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Inst itu te for New Technolog ies, United Nations University

University o f OxfordUn iversity of Rome, La Sepienza

Warwick Business School, Un iversity of Warwick

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Alessandra Canepa, University of YorkKim Kaivanto, Lancaster University Management SchoolPaul Stoneman, Warwick Business School

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THE PUBLIC PROVISION OF SALES CONTINGENT CONTRACTS AS A POLICY RESPONSE TO FINANCIAL CONSTRAINTS TO INNOVATION IN EUROPEAN SMES

Alessandra Canepa, Kim Kaivanto and Paul Stoneman1

February 2004

Abstract It is argued that in Europe (and elsewhere) governments intervene actively to stimulate the SME sector, and because SMEs face financial constraints in particular, governments encourage the provision of debt and venture capital to such firms. We discuss a particular form of finance – funding secured only on a claim written on sales, i.e. Sales Contingent Claim (SCC) backed finance – that offers a different risk-repayment profile to debt and equity instruments which will be attractive to many firms. We argue that if such financing were available it would further stimulate SME growth and innovation. However, for various reasons SCC-backed financial instruments are not available to SMEs on the market. We recommend the correction of this market incompleteness by the introduction of a scheme providing SCC-backed corporate finance for SMEs in higher risk (higher tech) sectors. This is not a recommendation of a subsidy for SMEs. We illustrate the workability of such schemes by looking at existing examples (aimed at project finance for larger firms) and also discuss other practical issues.

JEL number: O38 (Technological Change – Government Policy)

Acknowledgements: This work has been financed under the Fifth EU Framework Programme, Contract No. HPSE-CT-1999-00039, European Integration, Financial Integration and Economic Performance.

ISSN 1682-3739

Copyright @ 2003 EIFC Consortium [Contract No HPSE-CT-1999-00039]

Published by the United Nations University, Institute for New Technologies, Keizer Karelplein 19, 6211 TC Maastricht, The Netherlands

E-mail: postmaster@intech.unu.edu URL: http:\www.intech.unu.edu

1 Universities of York, Lancaster and Warwick respectively. Corresponding author, Professor Paul Stoneman, Warwick Business School, University of Warwick, Coventry, CV4 7AL,UK: phone +44 (0) 2476 523038, E mail, Paul.Stoneman@warwick.ac.uk.

TABLE OF CONTENTS

1. INTRODUCTION 7

2. WHAT ARE FINANCIAL CONSTRAINTS AND WHY MIGHT THEY EXIST? 9

3. FINANCIAL CONSTRAINTS TO INNOVATION IN EUROPE: THE EVIDENCE 11

4. CHANGES IN THE EUROPEAN FINANCIAL ENVIRONMENT 15

5. POLICY RESPONSES 19

6. SALES CONTINGENT CLAIMS 21

7. EXISTING SCC SCHEMES – TWO EXAMPLES 27

8. THE POLICY RECOMMENDATION 35

9. CONCLUSION 39

REFERENCES 41

7

1. INTRODUCTION

In this paper we argue that in Europe the innovative activity of small and medium enterprises is

constrained by financial factors, that this problem is widespread despite the diversity and

heterogeneity of member states’ national innovation systems and also persists, despite many

financial innovations that have been introduced in the last five-to-ten years. We argue further

that policy initiatives to overcome this problem have, however, been limited both in scope and

in vision, and we therefore suggest the consideration of a heretofore largely neglected policy:

the provision of finance for innovation in SMEs through state-guaranteed or state-provided

Sales Contingent Claim (SCC) -backed finance. We address why SCCs differ from debt and

equity instruments, why they might be preferred by firms and why they might not be supplied

by the market. We also consider past experiences with some examples of SCC schemes. In the

penultimate section we detail our policy recommendation.

9

2. WHAT ARE FINANCIAL CONSTRAINTS AND WHY MIGHT THEY EXIST?

According to Hall (2002) a financial constraint is said to exist when, even if there are no

externalities involved in the firm’s investment activity, there is a wedge (perhaps even a large

wedge) between the rate of return required by an entrepreneur investing his own funds and that

required by external investors. Stiglitz and Weiss (1981) consider a firm to be credit rationed if

it does not get as much credit as it wants although it is willing to meet the conditions set by the

lender on equivalent credit contracts. In essence therefore a firm is credit or financially

constrained if it cannot raise external funding at the market price or in order to raise external

funding it has to pay over the market price.

There are many reasons postulated as to why such financial constraints might exist. These are

reviewed in Canepa and Stoneman (2003a) as well as in Hall (2002). The existence of

uncertainty and thus risk is a sine qua non of such constraints. Beyond this, the most commonly

argued reasons for such constraints are asymmetric information between borrower and lender

and moral hazard resulting from the separation of ownership and control, although capital

market incompleteness and inefficiency, the problems of measuring risk, taxes, subsidies,

bankruptcy costs et. al. may also have roles to play. Furthermore the literature argues that the

importance and relevance of financial constraints may also differ across firm sizes, industries

and countries.

Smaller firms may be relatively more tightly constrained because (i) the availability of

internally generated funds may be more limited for smaller firms than larger firms (ii) problems

of information asymmetries may also be more severe for such firms (iii) smaller, newer firms

may have no track record upon which to base a case for funding and/or there may be fewer

realisable assets to use as collateral and (iv) the costs (to funding providers) of search may mean

also that the supply of finance to smaller firms may be more severely limited.

