their bank. Upon successful transformation of their management and practices (under the guidance of the Centre’s consultants), these businesses will again qualify for bank loans. In this way, the small businesses are helped, while the bank reduces the number of bad loans and increases the number of good customers. Of course, this Centre has been created with the support of banks and with key personnel borrowed from banks.
BANK LENDING THAT PROVIDES STABILITY AND NETWORKING FOR CONSULTANCY AND OTHER ADVANTAGES The system of bank lending in Japan is particularly interesting. Banks lending to businesses are often invited to take a small percentage of shares (normally not more than 5%) of these businesses. This is not a must, but is a common practice. The small- or medium-sized business essentially becomes part of the banking group’s network of business firms, which often enables it to obtain consultancy and other assistance both from the bank and from its related firms. At the same time, the small- or medium-sized business gains a more secure feeling about its bank loan. All of these are obviously advantageous to the business concemed-giving rise to considerable stability and increasing others’ confidence in the business. It should also be noted here that the laws in Japan do not allow banks to mn other kinds of businesses, thus eliminating the feat that the small businesses may be taken over by their banks.
274
C.L. CHOY
VENTURE CAPITAL Another source of financing, which is spreading from the United States to Asia, particularly among high-growth firms (which are also high-tech), are venture capital funds. Venture capital is becoming increasingly important, given the increasing numbers of high-tech firms being created as a result of the technological revolution that is taking place. Nevertheless, most venture capital companies prefer to invest in a firm that is already in its growth stage, preferably just before its public listing on the stock market. This is probably the safest method of investment, also yielding the fastest returns. In the United States, the venture capital industry is probably much more experienced than it is in East Asian countries, including Japan, where it is relatively new. Japanese venture capital firms are mostly related to major banking groups and insurance companies. In Taiwan, venture capital has to contend with the problem of an underdeveloped stock market and tough criteria for public listing of companies. In China, it is just another government fund to help finance high-tech ventures. However, in Japan, the system of venture selection for financing, as practiced by certain venture capital firms, is very consistent with Japanese business culture. The Japanese system may also offer a solution to the dual problem of too many ventures requiring financing and too few qualifying for it. Similarly, the practice of a few venture capitalist firms in the United States may also offer a solution to the above problem. Both of these practices are highlighted below.
SEED CAPITAL THAT COMES WITH NEEDED BUSINESS EXPERTISE AND CONNECTIONS Another interesting phenomenon can be seen in the practices of certain Japanese venture capital firms. True to the Japanese business culture, these venture firms will select a venture project (or enterprise) for financing, predominantly on the basis of tbe qualities of the entrepreneur. Once selected, the venture firm will work together with the entrepreneur to set up the firm, recruit people with sufficient expertise, and provide the necessary consultancy-networking with other firms as well as other agencies. The prior existence of a good business plan and a highly experienced management team is not the primary consideration. Obviously, this selection method makes many more venture projects eligible for financing than there are when financing availability is limited to those with sound business plans and an expert leadership and management team. It should also be noted that most venture capital in Japan is tied to established banks and insurance companies, which, evidently, are able to provide not only credibility to the new venture but also good business connections. Venture capital firms in the United States also help the entrepreneur assemble the necessary management team and the necessary expertise in addition to providing seed capital, but this is normally part of the condition for financing, rather than postfinancing, assistance. Consultancy assistance, business contacts, and even marketing assistance may sometimes be available through the venture capital firm. However, most venture capital firms will agree to financing only when everything is established, and few (probably less than 5% of the venture capital firms in the United States) will provide this kind of management assistance (in terms of gathering a competent management team).
GOVERNMENT FINANCING ASSISTANCE It is important to note here that most governments today do give some form of financial assistance to support some of their small businesses (whether these be in the form of grants, soft loans, subsidies, tax rebates, or holidays). However, these schemes will not be discussed
BUSINESS FTNANCING: U.S. VS. ASIAN COUNTRIES
here. Whether or not this financing assistance on the society and government concerned.
