How companies are structured financially is often debated by academics. Some argue that the capital structure of the company is determined by the ‘pecking order’, while others argue that there is an optimum structure. Those favouring
However, reality is often different from the theory. Most businesses in the United Kingdom are small- to medium-sized enterprises (SMEs) often owned by families. Many of such SMEs are run on the basis that the objective is to provide their owners with sufficient profit to enable them to maintain their preferred lifestyle. Growing the business is not on the agenda as the own- ers will simply not allow their equity holding to be diluted. Expansion is, therefore, limited to that that can be generated from profits and an acceptable level of debt. An acceptable level of debt will be dependent on the personal view of each owner but the maximum amount of debt will be determined by the level of security each business is willing or capable of offering their banker.
So for SMEs, the pecking order theory has to apply. Such companies cannot determine their gearing ratio (the comparison of debt to equity) as how much capital they have is determined by how much capital they can get their hands on. Once the owners of a business have found out how much debt they can have, they have to make a decision – do I aim to grow the company and settle for equity dilution, or do I retain total control of the business and accept limited growth? Many small business owners opt for the latter and this is given as one of the main reasons why businesses fail to achieve their growth potential in the United Kingdom.
Even where equity dilution is accepted, it can be difficult for small businesses to attract equity capital. What happens is that as businesses grow they need capital investment on top of higher levels of working capital and cannot offer sufficient security to meet their escalating needs. In addition, the SME will not have grown big enough to attract capital on the equity markets. Also, the cost of raising money on equity markets, together with the additional costs of meeting the required compliance requested by those markets, means that below a certain level, such a course of action would not be viable. This was first discovered in the United Kingdom by the Committee on Finance and Industry, set up by MacDonald’s Labour government in 1929 and chaired by Lord Macmillan. This phenomenon became known as the MacMillan Gap or the Equity Gap.
Nothing much was done to alleviate the Equity Gap until 1945 when the incoming Labour government set up the Industrial and Commercial Finance Corporation (ICFC), a state-owned organisation. The setting up of this organ- isation that eventually became 3i Group plc is described fully in Coopey and Clarke (1995).
In this book, they describe the early problems found by ICFC:
In many cases the central problem was that firms could not provide an estab- lished profit record, so good judgement on the part of the investor was crucial.
In addition, the kind of expansion involved often entailed a high element of risk, since it meant investing in new, and often unproven products and markets. The risk was all the more acute because money would be tied up over a long period.
Yet another drawback was that there was little or no secondary market for any equity which ICFC might take.
What this meant, of course, was that a new paradigm had to be developed to assess young and growing companies, operating in entrepreneurial markets with no financial track record. ICFC was (due its size and capital structure) effectively the start of what is known today as venture capital, or private equity, although there had been a few privately owned venture capital houses set up before Second World War.
Despite the progress made by ICFC and others to provide capital for innovative small companies, by the late 1960s, it was obvious that many had difficulty in raising the capital needed. A government enquiry was set up and in 1971 the Bolton Report concluded that the equity gap still existed. The problems were the same; the bankers were unwilling to take risks, the cost of raising equity on the capital markets was prohibitive and financial institutions were wary of SMEs.
In the early 1970s, the incoming Labour government took the view that as the concept of free markets was not working, they had to improve the deteriorating economic position through state intervention. So the National Enterprise Board (NEB) was set up to provide venture capital to innovative SMEs, especially those set up in areas of deprivation, and to fund state takeover of larger failing businesses. Unfortunately, it was the latter that fell under media spotlight, portraying the Labour government of being akin to the then USSR, thereby putting it on the back foot. This and the ‘winter of discontent’ in the late 1970s led to the Conservatives winning the 1979 general election with Margaret Thatcher becoming Prime Minister.
In her first term, Margaret Thatcher set out to do away with state intervention
ICFC had undertaken many name changes since its formation and in the early 1990s the business was known as 3i (three i’s, with iii standing for investors in industry), but it was still state-owned. Privatising the business had proved difficult over the years, as investors were unsure about investing in what was seen as a risky option. However, the government took the plunge in June 1994, pricing the shares at 272 pence, a price that seemed a fair val- uation given that the net asset value of the business at 31 March 2004, the year end, had been 315 pence. The first day of dealings had been fixed for 18 July 1994 and soon the price of 3i plc’s shares moved above 300 pence, allowing the company to join the FTSE 100 on 19 September 1994 (Coopey et al.).
As ICFC had originally discovered, the big disadvantage for those offering venture capital was that there was no secondary market, so the investments could be realised only through a trade sale or flotation on the main stock exchange. To alleviate these problems, the Conservative government helped to set up the Unlisted Securities Market (USM) and the Business Start-up Scheme (BSS). Under BSS, high-rate tax payers could reduce their income tax liability, but the restrictions placed upon it to avoid mere tax avoidance made the scheme virtually unworkable. Accordingly, it was replaced by the Business Expansion Scheme (BES) where both income tax relief and capital gains tax relief were available.
This government action spurred on the venture capital industry and it led to the formation of the British Venture Capital Association in 1983. This organisation has hundreds of members who over the last 20 years or so have invested over £60 billion to help start-up, expand and buyout over 25 000 companies (BVCA directory 2004/5). In addition, there is also an European Venture Capital Association with members providing equity and other capital in the United Kingdom and rest of Europe.
Over the last 20 years, the tax incentives available to those investing in venture capital, or private equity, and the capital markets have changed. The BES has been replaced by the EIS and VCTs, while the USM closed down to be replaced by the AIM.