Differences across industries may also exist so that, for example, firms in high-tech and newer

industries may face stricter constraints to raising external (and internal) funding either in terms

of cost and/or availability. This is because: (i) in riskier industries it may be more difficult to

raise funding from outside the firm purely because of the risk factor (ii) in more high-tech

sectors not only may risk itself be a factor but also the proportion of assets that are realisable

may be lower (iii) in high-tech industries innovation is more likely to be of a sort that has not

been undertaken elsewhere before and it may be particularly difficult to observe the systematic

risk of such projects (Goodacre and Tonks, 1995) and thus difficult to determine the appropriate

10

discount rate to use in evaluating investment in the firm and (iv) information asymmetries may

also be greater in such industries.

Differences in national systems of innovation (see Nelson, 1993) across countries may also lead

to differing financial constraints upon firms operating in different economies (as the result for

example of differing taxes and subsidy regimes, the completeness of markets for finance, the

legal environment as regards bankruptcy, government intervention etc.). Of particular interest

are differences in the financial environments in different countries. European financial

environments are both heterogeneous and changing (see Stoneman, 2001b). On the one hand,

there are bank-based systems as typified by the German system and on the other, market-based

systems as typified by the UK system. Most continental European systems are largely bank-

based although there are signs of some movement in certain countries (e.g. France) from a bank-

based to a market-based system. Alongside these different financial system environments there

are different patterns of ownership of industry. The German system reflects greater private

control, more concentrated ownership and more pyramid ownership. In the UK the pattern is for

less concentrated holdings, less private control and few inter-corporate holdings. The financing

of investment by firms also differs across systems. Although self-generated funds are the main

finance sources for firms in all countries (except SMEs) these are more important in the UK

with bank finance more important in bank-based systems.

It is argued that such differences across systems have important implications for the way firms

behave. The argument is that bank-based systems with insider control are particularly

favourable to longer term steady development built upon the construction of trust-based

relations, firm-specific investments and gradual continual change but may generate a higher cost

of capital due to bank monopoly power, informational capture (of the firm by the bank) and

perhaps undue conservatism. On the other hand market-based systems with outsider control and

more arms-length relationships between financiers and managers are seen as more favourable to

major change and switches of strategic direction (but with no obligation for financiers to take

anything other than a short-term view, encouraging liquidation of investment in the event of

dissatisfaction). These arguments lead us to believe that firms will be differentially affected by

financial constraints under different national financial systems.

11

3. FINANCIAL CONSTRAINTS TO INNOVATION IN EUROPE: THE EVIDENCE

There is a growing body of empirical research relating to the relationship between finance and

investment in plant and machinery and or innovation (largely measured by R&D). The two main

strands in the literature investigate (i) the sensitivity of the investment rate to cash flow (ii) the

results of innovation questionnaire surveys.

The correlation between cash flow and investment is usually investigated by estimating a

standard investment demand function (see for example the surveys by Hubbard, 1998 and Hall,

2003). Three main approaches can be identified:

i) estimating a dynamic neoclassical accelerator model in which the profit maximizing

firm equates the marginal cost of capital to the marginal product (see Fazzari,

Hubbard and Petersen, 1988, and Carpenter and Petersen, 2002 for the US,

Devereux and Schiantarelli, 1989 for the UK).

ii) estimating an Euler equation derived for the profit-maximizing firm without

including the shadow value of capital among the regressors (see Bond, Elston,

Mairesse and Mulkay,1997).

iii) estimating directly the investment demand function where the shadow value of

capital is proxied by a VAR forecast of firm fundamentals observable to the

econometrician (see Bond, Harhoff, and Van Reenen, 1999 ).

These methodologies have been applied to investment data for a number of different countries.

Overall the voluminous literature presents strong empirical evidence of a correlation between

cash flow and investment in plant and machinery and/or R&D. For example, in an early paper

Fazzari et al. (1988) found that cash flow tends to affect the investment of low-dividend firms

more than that of high dividend firms leading them to conclude that finance rationing matters.

An example of the later literature is Carpenter and Petersen (2002) who find that for small,

quoted firms in the US, the sensitivity of growth to cash flow of firms that use external equity is

lower than that of firms that make little use external equity. Bond et al. (1997)2 estimate

accelerator, error correction model and Euler equations for different countries. Although they

find that the simple accelerator equations tend to exaggerate the importance of financial

variables relative to richer dynamic specifications, they also find robust results across all

econometric models indicating that the sensitivity of investment to financial variables is both

2 See also Bond, Harhoff, and Van Reenan (1999).

12

statistically and quantitatively more significant in the UK than in France, Germany or Belgium,

although there is the possibility that this greater responsiveness may arise because firms in these

economies are more sensitive to demand signals in thicker financial equity markets. Canepa and

Stoneman (2003b) explore the relatively neglected area of technology diffusion rather than

technology generation (R&D) and show, using UK data, that the diffusion of new technology is

similarly sensitive to cash flow.

In contrast, Kaplan and Zingales (1997) have argued that studies such as those cited above

which estimate the sensitivity of investment to cash flow are fundamentally flawed in that such

sensitivities are unable to reflect financial constraints in an unbiased manner. However, the

empirical evidence on the relationships between finance, investment and innovation has been

further augmented and extended through the analysis of innovation survey data. Canepa and

Stoneman (2003a) for example explore Community Innovation Survey (CIS) questionnaire

response data to investigate whether European firms consider themselves to be financially

constrained in their innovative activity. They find that (i) the cost of finance or the availability

of finance ranks among the more significant factors that have acted as hindrances to innovation

in Europe, both in 1994 – 1996 and 1998 – 2000; (ii) the probability that a firm’s innovative

activity will be financially constrained is greater for small firms than for medium and larger

firms, in the latter case there being only minor differences between the UK and other countries;

(iii) when firms are constrained such that their innovative activity is delayed or reduced, then

financial factors (the cost or availability of finance) are more likely to have a high (as opposed

to medium or low) impact for small firms than for large firms. Their results also confirm that

differences in European financial systems also matter: the market-based economies (e.g. the

UK) exhibit greater sensitivity of innovation to financial constraints than bank-based economies

(e.g. Germany).