is achieving
275
its purpose depends very much
INCUBATOR!3 One important form of assistance originating in the United States (with profitable participation in the private sector) is the new-business incubator, an extremely efficient vehicle for helping new businesses. A considerable savings of costs derives from the shared premises and facilities enjoyed by businesses situated in an incubation center. In cases in which the government provides the building, or if a government grant pays for all or a part of the premises, rental costs are likely to be lower. In addition, these businesses can also enjoy both management and technical consultancy services provided by the management of the center. Finally, the small firms are assisted in their applications for access to financing and other assistance, whether these be to venture capitalists, government agencies, or other organizations. Another advantage of incubators is the very real possibility that the different businesses tenanted in the same center might be able to support one another and to give business to one another. What is of interest here is the fact that a comprehensive business package, including management and technical consultancy, as well as financing, is provided here. Lower costs also mean lesser financing, which is extremely helpful to new firms. This will increase the new businesses’ chances of success and make them safer candidates for financing.
CONCLUDING REMARKS The obvious lesson that can be drawn from the highly successful operations of the Small Business Integrated Assistance Centre in Taiwan, the successful partnership of small and medium businesses in Japan with their banks, the success of incubator centers in the United States, and the practices of certain venture capital firms in Japan and the United States, in their provision of seed capital, is that there is considerable scope for cooperation and partnership between the providers of business financing, their clients, and potential clients. Both lenders and investors have a common interest in the success of their clients; the success of their client businesses is success for tbe financing organizations. The provision of needed consultancy to client businesses by financing organizations (and even involvement in the management of these businesses) may prove to be not only helpful to the clients, but extremely prudent for financing organizations.
FORUM
SOURCES OF BUSINESS FINANCING AND FINANCING PRACTICES:
A COMPARISON AMONG U.S. ANDAsIANcouNTRIEs CHONG LI CHOY National
University of Singapore
INTRODUCTION Lack of financing has traditionally been cited as a major problem facing small and medium businesses across the world. Indeed, this is probably still a major complaint of many such firms today. At the same time, there is little doubt that much money is available for investment in high-growth business ventures, but too few small and medium businesses qualify for such financing. Banks, too, are keen to lend money to businesses, but they are certainly not keen to have businesses default on their loans. Thus, there is always a conflict between the need of small and medium businesses for financing and the need of banks and investors to ensure the safety of their loans and investments. The pertinent question that needs to be answered is: “How does one increase financing opportunities and venture successes at the same time?’ This would certainly be ideal both for the ventures who needs financing but do not qualify, and for the financers (investors and lenders) who cannot find sufficient quality business ventures in which to invest or to whom they would lend money. This forum outlines an ongoing research project that compares the similarities and differences in the sources of financing for business enterprises in three East Asian countries and the United States. It is evident that business financing is influenced by the environment and often does more than just finance the business concerned. Certain financing practices in East Asia, as well as in the United States, that may have achieved the ideal of increasing financing opportunities and venture successes simultaneously, are also discussed. I wish to thank Dr. Ian C. MacMillan for his encouragement and valuable assistance in the preparation of this paper, which was written during the author’s stay as a research fellow at the Sol C. Snider Entrepreneurial Center of the Wharton School, the University of Pennsylvania. Address correspondence to Ian C. MacMillan, Sol C. Snider Entrepreneurial Center, 402 Vance Hall, 37th and Spruce Streets, Philadelphia, PA 19104-6374. Journal of Business Venturing 5, 271-275 0 1590 Elsevier Science Publishing Co., Inc., 655 Avenue of the Americas, New York, NY 10010
271
272
c.L.CHOY
SELF-FINANCING Throughout the world, self-financing is probably the most important source of start-up capital. The financing is normally accumulated from the wealth or savings of the entrepreneur. It can also derive from personal loans from banks or other sources, or from the mortgage or sale of personal properties or assets. In China, self-financing is normally possible only for people who have some additional income derived from the sale of their products or services in the marketplace. Interestingly enough, most of these people are rural folk who have their own agricultural products to sell in the marketplace. Family support is also particularly important in China, particularly in farm families that are able to meet the basic needs of the family member who stops working on the land to become an entrepreneur. Another important group with disposable funds is managers whose incomes would allow them to save some funds. Of course, those who have previous businesses or work on their own may also invest their profits or earnings in a new venture.
