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Financial engineering


It's a combination of various financial instruments aiming at allowing enterprises access to external funding sources. They can be clustered in 4 major groups: grants, loans, equity and guarantees. Most countries/regions are also offering tax holidays.

Written by Christian Saublens

Reviewed by David Walburn

 

The concept

How to implement it?

Step in the RIS process

What can be expected?

A quote

References

Experts' comments

 

The concept


The concept covers a wide range of tools. Hereafter is a review/definition of the most common ones:

  • Business angels (informal venture capital): private individuals who invest part of their estate in start-ups in the form of venture capital and also contribute their personal managerial expertise.
  • Business Angels Networks (BANs): standing regional platforms that promote the matching of business angels with potential investees.
  • Buyouts: existing investors’ shares in a business are bought by the latter’s own management team (MBO – Management Buy Out) or by another management team supported by a venture capital fund.
  • Corporate venturing: venture capital invested by existing firms for the purpose of funding innovative businesses set up by their own staff or active in industries considered of strategic importance.
  • Crowdfunding: a process whereby a large number of individuals – generally web users – fund a project via a personal contribution in the form of equity or a loan.
  • Development or expansion capital: financing provided for the growth and expansion of a company, which may or may not break even or trade profitably. Capital may be used to: finance increased production capacity; market or product development; provide additional working capital.
  • Early stage (or start-up) finance: equity invested in businesses that are past research and development but need additional funding to market their products and services.
  • Equity: ownership interest in a company, represented by the shares issued to investors.
  • Expansion: growth, bridging or restructuring capital.
  • Factoring: a technique whereby SMEs sell invoices to specialised firms.
  • Financial package: a combination of different funding sources.
  • Grants: subsidies paid—without an obligation to refund—by public authorities to companies investing in a region for the purpose of facilitating their establishment or expansion.
  • Growth accelerator: an advisory and matching platform where tech start-ups and investors meet to allow businesses to access financial resources, new markets and specialist expertise.
  • Investment readiness: set of advice given to to entrepreneurs in order to better prepare them to meet with potential investors.
  • Leasing: hire-purchase of capital goods.
  • Loans and debt: the main sources of funding for SMEs offered by banks. Today some peer-to-peer crowdfunding platforms are active in this field.
  • Mezzanine: combination of equity and loans. Applicable interest rates are often comparatively high.
  • Microcredit: small loans given to an entrepreneur, sometimes an unemployed person, to start a business. The EU Progress Initiative allows up to EUR25,000 per project.
  • Proof of concept: finance provided to a researcher’s team to support the validation of their business ideas. Often, the financial instrument takes the form of a grants and subortinated loans.
  • Quasi-equity investment instruments: instruments whise return for the holder (investor/lender) is predominantly based on the profits or losses of the underlying target company, are unsecured in the event of default and/or can be convertible into ordinary equity.
  • Replacement capital (also called secondary purchase): Purchase of existing shares in a company from another private equity investment organisation or from another shareholder or shareholders - an investor buys another’s stake.
  • Risk capital: Equity and quasi-equity financing to companies during their early-growth stages (seed, start-up and expansion phases) in the hope of a return on investment (ROI) that is both large and speedy, on a par with the level of risk taken.. It includes: (1) informal investment by business angels; (2) venture capital; (3) alternative stock markets specialised in SMEs and high-growth companies.
  • Seed capital: Financing provided to study, assess and develop an initial concept. It precedes the start-up phase. Seed capital is required to fund a business project before the product or service is marketed. Seed capital is often pivotal in high-tech projects to allow businesspersons to conduct market and technology surveys as well as research and development on prototypes that will become companies’ core business.
  • Start-up capital: Financing provided to companies for product development and initial marketing. Companies may be in the process of being set up or may already exist, but have not sold their product or service commercially and are not yet generating a profit.
  • Venture capital: Investment in unquoted companies by investment funds (venture capital funds) that, acting as principals, manage individual, institutional or in-house money. It includes early-stage and expansion financing, but does not include replacement finance and buy-outs.

 

How to implement it?


Public authorities can earmark budget to provide direct funding to SMEs in case of grants or to provide means to interesting intermediary or private organizations to implement the tools (equity, guarantees, loans, …). Think in terms of value chains in order to ensure that investors can exit or recover their money from another type of investors and are able to reinvest in other projects. Hereafter is a mapping of such a value chain.

 

Step in the RIS process


5. Definition of a coherent policy mix, roadmaps and action plan.

 

What can be expected?


A comprehensive regional value chain.