Further research also suggests that capital market imperfections affect SMEs more in high-tech

industries than in traditional sectors.3 For example, Westhead and Storey (1997) examine the

relative importance of several potential problems faced by high-tech SMEs. Their multivariate

analysis on a sample of UK firms shows that technologically sophisticated high-tech firms were

significantly more likely to report the presence of a continual financial constraint than less high-

tech firms. In a similar study of Italian high-tech firms, Giuduci and Paleari (2000) confirm that

50% of the sample companies experienced difficulties in financing their innovative projects.

The work of Canepa and Stoneman (2003a) confirms these findings and extends them to the

majority of European countries.

3 In reviewing the financial environment in which European SMEs operate, the European Commission (2000), using a very different methodology, argues that SMEs do face specific problems in accessing finance and early stage enterprises in particular face the most severe financial constraints.

13

To summarize, although there is not universal acceptance that European firms do face financial

constraints (see for example Wagenvoort, 2003), the overview of various empirical studies

relating to investment in plant and machinery, R&D and diffusion suggests that:

(i) small firms are more likely to be financially constrained in their innovative activity

(ii) firms (especially small and start-up firms) in R&D intensive industries face a higher

cost of capital.4

(iii) the evidence for a financing gap for large and established firms is harder to establish

(iv) the Anglo Saxon economies, with their thick and developed stock markets and

relatively transparent ownership structures typically exhibit greater sensitivity of

innovation to cash flow than continental economies.

4 Although we do not know of any particular evidence that this is true risk adjusted.

15

4. CHANGES IN THE EUROPEAN FINANCIAL ENVIRONMENT

By necessity much of the empirical support for propositions relating to financial constraints in

Europe is predicated upon data compiled largely prior to the recent important changes to

national financial systems in Europe. In this section we address whether these changes

themselves are likely to have diminished the importance of financial constraints to innovative

activity in Europe. It should be noted that for most firms in most countries, the dominant source

of investment funds is still internal and as such the impact of such recent developments on

innovative activity may be quite limited.

Of the changes that have been occurring we emphasise four. The principal change in the

European financial environment is the advent of EMU. The prime direct embodiment of EMU

was the move first to rigidly fixed exchange rates between member countries and then to a

common currency. (It should be noted of course that the UK has not as yet joined the EMU). It

was argued that EMU would eliminate foreign exchange risk to a great degree and as such

encourage investment and innovation.

Danthine et al. (2000) point out that non-EMU currency risk (in particular that associated with

the US dollar) was a much larger risk factor than intra-EU currency risk and as such the

reduction of currency risk resulting from EMU may only have a limited impact upon portfolios.

They do however report that as a result of the elimination of foreign exchange risk with

monetary union and as an implication of transparency, a single European yield curve for the

private debt market emerged. Private interest rates across EMU participants had almost

completely converged by June 1996, and as of May 1998 when irrevocable exchange rates were

instituted, the by then almost identical yield curves of different countries collapsed into a single

yield curve. Since the second half of 1998 this yield curve also has moved down.

However, the impact of EMU on the cost of capital for SMEs could be very different from that

experienced by larger firms. SMEs tend to raise funds locally and so are unlikely to access the

euro bond market. Thus downward movements of the yield curve are unlikely to have much

impact on SMEs. SMEs are also more likely to rely more heavily than large firms on bank

lending and venture capital.

A further direct consequence of EMU is that the central banks of countries belonging to the

Euro zone now have only loose control over their own monetary policy. That policy will be set

zone-wide with individual country financial markets determining how the innovation

performance of firms of different sizes will be affected . Differences in monetary transmission

16

mechanisms resulting from different financial structures will thus mean that the single monetary

policy conducted by the ECB may well have different effects on innovation in different

countries.

The second major change we observe is that indicators suggest that the euro area is moving

towards a more equity-oriented structure as shown by the growth of the stock market in nearly

all countries (see Mayer, 1999) and new markets being established. For example several stock

exchanges (Frankfurt, Paris, Amsterdam, Milan and Brussels) launched markets for high growth

company stocks integrated under the EURO.NM initiative. This should lead to (i) geographical

location diminishing as a determinant of where companies choose to list and multi-market

listing growing in importance; (ii) minority shareholders becoming more vocal; and (iii)

attempts to be made by the EC to harmonize governance, information disclosure, investor

protection and take-over rules across countries. Primarily however it is to be expected that

companies will find it easier to raise finance locally from equity markets. However this opening

up of local equity markets may not be of great advantage to smaller firms who rely upon debt

and particularly bank finance.

