It's not all about Tech - Canberra's figuring out Innovation, Jobs and Growth but what about Finance?

It is very encouraging that in this year’s "Australian Innovation System Report" the Department of Industry, Innovation and Science has focused on the businesses that succeed the most, referred to as “high-growth firms” (HGFs). Well done!

"Australian HGFs make a disproportionate economic contribution compared to other firms. About 11,000 businesses, mostly Medium-Sized Businesses (20-199 staff, median turnover of $8 million) but also some larger corporates, were responsible for about 46% of new jobs between 2004/05 and 2011/12.
The growing policy interest in HGFs has given rise to a number of myths, including that HGFs are all high-tech firms or that HGFs are all small and young. In fact, international evidence suggests remarkable diversity in the HGF population ... HGFs can be found in every industry, size and age cohort.
Most growth firms are in established sectors, often providing well-established products in new or more efficient ways."

So as well as supporting earlier stage businesses, Australia needs to get behind our established  businesses and help them grow. This will really move the needle on job creation.

The report found that "improving access to finance, particularly for innovation-active SMEs, would further support the growth of innovative and disruptive firms. In 2015–16, 21-27% of innovation-active SMEs reported lack of additional funds as a barrier to innovation."

The report claims that access to debt finance is not a problem, pinpointing equity finance as the key issue. We're not so sure about this. It is possibly due to years of conditioning of expectations by our mortgage banks where real estate is clearly required to get access to core debt funding.

We think that access to Core Working Capital facilities is a critical issue for High Growth Firms. To grow any business, you need capital, particularly working capital in 21st century Australia where services dominate the economy. 

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What kind of company is driving Jobs and Growth in Australia?

Most growth firms are in established sectors, often providing well-established products in new or more efficient ways. As reported, between 2004–05 and 2011–12:

  • Firms with high-growth in employment (Employment HGFs) represented only 9% of all firms but contributed around 46% of net positive employment growth
     
  • Firms with high-growth in turnover (Turnover HGFs) represented just 15% of firms, and contributed about 66% of the net positive sales growth and 69% of the net positive value added growth

Medium-sized firms are most numerous among HGFs, both by employment and turnover growth. They are also the second most important contributor to net growth in all three variables. Between 2004–05 and 2011–12, medium-sized HGFs contributed 18% to net positive growth in employment and sales, and 22% net positive growth in value added.

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How does this compare with other countries?

Many studies, focusing on OECD countries, have shown that 4% of firms, or perhaps fewer, create about 50% of the jobs.

The evidence suggests, however, that HGFs are not more common in high-tech sectors — HGFs are found in all sectors, and in fact they appear to be relatively under-represented in high-tech manufacturing sectors. Nevertheless, it may be that HGFs are relatively high-tech when compared to their peers within their low-tech sectors. For example, IKEA revolutionised the generally low-tech furniture industry.

A broad-based portfolio investment approach needs to be followed, however, because picking out an individual firm as a future HGF is prohibitively difficult — for investors as well as for policymakers. The evidence also shows that boosting the raw number of business start-ups will not increase the number of HGFs, because there seems to be a trade-off between quantity and quality of new firms.

HGFs play an important role, but they are not a sufficient ingredient for economic success per se — an innovation system requires other agents too, such as removing barriers to facilitate growth.

Policy considerations: Risk capital access

"Access to risk capital appears to be a major hurdle for innovative Australian businesses.
The review also found that while financial markets generally function well, access to risk capital is a constraint for Australian businesses."

At the SME end of the business size spectrum, access to risk capital appears to be a major hurdle for innovative Australian businesses. In 2015–16, between 21 and 27 per cent of innovation-active SMEs reported lack of additional funds as a barrier to innovation (Figure 6.5). The Innovation System Review also found that while financial markets generally function well, access to risk capital is a constraint for Australian businesses.

A relatively large proportion of Australian SMEs do not seek external finance, and those firms that do so are more likely to seek debt finance, rather than equity finance. In 2015–16, only 12 per cent of microbusinesses, 19 per cent of small businesses and 24 per cent of medium-sized enterprises sought debt or equity finance (Figure 6.6). Of these, around 94 per cent sought debt finance and only around 24 per cent sought equity finance. The rate of success for debt finance acquisition was in the range of 88–95 per cent. For equity finance, however, the success rate ranged between 50–53 per cent.

The types of finance sought by SMEs can have implications for their future growth and are heavily influenced by the risk profile and collateral available within the business. Recent research has found that “debt financing appears to be ill-suited for newer, innovative and fast-growing companies, with a higher-risk return profile”. A lack of funds for the higher-risk early stages of innovation may impose significant limitations on the growth potential of innovative and disruptive firms in Australia.

Furthermore, the interest rate disparity between loans to SMEs and to large firms has remained high ever since its increase during the GFC. This is likely underpinned by SMEs’ share of total outstanding loans, which increased by 4.6 percentage points between 2007 and 2015. While the average interest rate charged to Australian SMEs declined by 2.4 percentage points between 2007 and 2015, it is still high compared to most other OECD countries.

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Venture capital investment is low in Australia but the focus needs to be on small and mid-market companies

According to the Australian Private Equity & Venture Capital Association (AVCAL), between 2013 and 2016, the average Private Equity investment in a company was $41.5 million, concentrated in small and mid-market companies, while the average Venture Capital investment ($3.4 million) was focused on early stage companies. 

"There remain too many high-growth companies which are missing out on the capital and expertise they need. "

AVCAL, Australian Innovation System Report 2017

According to AVCAL, while much of the focus has been on the burgeoning start-up sector, a vital part of the national economy has remained somewhat misunderstood: the role of high-growth companies in driving an enduring value creating economic transition.

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So what do we need to do?

As reported, at the SME end of the business size spectrum, access to risk capital appears to be a major hurdle for innovative Australian businesses.

Medium-sized Businesses are well placed to move the needle on Jobs and Growth. They are in most need of support, particularly in funding growth in working capital, we find. Banks are not set up to provide finance without tangible security - they can help with equipment purchase but working capital finance needs real estate security. And the average SME 'Fintech' lender will not lend much over $100k. So there is a substantial void as 21st century services businesses, the bulk of our economy, tend to be working capital heavy and fixed asset light. And our next generation are bit short on surplus real estate!

By all means, we should encourage early stage companies and venture capital but it would be a costly mistake not to see the wider picture.

So it is time to get behind our High Growth businesses and help provide access to working capital finance. Government does not need to pick winners but it does need to fix the failure of the market to address this need. The opportunity is very significant  - this matters.