THE INFORMAL SECTOR AND CONNECTIONS Across the world, the ability of entrepreneurs to raise financing for their businesses can depend very much on their network of relationships or connections with people who can help obtain funds. This is true of almost every society, although there are obviously considerable differences among societies. Family members and friends are the most common sources of financing. In Chinese and Japanese societies, where the family is more closely knit (as is also true of many communities in the United States), borrowing from family members or just getting money from them to start a business is very common. Connections and loose friendships can also lead to other sources of financing outside one’s family members and immediate circle of friends. In China, where relationships seem to take precedence over rules, the right connections can mean the availability of scarce funds from government banks and even venture funds. One might also obtain a business license in the same manner, which almost inevitably leads to profits because of the scarcity of products in the market. Even in the United States, the right connections can lead to financing from “angels,” the informal venture capitalists. Other sources of financing for new enterprises from the informal sectors are moneylenders and tontines or huays (an informal banking system which is described below). Of course, there are such sources of funds as goods supplied on credit terms, and advanced payments for goods and services yet to be supplied. The relationship of the entrepreneur with the persons involved in the granting of such credit or advances is again crucial; these are important sources of funds everywhere, including China.
TONTINES OR HUAYS The huay is an informal system of banking commonly found among Chinese and other Asian communities. It normally involves a group of persons who each subscribe to one or more shares in a common fund through the payment of a fixed (usually monthly) subscription. Each month, beginning with the first month and continuing through to the last, depending on the number of shares subscribed to, a member or tbe owner of one share will be allowed to utilize all of the funds collected for that month. In order to get access to the fund for each month, all eligible members who are interested have to make a bid with a premium that the member is willing to pay the group (as a form of interest) for using the fund first.
BUSINESS FINANCING: U.S. VS. ASIAN COUNTRIES
273
The member who makes the highest bid will then have access to the fund for that month. Unless the member has more than one share, this will be the last bid allowed for that member. When all eligible members have completed their turns in getting the funds, the huay terminates. Evidently, the last person who gets to use the fund will not need to pay any premium (or interest) for its use. He or she will also benefit most from the premiums paid by other members.
BANKS Once again, throughout the world, loans from banks for business financing are generally available to those with a good track record. Most businesses that can show evidence of their capability to repay loans will normally qualify for bank loans. Generally, businesses in the growth stage face few problems when borrowing from banks. However, in China, banking practices are also considerably affected by political circumstances and administrative rules, as well as other social factors, such as personal relationships. Many countries currently have small-business development banks or similar institutions to help small businesses. Taiwan, for instance, has such a development bank. While softer and easier loans may be helpful to some new businesses, the combination of too few small businesses qualifying for bank loans coupled with too many small businesses defaulting on their loans is still the main problem. A Taiwanese innovation designed to solve this dual problem, and the solutions that can be found in the Japanese banking system, are particularly interesting here.
BANK LENDING TIED TO CONSULTANCY The work of the Small Business Integrated Assistance Centre in Taiwan is extremely interesting. This entity helps small and medium businesses, particularly those that are faltering, to transform their management and business practices so that they can qualify for bank loans. These faltering businesses are normally referred to the centre by their bank. Upon successful transformation of their management and practices (under the guidance of the Centre’s consultants), these businesses will again qualify for bank loans. In this way, the small businesses are helped, while the bank reduces the number of bad loans and increases the number of good customers. Of course, this Centre has been created with the support of banks and with key personnel borrowed from banks.
BANK LENDING THAT PROVIDES STABILITY AND NETWORKING FOR CONSULTANCY AND OTHER ADVANTAGES The system of bank lending in Japan is particularly interesting. Banks lending to businesses are often invited to take a small percentage of shares (normally not more than 5%) of these businesses. This is not a must, but is a common practice. The small- or medium-sized business essentially becomes part of the banking group’s network of business firms, which often enables it to obtain consultancy and other assistance both from the bank and from its related firms. At the same time, the small- or medium-sized business gains a more secure feeling about its bank loan. All of these are obviously advantageous to the business concemed-giving rise to considerable stability and increasing others’ confidence in the business. It should also be noted here that the laws in Japan do not allow banks to mn other kinds of businesses, thus eliminating the feat that the small businesses may be taken over by their banks.