The third major change has been in the European banking environment. With EMU there will

be more pressure for less segmentation of national banking markets and as other institutional

and regulatory barriers fall this is likely to be further emphasised. This is expected to increase

competition and reduce costs and therefore charges. There have already been a steady stream of

bank mergers in European banking throughout the 90s. This has led to larger banks and a

beginning of cross border expansion. Most bank mergers in the 90s have been domestic, but the

domestic proportion is now falling. However, even in early 2000, European banking markets

were still highly fragmented along national lines with shares of domestic inter-bank claims

standing at roughly 64% and that of domestic loans in total loans at roughly 80%. Molyneux

(2001) argues that although increasingly foreign banks constitute a significant proportion of

banking assets (in 1996, 57% in the UK, 48% in Belgium, 14% in France and 35% in Portugal

but less than 8% in all other countries) such banks still play only a minor role in domestic retail

and corporate banking. Nor is there any evidence (Schenk, 2000) to suggest that banking

mergers increased internal efficiency in terms of cost improvements, he in fact suggests that one

effect of increasing bank size has been to increase the costs and reduce the availability of loans

to SMEs. There does not seem any evidence (Danthine et al., 2000) that changes in banking

markets have as yet led to cheaper or more readily available finance to SMEs. This may be

because SMEs (particularly very small firms) are typically very reluctant to change banks

because of the perceived complexity of switching for little benefit, the importance of

maintaining relationships with a particular bank, informational capture by the relationship

17

lender, and the ability of the existing bank to negotiate lower charge if there is a threat of

switching (see Competition Commission, 2002).

Finally, there have been changes over time in financial products and instruments available on

the market. Molyneux and Shamroukh (1999) argue that the major financial innovations of the

last twenty years have reflected two interrelated trends. The first is securitisation and the second

is the growth of the Off Balance Sheet Activities (OBSA) of banks. They note the development

and growth of a number of specific markets and products, for example: (i) the growth of the

Eurodollar market from the early 1970s; (ii) the establishment of the Eurobond market in 1974

and is subsequent growth; (iii) the launch and growth of issues of Floating Rate notes and

Eurodollar floating rate notes; (iv) the development of note issuance facilities, revolving

underwriting facilities, eurocommercial paper and euro medium-term notes in the euronote

market; (v) the growth of the syndicated loans market; and (vi) extensions of bank asset

securitisation. One might think once again that such changes would facilitate investment and

innovation by firms. However, the potential impact is much more likely to be felt by large firms

rather than SMEs.

Overall it seems that, although such a conclusion is not undisputed (Hooker, 2003), there is little

evidence or argument to support the view that recent events have made financial constraints to

innovation irrelevant5 to smaller firms in Europe. If anything, the analysis above suggests that

the availability of finance to larger firms is being made easier while that to SMEs is being less

affected.

5 The changes do however inevitably lead to another question: Is EMU likely to change the structure of SME corporate ownership? As Mayer (1999) points out continued financial market integration does not necessarily mean the convergence of financial systems. In contrast, the type of financial system and regulatory environment may influence the structure of economic activity. For example, UK’s equity orientated, diversified ownership structure and developed venture capital system may be better suited for investment in risky new technologies and therefore suitable for encouraging SMEs in high-tech sectors. On the other side, the German system based on concentrated ownership and bank finance facilitates the monitoring and control of managers by investors and may be better suited to SMEs in more traditional sectors (e.g. manufacturing). Therefore, Mayer (1999) suggests that there will probably be two opposing driving forces: the first will increase country-level specialisation in financial services (therefore increasing differentiation), and the second will increase the pressure of convergence due to the integration of financial system and regulation across the whole the euro zone.

18

19

5. POLICY RESPONSES

We have argued that there are financial constraints to innovation in Europe. That those

constraints are greater (i) for firms engaged in riskier activities and (ii) for small and medium

sized firms and (iii) for firms in market-based financial systems. We have also argued that the

extensive changes in the European financial environments have, if anything, exacerbated rather

than alleviated the problems of SMEs relative to larger firms.

There has for many years both at a national and a community wide level been a desire in Europe

to improve the innovative performance of the SME sector. This has been reflected in a large

number of national and EC wide policy interventions. The economic justification of such

interventions has been on the grounds of two main arguments: (i) network externalities, it being

argued that the growth of SMEs encourages growth in the economy as a whole, and (ii) market

failures. There may be several different market failures but the failure which we have been

documenting above – financial constraints to SMEs – is one of the more frequently discussed.

Over the years the various different policy interventions have included tax subsidies to R&D,

other SME favourable tax schemes, public finance of innovative projects, etc. Given our interest

here however, two policies are of particular relevance when it is financial constraints that are the

problem – finance guarantees and the support of greater provision of venture capital.

Finance guarantee schemes issue government guarantees for debt finance to a wide group of

intermediaries who support investment in SMEs. For example under the scheme operated by the

European Investment Fund “loan guarantees support enterprises with growth potential with up

to 1000 employees. Under this window, the EIF issues partial guarantees (directly or indirectly)

to cover portfolios of loans.”6 Basically the purpose of such schemes is to make finance either

cheaper or more readily available to SMEs.

For a number of years Europe has tried, both nationally and as a whole, to encourage the

development of a larger early-stage venture capital industry. Early-stage venture capital is

primarily funding provided to (a) young companies that are not quoted on the stock market (b)

in return for an equity share.7 Such funding usually has a term of 3 to 7 years, frequently

involves complementary input from the venture capitalist in the form of support, advice and

management expertise, and the returns are usually harvested in the form of capital gains at the

end of the investment, often through an initial public offering. Although still representing only a

6 www.eif.org/Attachments/productdocs/sme_gf_summary.pdf (page 1). 7 Distinct from early-stage venture capital investment, venture capital firms do also participate in management buy-outs and related rescues and transformations of listed firms.

20

small fraction of SME finance, venture capital and related forms of equity financing can be a

vital source for high-risk and high-growth ventures. Venture capital is of course a form of

equity finance.

