The Royal Bank of Scotland has announced its intentions to step up its efforts to lend more money to small and medium-sized enterprises (SMEs) in order to finance expansion efforts.

Of all the UK's big banks, the beleaguered RBS has been experiencing the greatest difficulty in achieving its Merlin commitments – the government conditions the banks agreed to that must see them provide £76 billion of new loans to SMEs.

The bank's difficulty in achieving its targets has largely been due to the fact that it is already the largest provider of SME loans in the UK, with around a quarter of the market, meaning that its lending targets are particularly stretching.

It has now announced that it aims to increase lending to small businesses over the next three months by 15 per cent and waive early repayment charges as well as the upfront fees, which usually amount to around 1.5 per cent of the loans.

RBS, which is still 83 per cent owned by the government, lent a total of £44.2 billion to British businesses in the first half of 2011. That amount included £15.5 billion of loans and £4.8 billion of renewed overdrafts to SMEs.

Came across a wonderful graphic put together by Mark Shuster of VC firm, GRP Partners, that shows just how much a founder’s shares in a business can dilute over time following a series of capital raising initiatives.

Of course your share of the company is going to shrink if you sell off chunks of capital. Many start-ups couldn’t get off the ground without having to raise money at the outset. And raising money no longer includes bank loan finance. Which means shares have to be surrendered.

The hopeful aim is that the money raised will lift the overall value of the business, so that your smaller share of a larger business is ultimately more valuable than a lager share of an uncapitalised business.

Example. You own 40% of a company worth £1m, i.e. £400k. You raise a round of VC, say £2m on a pre-money valuation of £4m, equating to a post-money valuation of £6m. You get diluted by 33% (£2m / £6m) so you now only have 26.67% of the company. But the company is now worth £6m and your 26.67% share is worth £1.6m, a gain of £1.2m.

But then the company grows and further rounds of finance are required. The following graphic shows just how dilution adds up and can sometimes mean that the founders original personal financial expectations might not pan out so well in the end. It’s US-based, but the general math can be applied in the UK. Also remember that in the UK, if the founders are ultimately left with less than 5% each then they become unable to claim the preferential 10% rate of Entrepreneur Relief upon exit, instead being hit with the standard 28%.

Business secretary, Vince Cable, has heaped pressure on the UK's banks to increase their lending to small- and medium-sized businesses, after threatening them with new taxes on profits, bonuses and balance sheets if they miss lending targets.

Cable was telling MPs on the House of Commons Business and Skills Committee that the Government's Project Merlin deal with the banks was for one year only. He said that if targets were not met by the end of that period, then the banks would not be able to escape facing extra penalties. Larger UK banks have missed their Project Merlin target to lend to £19billion to SMEs in Q1 2011 by £2.2billion.

"It will be a question of the Government saying, 'Sorry, this agreement hasn't worked and we are absolved of any commitment on our part in terms of taxation'," he explained.

He said there would also be extra pressure put on the financial institutions to disclose the mechanisms they use to make sure credit is available to the smaller business sector. He added that the banks' use of the excuse that any shortfall in SME lending was due to lack of demand would not be tolerated: he said that he believed that banks had gone some way to "discourage demand" by charging high prices or showing lack of interest in lending.

Meanwhile the shortage of bank finance has put pressure on businesses to lend money to their customers to allow them to make vital investments.

Recently released data from the Finance & Leasing Association shows that the amount of money provided for vendor finance jumped to £1,171m in this year's first quarter, up from £942m in Q1 2010 – a rise of 24%.

Philip White, the CEO of finance company Syscap commented: “Vendor finance is increasingly seen as the way around the roadblock caused by the reluctance of some banks to lend to SMEs.”

“Vendor finance allows businesses to invest in the new plant, machinery and IT they need without having to go cap in hand to an unsympathetic bank. It allows UK machinery and IT suppliers to unlock the sales that wouldn’t otherwise go ahead.”

“If businesses can’t get the funding to upgrade out of date machinery and IT then the UK economy will become increasingly uncompetitive – so vendor finance is playing a really important role.”

In a survey of IT vendors commissioned recently by Leasing Life, 63% of vendors expect demand for vendor finance to increase in 2011.

Despite the government's attempts to boost business lending, nearly 60 per cent of UK companies were refused credit by their banks last year, leaving a fifth to turn to credit cards to finance their enterprises.

That's the main finding from an Institute of Directors (IOD) survey of more than 1,000 company directors, which goes against recent claims by lenders that they've been allocating finance to firms that need it.

Of the companies that were refused credit, 83 per cent were not offered information on the government's Enterprise Finance Scheme, which guarantees business loans between £1,000 and £1 million.

Another fifth of firms questioned did not even apply for bank loans because they either felt they would not get them or believed the costs involved would be too high.

"It seems that more businesses are turning to forms of unsecured finance, such as credit cards, to get them through their short-term spending needs," confirmed Miles Templeman, director-general of the IOD.

"The low interest rates on credit card balance transfers may partially explain the increasing use of this form of finance, but any contraction in credit card finance could see significant price hikes, adding to the already grave difficulties that many businesses are having accessing funds."

The British Bankers' Association has countered that the sample size of the survey is too small to draw any meaningful conclusions.

A look at the current state of the M&A market for small and medium sized businesses

Up until this summer, the small to mid-sized business M&A market has not been severely affected by the problems in the financial markets. However, as the general lack of confidence continues and lending remains very scarce it is now no longer immune. The almost complete lack of IPO’s on both the main market and AIM, has meant a reduced number of businesses raising cash for acquisitions. Consequently, this has significantly reduced the total number of transactions being done.

On current deal values, Marc Fecher from Devonshire Corporate Finance comments: “there has been pressure on prices, mainly due to the EBIT multiples that banks are prepared to lend on coming down. Before the credit crunch last summer, it was common for banks to lend up to
five times EBIT. This figure is now more like two to two and a half times.” However, the landscape is constantly changing and this is reflected, and could be argued is caused by, the large fluctuations in the stock markets. In addition, the reactive and unprecedented course of government and monetary policy has had a major part to play. The result is that it has become virtually impossible to forecast what is going to happen in any real time frame.

For nervous buyers or sellers nearing the completion of a transaction, advisors are finding it difficult to say with certainty whether their clients are sitting on a good deal. Instead they are trying to ensure that their clients remain fully informed and are aware they are taking on perhaps more risk than would have been the case twelve months ago.
However, there are still many reasons why entrepreneurs should still maintain their acquisition focus: people will always want to retire; owners will always have health issues; companies will need to find ways of solving problems and being bought is one of them.

So who is out there buying?

Trade buyers are still in the market looking to make strategic purchases. They are looking at new markets, higher return on capital, have a need to diversify and/or have cash cow businesses that need to reinvest and expand.
With regard to financial buyers there is understandably much uncertainty and many private equity funds are turning themselves into cash. However, they will come back into the market in time. Private equity funds have been unable to raise the same level of debt as previously. Some private equity buyers are providing their own underwriting facility to insure the financing. However, this all costs money.
Currently the best buyer in the market is the consolidator or platform builder who wishes to take advantage of the fragmented market in its sector. Recent purchases such as Melorio acquisition of Zenos, the Oxfordshire-based provider of vocational training services to the IT sector with 116 staff, for an initial £21m is one example.