274
C.L. CHOY
VENTURE CAPITAL Another source of financing, which is spreading from the United States to Asia, particularly among high-growth firms (which are also high-tech), are venture capital funds. Venture capital is becoming increasingly important, given the increasing numbers of high-tech firms being created as a result of the technological revolution that is taking place. Nevertheless, most venture capital companies prefer to invest in a firm that is already in its growth stage, preferably just before its public listing on the stock market. This is probably the safest method of investment, also yielding the fastest returns. In the United States, the venture capital industry is probably much more experienced than it is in East Asian countries, including Japan, where it is relatively new. Japanese venture capital firms are mostly related to major banking groups and insurance companies. In Taiwan, venture capital has to contend with the problem of an underdeveloped stock market and tough criteria for public listing of companies. In China, it is just another government fund to help finance high-tech ventures. However, in Japan, the system of venture selection for financing, as practiced by certain venture capital firms, is very consistent with Japanese business culture. The Japanese system may also offer a solution to the dual problem of too many ventures requiring financing and too few qualifying for it. Similarly, the practice of a few venture capitalist firms in the United States may also offer a solution to the above problem. Both of these practices are highlighted below.
SEED CAPITAL THAT COMES WITH NEEDED BUSINESS EXPERTISE AND CONNECTIONS Another interesting phenomenon can be seen in the practices of certain Japanese venture capital firms. True to the Japanese business culture, these venture firms will select a venture project (or enterprise) for financing, predominantly on the basis of tbe qualities of the entrepreneur. Once selected, the venture firm will work together with the entrepreneur to set up the firm, recruit people with sufficient expertise, and provide the necessary consultancy-networking with other firms as well as other agencies. The prior existence of a good business plan and a highly experienced management team is not the primary consideration. Obviously, this selection method makes many more venture projects eligible for financing than there are when financing availability is limited to those with sound business plans and an expert leadership and management team. It should also be noted that most venture capital in Japan is tied to established banks and insurance companies, which, evidently, are able to provide not only credibility to the new venture but also good business connections. Venture capital firms in the United States also help the entrepreneur assemble the necessary management team and the necessary expertise in addition to providing seed capital, but this is normally part of the condition for financing, rather than postfinancing, assistance. Consultancy assistance, business contacts, and even marketing assistance may sometimes be available through the venture capital firm. However, most venture capital firms will agree to financing only when everything is established, and few (probably less than 5% of the venture capital firms in the United States) will provide this kind of management assistance (in terms of gathering a competent management team).
GOVERNMENT FINANCING ASSISTANCE It is important to note here that most governments today do give some form of financial assistance to support some of their small businesses (whether these be in the form of grants, soft loans, subsidies, tax rebates, or holidays). However, these schemes will not be discussed
BUSINESS FTNANCING: U.S. VS. ASIAN COUNTRIES
here. Whether or not this financing assistance on the society and government concerned.
is achieving
275
its purpose depends very much
INCUBATOR!3 One important form of assistance originating in the United States (with profitable participation in the private sector) is the new-business incubator, an extremely efficient vehicle for helping new businesses. A considerable savings of costs derives from the shared premises and facilities enjoyed by businesses situated in an incubation center. In cases in which the government provides the building, or if a government grant pays for all or a part of the premises, rental costs are likely to be lower. In addition, these businesses can also enjoy both management and technical consultancy services provided by the management of the center. Finally, the small firms are assisted in their applications for access to financing and other assistance, whether these be to venture capitalists, government agencies, or other organizations. Another advantage of incubators is the very real possibility that the different businesses tenanted in the same center might be able to support one another and to give business to one another. What is of interest here is the fact that a comprehensive business package, including management and technical consultancy, as well as financing, is provided here. Lower costs also mean lesser financing, which is extremely helpful to new firms. This will increase the new businesses’ chances of success and make them safer candidates for financing.
CONCLUDING REMARKS The obvious lesson that can be drawn from the highly successful operations of the Small Business Integrated Assistance Centre in Taiwan, the successful partnership of small and medium businesses in Japan with their banks, the success of incubator centers in the United States, and the practices of certain venture capital firms in Japan and the United States, in their provision of seed capital, is that there is considerable scope for cooperation and partnership between the providers of business financing, their clients, and potential clients. Both lenders and investors have a common interest in the success of their clients; the success of their client businesses is success for tbe financing organizations. The provision of needed consultancy to client businesses by financing organizations (and even involvement in the management of these businesses) may prove to be not only helpful to the clients, but extremely prudent for financing organizations.