Over time the amount of venture capital in Europe has grown, especially post 1996.8 However

there are still significant differences in the availability of venture capital across the European

economies.9 Venture capital took off much earlier and more extensively in the US than in

Europe, although even in the US venture capital still represents only about 3% of total R&D

spending (Kortum and Lerber, 1998). In Europe and many other countries there have been a

number of significant policy interventions attempting to boost the supply of venture capital

(OECD, 1997).

Loan guarantee schemes and the stimulation of venture capital are logical policy reactions to

financial constraints that limit the growth and/or innovative activity of SMEs, viewed as a

means of either alleviating market failures or stimulating the generation of network externalities

and other spin-off social benefits. Despite these potential benefits, we wish to argue in the rest

of this paper that there is an alternative policy instrument that may have properties that make it

as least as appealing in the right context as either of these initiatives and thus may be a valuable

component of a portfolio of policy instruments. This instrument involves the support of a class

of SME funding that we label sales contingent claims. It is to this that the rest of this paper is

devoted.

8 One must note however, that the figures refer largely to formal venture capital. There is much less information upon informal venture capital sometimes called finance by business angels. In the US, it has been estimated that business angels invest in 20 to 40 times the number of companies as the institutional venture capital industry. For the UK, Mason and Harrison (2000) estimate that eight times as many businesses raise finance from business angels as from institutional venture capital funds, but as the average investment is smaller the amount of finance supplied is broadly equivalent to that provided from institutional sources. 9 One has to be careful however with the data. It is often thought that all venture capital is for high-tech start-up finance. In 1999 (source EVCA) the allocation of venture capital was seed 1.9%, start-up 11.0%, replacement 4.7%, expansion 29.6% and buyouts 52.8%. Thus more than half of all venture capital is directed towards buyouts rather than start-up or expansion finance.

21

6. SALES CONTINGENT CLAIMS

A Sales Contingent Claim (SCC) has the following structure (also see Kaivanto, 2002). The

financier provides to the firm, normally for the (complete or partial) development of a new

product, a sum (of present value Ko, which may be paid up front or spread over time) that is to

be repaid by a levy on future sales (usually but not necessarily) of that product according to a

schedule agreed in advance. This schedule will specify a threshold of cumulative sales below

which no repayments are made (which may be zero), a second threshold of cumulative sales

above which no further repayments are made (which may be infinite) and a series of levy rates

for all cumulative sales between these two extremes. For example, a simple schedule would be

linear where if X1 and X2 are the lower and upper thresholds respectively, and � a constant

repayment rate, then the repayment, h , on the Xth unit sold cumulatively would be

h(X) = 0 for X < X1 and X > X2

h(X) = � for X1 � X � X2

and yielding total repayments by the borrower, H, for each X as per

H(X) = 0 for X < X1

H(X) = � (X – X1) for X1 � X � X2

H(X) = � (X2 – X1) for X > X2

For many purposes it is more convenient to think of the repayment schedule as a function of

time rather than cumulative output, especially if discounting is to be introduced. Under this

change of variables, we may for present presentational purposes furthermore assume that annual

sales take place at a constant rate � so that (counting from the date of first sale) the Xth unit is

sold at time X/�. We may then specify t1 and t2 as the lower and upper dates between which

repayments are made where t1 = X1/ � and t2 = X2/ �. Between these dates an annual repayment

of �� is made. The present value of repayments made over the lifetime of the repayment

schedule (PVH) would, if total cumulative sales X3 eventually equal or exceed X2, then be given

by

22

PVH = (��/�) [exp(-�t1) - exp(-�t2)]

where � is the discount rate, or the lesser amount

PVH = (��/�) [exp(-�t1) - exp(-�t3)]

when the total sold X3 � X2, t3 = X3/� and repayments are made only to the date t3 < t2. Obviously

the total repayments are greater the larger are the cumulative sales (up to X2), the lower is the

threshold for payment X1, the faster these sales take place (the larger is �) because of

discounting, and also the greater is �, the levy per unit.

Under the assumption employed for the above presentation – that sales take place at a known

and certain constant rate � – there is no reason why there should be any difference between the

payment obligation profile of the SCC and that of a debt contract for an equal principal.

However, even with certainty, a firm’s sales rate � will not in general be constant, but will vary

from quarter to quarter, year to year. The quarterly or annual payment obligation imposed on

the firm by the sales contingent claim will thus vary accordingly, whereas the payment

obligation imposed by a debt contract will not.10

More importantly innovative activity (and in fact the growth of SMEs in general) is undertaken

in an environment of risk and uncertainty, both technological and market related. The key point

to emphasise is that in an uncertain world, relative to debt and equity, finance that is to be

repaid through an SCC provides the firm with a very different risk profile. To illustrate, we can

consider firm risk as resulting from uncertainty relating to future sales, which in a project

similar to that discussed above will be reflected in uncertain future values for the rate of sales �

and cumulative sales.

If debt finance is used to fund an innovation project (subject only to bankruptcy), the required

repayments will be independent of the outcome of the project and thus all risk relating to the

project falls upon the innovating firm. In particular the downside risk (i.e. the innovation project

largely fails) is large. However the upside gain (when the project largely succeeds) is also large,

the innovator retaining all profits in excess of the cost of finance. In the face of the downside

risk, debt financiers usually seek collateral so that in the event of failure they will be repaid.

10 Negotiation may allow some adaptation of repayment obligations to available revenue, but such rescheduling negotiations are costly and may not be taken up in each and every payment period.

23

With debt finance the net present value of repayments due (PVD) will depend upon amount

borrowed, the interest rate, the repayment schedule and the discount rate.