 

A quote


"Entrepreneurs and public stakeholders have to be aware that each funding tool has a specific role to play during the enterprise life cycle." - Rudy AERNOUDT, Principal economist European Commission

 

References


EURADA – All Money is not the Same

 

Mr Christian Saublens


 

Christian Saublens has more than 30 years of working experience in European trade organizations. Since 1992 he is the Executive Manager of EURADA, the European Association of Development Agencies, a network of 145 organisations. Christian has been involved in the organization of numerous conferences and meetings dealing with all matters related to regional development. He wrote several papers and working documents on business support schemes for SMEs. He played an important role for the dissemination in European regions of concepts such as benchmarking, business angels, investment readiness, proof of concept, clusters, open innovation, financial engineering, crowdfunding, … Several times Christian has been appointed as an expert by the European Commission and the Committee of the Regions.

christian.saublens@eurada.org

 

Experts' comments


Public policy has had a concern to ensure an adequate and suitable supply of finances to small and medium-sized enterprises (SMEs) for many decades, suggesting a realisation of the importance of growing SMEs to the health of modern economies. It should come as no surprise that the list of tools and programmes in these notes is long and involves the participation of both public and private sectors.

The problem for regional stakeholders is to identify which of the programmes are appropriate to their particular circumstances. Additionally there is also the danger of a pressure to have a bit of everything from wide range of policies on the assumption that this will produce maximum advantage.

The toughest challenge for smaller business in the current economic crisis is the difficulty in obtaining bank loans. For the vast majority of small firms loan finance is vital to normal operations, even when their growth prospects are modest. It follows that interventions from development agencies to improve the availability of loans should probably be the highest priority right now, with a much greater importance than is suggested in just the single item on the long list in the main body of this paper. A multi-faceted approach to doing this is likely to have the greatest impact:

  • helping firms to meet the more stringent conditions imposed by the banks, to become, in effect, more “investment-ready”
  • exploring other forms of secured loans such as factoring and leasing
  • attempting to set up alternative sources of loan funding with the region, maybe using municipal reserves, the resources of high net worth individuals, and crowd funding to help fill the gaps[1]
  • using local political leadership, and the considerable leverage potential of municipalities within the local and regional economy, to bring any stakeholders, including the banks, who might have a contribution to make to ease the situation of cash-starved small firms, into coordinated activity to achieve that end

The provision of micro loans and grants to very small firms is also an area which requires higher priority in the current tough economic times. Where paid employment is unavailable, the option of starting a business, maybe just a one-person enterprise, can be a means of getting back into economic activity for many people. Development agencies and local authorities can make a major contribution to making finance available to facilitate this process, again involving regional stakeholders in the manner already suggested above.

The provision of equity finance for small firms which have the capacity for high growth was once seen as the major issue for public policy in economic development. National governments provided large amounts of finance for this purpose, and set up special purpose companies and funds, often with banks and other private sector partners. There was mixed success. In recent times a more flexible approach has been taken with the considerable growth in business angel activity, encouraged and incentivised by government, as well as niche funding aimed especially at high tech firms, and university spin-out enterprises.

These trends are much more suited to the practical capabilities of regional economic development. Business angels are usually the most appropriate equity source for the type of deal flow likely to be generated in most regions. They are flexible in their criteria, bring their own expertise along with their funding, and do not require a high or steady volume of deals to sustain their interest and activities. Being regionally based, business angels may also be partly motivated by regional loyalty and identification, particularly during troubled economic times. Most regions outside capital or major city locations would be unable to sustain large venture capital firms and institutions. Almost all regions could set up and support a business angel capability, as well as collaborate with a crowdfunding platform including the ones specialised in peer to peer lending for start-ups.

 

Mr David Walburn


After a career in business David Walburn joined Greater London Enterprise in 1986 where he was responsible for venture capital and other small business support, before becoming Chief Executive of the organisation. He was the Chair of the London Business Angels Network and played a key role in the setting up of the European Business Angels Network. He has worked with the UK government and the European Commission on developing public policy initiatives to improve the financing of small and medium-sized enterprises. He was the Chair of Capital Enterprise, the umbrella body for organisations supporting micro business development in London, until 2012.

For the last ten years he has been a Visiting Professor at London South Bank University where he headed the Local Economy Policy Unit and was the managing editor of the journal Local Economy.

He has served as President of EURADA, and been a member of a number of advisory bodies of the European Commission.  He has been an active member of the International Economic Development Council in Washington DC and has a wide range of international contacts with economic development organisations.

He continues to write and lecture on small business finance and regional economic development.

davidwalburn@london.com

 


[1] This may seem a very radical suggestion, but in times of crisis new tools of financial engineering are needed. Relying on tools that worked when finance was relatively plentiful will no longer do. Development agencies need to innovate too.

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