Equity finance on the other hand has a very different risk profile. We may think of equity

finance as funding that is to be repaid as a share (venture capitalists usually take a 40% share

holding) of the profits of the firm in perpetuity (although the shareholder might sell the share at

some future date the value of the equity will reflect expected future returns). If the innovation

project fails then the financier will share in the losses incurred, so the downside cost for the

innovator is less although for the financier more. If the project succeeds the financier shares in

the upside gain without limit. Moreover the financier shares in the gains (and losses) of all

future activities of the innovator. Compared to debt finance, equity finance has for the

innovator (financier) a lower (higher) downside risk but also a lower (higher) upside gain.

The present value of repayments with equity finance (PVE) for a project for which annual sales

take place at a constant rate � (in perpetuity thereby allowing for a claim on future project

surpluses) so that the Xth unit is sold at time X/�, allowing a fixed price for each sale of p, a

fixed cost of production for each unit c (thus assuming for simplicity no fixed costs and profit

per unit of p-c), and an equity share �, is given by11

PVE = ��(p – c)/r

From the above expressions, corresponding financier net present values may be obtained by

subtracting the value of the principal made available to the firm (assumed at time zero) K0,

which we assume here to be used to fund innovation (e.g. R&D).

FNPVE = ��(p – c)/r – K0

FNPVH(X3 > X2) = (��/�) [exp(-�t1) - exp(-�t2)] - K0

FNPVH(X3 � X2) = (��/�) [exp(-�t1) - exp(-�t3)] - K0

Diagrammatically, in Fig 1 we plot, against the realised rate of sales, �, the PV of repayments

on finance of a given principal under the three different financing arrangements: equity, debt

and SCC. The figure reflects that for an SCC, if there are no sales there are no repayments,

whereas if the investment is a great success the repayments will be high, but, as there is a cap

11 Where the discount rate is written as r rather than � to indicate that different discount rates might be used with different types of funding.

24

upon the repayments to be made, these will eventually level out. The actual positioning of the

curves will depend upon the various parameters of repayment schedules but we have drawn the

figure such that at higher sales rates, equity and SCC involve greater repayments than debt, to

compensate for the lower repayments than debt at lower sales rates, while for some intermediate

sales rate the repayments under an SCC are above those for equity to compensate for lower

repayments under low and high sales rates. The curves essentially reflect our argument that, for

the firm, downside risk will be greatest with debt finance, upside cost is greatest with equity

finance, whereas SCC finance repayments will be intermediate between debt and equity at both

extremes of the sales spectrum.

Figure 1. The present value of the firm’s repayment obligation under equity, debt and

SCC contracts as a function of sales.

SCC

NIL

Equity

X1/t1 X2/t2 Sales rate β

PV

DEBT

25

It is important to note that in general the risk (i.e. the repayment to sales) pattern of an SCC is

not reproducible with a mix of debt and equity finance alone. An SCC thus offers to the

borrower a unique mix or risk and return not otherwise available and which may, even for a

given present value of repayments, be preferred by the entrepreneur to debt or equity finance. In

addition an SCC does not imply the potential loss of control that entrepreneurs argue results

from accepting venture capital (although venture capitalists tend to argue that in addition to

funding they also supply expertise). Finally of course one may note that as SCC repayments are

contingent upon the future sales revenue there is no necessary requirement for the firm to have

the collateral that is frequently required as a condition of debt financing.

Despite what we see as the potential desirability (to the firm) of SCC-backed finance initiatives,

where loans are repaid through a levy on units sold, such instruments are generally not available

on the private market.12 We address below why this might be. At this point however we note

instead that, in contrast to the private market, there is in fact quite a long, if thin, history of the

public provision of financial support for innovation based upon sales contingent claims.

12 One might note that for certain economic activities something very similar is available. There has been a move in recent years especially in private equity venture companies to use securitisation as a means of raising finance for acquisitions. Securitisation essentially sells claims to a future cash flow for a sum today that may be used to purchase assets. Securitisation is thus very similar to an SCC. Such securitisation tends however to be restricted to secure, steady, well defined and largely riskless cash flows – or portfolios of claims on sales streams that achieve the same effect. This tends to limit the activity to large firms in stable markets. It is unlikely to be applied to the uncertain profit flows arising from innovation in SMEs.

27

7. EXISTING SCC SCHEMES – TWO EXAMPLES

Although the government provision of SCC-backed finance has not been widespread, there

nevertheless have been some examples of this. In the UK the SCC scheme that became known

as Launch Aid is the major means by which finance has been provided to support civil

aerospace product development, the policy being continuously underpinned by an Act of

Parliament since 1945,13 In addition to the UK, virtually every other country engaged in

significant manufacturing of large civil aircraft or their subsystems has, with the exception of

the United States, operated a Launch Aid style SCC-backed government funding support

scheme. Outside the civil aerospace industry, SCC-backed government funding has been

available in e.g. Canada, Sweden, Finland, The Netherlands and Israel.14 In this section we

discuss the experiences of two schemes. The first is UK Launch Aid for civil aerospace product

development programmes. The second scheme we consider, which unlike UK Launch Aid has

not been limited to any particular industry(ies), is the Dutch TOK programme.

UK Launch Aid

To our knowledge, the UK Launch Aid scheme – which was born out of the effort to exploit and

convert to civilian applications the UK war-time (bomber) aircraft industry – is the earliest

example of an SCC-backed government funding policy for innovation. Moreover, the

programme is still in place. As it currently stands

...The schedule [of levy payments] and applicable contract clauses aims to reduce the element of risk to the minimum necessary and to ensure HMG’s recovery of its investments (at a positive rate of return). The timing of recovery is primarily linked to the production rate of the aircraft programme but may also involve a target date by which recovery is expected. The profile of levy repayments per aircraft is such that the initial run of aircraft, say a year’s full production, attracts no levy. At a trigger number a modest repayment is levied. At each successive trigger number the levy is increased until the number of aircraft delivered has reached the target at which HMG expects to recoup its investment. Beyond this point smaller royalty payments continue, for specified numbers of aircraft deliveries. (taken from a private communication to the authors from the DTI)

13 Initially under the 1945 MCAA, subsequently under the CAAs of 1946, 1949, 1968 and 1982. 14 administered by Technology Partnerships Canada (TPC), Industrifonden [The Swedish Industrial Development Fund], TEKES [National Technology Agency of Finland], Senter [an agency of the Dutch Ministry of Economic Affairs] and The Office of the Chief Scientist (OCS; see Trajtenberg, 2002), respectively.

28

Launch Aid is restricted to civil aerospace product development programmes, thus mainly to

airframe and aeroengine development programmes, although major sub-assembly (e.g. wings,

fuselage) and helicopter development programmes have also received support. Support for the

“design, development and production” of civil airframes and aeroengines is the only form of

government support for R&D that is enshrined in a UK Act of Parliament. Nevertheless there

are no funds set aside in the budget for Launch Aid, and civil aerospace programmes seeking

support must vie against competing demands on public funds. In this sense the granting of

Launch Aid is entirely discretionary.

Responsibility for administrating the Launch Aid scheme rests with the DTI. Total DTI

expenditure has to be approved annually by the Treasury through a series of ‘bilateral’

discussions that tend not to consider individual expenditure components separately – Launch

Aid is just one of the many expenditure categories that the DTI has to ‘fit in’ to its overall

budgetary authorisation.

The justification for a policy in support of civil aerospace development is rooted in the

immediate post WWII environment, however the reason for making Launch Aid an SCC

scheme are essentially still in place today. It was argued that the financial outlays required for

development activity in this industry were too large and risky for manufacturers to be able to

raise sufficient finance from the market and their bankers alone and thus the government acted

as funder, such funding being provided in exchange for a sales contingent claim issued (and

fulfilled) by the manufacturer to the government, that mechanism thereby shifting risk from the

manufacturer to the government.

Under the current Labour administration the DTI has dropped all references to ‘Launch Aid’,

and has systematically substituted such references with ‘Launch Investment’. Irrespective of

the proper noun used, the scheme itself remains intact, as does the original justification for its

existence (DTI, 2000):15

Launch investment remedies a market deficiency in the availability of

development funds for aerospace companies to undertake large

development projects. These projects typically have high costs and pose a

high level of risk, and generate a return only in the long term.

This re-labelling, though notionally helpful in policy discourse and useful in transatlantic trade

negotiations, does not resolve a long running argument relating to such Aid. Much public

29

discourse, especially that relating to government support to US vs. European Aerospace

industries has tended to treat Launch Aid as a mere euphemism for subsidy. The nominal re-

labelling as ‘Launch Investment’ has not been successful in deflecting this association. With

the sole early exception of Gardner (1976), when Launch Aid -type direct support for civil

aerospace R&D has been considered in the economic literature, it has invariably been in the

context of strategic trade policy studies concerned with the welfare effects of Airbus’ subsidised

entry into the large civil aircraft market, rather than in the context of technology policy or

innovation policy (see Dixit and Kyle, 1985; Baldwin and Krugman, 1988; Klepper, 1994,

1995; Neven and Seabright, 1995).

The question of whether Launch Aid is a deplorable ‘subsidy’ or a legitimate ‘investment’

cannot be answered without reference to the terms of specific Launch Aid contracts. The

relevant question is thus not ‘Is Launch Aid a subsidy?,’ but ‘When is Launch Aid a subsidy?’

According to the reasoning advanced by Kaivanto and Stoneman (2003), existing definitions

and practical criteria used for identifying cases of subsidy (in the WTO context) or state aid (in

the EU context) work perfectly in complete markets, but break down when applied to cases

where significant market incompleteness is present and relevant. And such is the case for

Launch Aid support for drastic innovation. Regardless of whether it is the Kaivanto and

Stoneman (2003) criterion for subsidy in incomplete markets which gains general acceptance, or

whether some other criterion will be proposed and gain acceptance, the mere determination of

whether a particular Launch Aid contract constitutes an ex ante subsidy (or not) is a non-trivial

exercise in applied economics. We argue however that even if the terms of the Launch Aid

contract do not involve a subsidy, the risk shifting character of such contracts are not available

in private markets and thus government provision assists in closing a market failure. This makes

public provision of SCC schemes supportable.

Launch Aid has been of great significance to the UK civil aerospace industry. Indeed the very

existence and development of the UK civil aerospace industry is intrinsically entwined with the

historical availability of Launch Aid and the manner of its administration. It is difficult to

conceive of the UK civil aerospace industry ever having developed and evolved into its current

form without Launch Aid. This is so for several reasons. Firstly, because Launch Aid has made

funds available for product development programmes in the civil aerospace industry per se –

where private sector financiers are wary of the high-technological and commercial uncertainty,

the high absolute and relative cost of product development programmes, and the long payback

periods. Secondly, because not only has Launch Aid made funds available per se, but under its

distinctively sales contingent repayment conditions, it has done so with particularly favourable

15 On-line DTI prospectus at http://www.dti.gov.uk/eid (current prospectus available at http://www.dti.gov.uk/aerospace/launch-investment.htm).

30

risk shifting properties. Thirdly, because the absolute level of Launch Aid support has been

large: net real cumulative UK Launch Aid support for the civil aerospace industry has been in

excess of £6 billion. Net real (in year 2000 £) cumulative Launch Aid support for civil

aerospace between 1945 and 31/3/1975 was £4.804 billion, while between 1/4/1975 and

31/3/2000 it was £1.308 billion (see Figure 2 below), giving a total of £6.112 billion.

Figure 2. Net real annual non-cumulative Launch Aid repayments 1975–2000 (in year

2000 £m)

-300

-200

-100

0

100

200

1975 1980 1985 1990 1995 2000

Source. Kaivanto (2002)

Since its first inception, the terms of the Launch Aid contract have progressively become less

generous, decade-by-decade shifting less risk away from the manufacturer. Today, under the

terms of the 1992 EC-US Bilateral Large Civil Aircraft Agreement, Launch Aid for large civil

aircraft (>100 seats) – that is, excluding regional aircraft (<100 seats), aeroengines, helicopters,

and components – is limited to 33% of the aircraft’s total development cost, with 25% to be

repaid at the cost of government borrowing and the remaining 8% to be repaid at the cost of

government borrowing plus 1%. The reimbursement period is limited to a maximum of 17

years, with 20% of the repayments to be made over the first 40% of aircraft deliveries, and 70%

over the first 85% of deliveries. Simultaneously, manufacturers have been taking on more risk

from their downstream markets as well, just as the absolute costs of civil aerospace R&D

31

programmes have been escalating. Hence the observed increasing rationalisation of the

industry, first intra-nationally, then internationally.

From a theoretical perspective, innovative civil aerospace product development programmes

display two of the three generic causes of market failure – namely indivisibility and uncertainty.

It is not feasible to undertake a fraction of a civil aerospace programme. Either a civil aerospace

product development programme is carried through the certification stage and well into the

production phase, or it will be a crippling failure for the manufacturer undertaking it. This is to

say that civil aerospace product development programmes are indivisible. Moreover, innovative

civil aerospace product development programmes are subject to great uncertainty, both

systematic and idiosyncratic. Furthermore, the degree and composition of uncertainty perceived

is not uniform across all economic actors concerned. The asymmetry of information – which is

intrinsic to the enterprise of drastic innovation – between the civil aerospace manufacturer and

virtually all other economic actors in the economy, is very pronounced.

Kaivanto and Stoneman (2003) argue, on the basis of the theoretical results of Mukerji and

Tallon (1999) relating to patterns of background and idiosyncratic risk, that innovative civil

aerospace development programmes (as detailed above) are just such that one might expect

markets for finance – particularly SCC-backed finance – to close down endogenously.

Moreover, although the latter result does not require asymmetry of information, in the presence

of asymmetry of information, which is intrinsic to drastic innovation, the results of Morris

(1997) also apply: that a no-trade theorem based on the lemons problem arises in markets with

risk, uncertainty and hidden information. Both arguments suggest that the market for finance for

large aerospace projects and in particular SCC-backed finance will close down endogenously

and if such projects are to be financed (especially via SCCs) then the government must act as

financier or guarantor of financiers.

Dutch TOK – Technisch Ontwikkelingskrediet

TOK is the Dutch acronym for ‘Technological Development Loan’, an innovation support

programme administered by the Senter-agency of the Dutch Ministry of Economic Affairs.16

This scheme was introduced in The Netherlands in the wake of the Marshall Plan in 1954, and

continued to operate until 2001 at which time it was superseded in slightly altered form by

TOP,17 which in turn was terminated in 2003.

In order to obtain a TOK, a firm had to convince a committee that its project (a) would provide

a result new to The Netherlands, (b) had a realistic chance of success both technically and

16 We would like to thank the agency for supplying information relating to this scheme. 17 The ‘P’ in TOP stands for ‘projects’.

32

commercially, and (c) would properly qualify as a technically high-risk project. This

examination was not perfunctory; convincing the committee on these points was considered to

be very demanding. Only firms satisfying the following criteria were eligible to apply for a

TOK: those (i) operating in The Netherlands, (ii) having no more than 20,000 employees, (iii)

having a technologically risky development project18 with real technical and commercial

chances of success, and (iv) being otherwise unable to finance their risky technological

development project without the TOK. Eligible development projects included products,

working methods or technological services, with no prejudice regarding the area of industry or

technology. Most common development costs were eligible to come under TOK support,

including wages, materials, tooling, running expenses, consumables, patent acquisition fees, and

so on, but with the explicit exclusion of the cost of management time, general research costs,

selling and advertising costs, interest costs, and dividend/profit payment to staff.

While originally a TOK could cover up to 70% of the project’s projected eligible costs, in 1985

this was brought down to a maximum of 60%. Finally in 1991, under pressure from the EC, this

was lowered in turn to 40%. However, at the same time, in 1991, an additional allowance of

25% of eligible project costs was made for ‘commercialisation costs’. Hence the maximum

became 40% × 125% = 50% of the project’s projected eligible costs. Nevertheless, it was

ultimately the size of the firm and its financial resources that determined the ceiling for TOK

participation in project costs: the larger the firm and the deeper its pockets, the lower the TOK

share.

The TOK financing is said to be ‘risk-bearing’, by which it is meant that repayment ‘is related

to turnover achieved with the new product/working method/service.’ The loan is paid back as a

percentage of project related sales revenue at rates that reflect the expected profitability of the

project and the government contribution. As the TOK repayments are a function of turnover,

the scheme meets the necessary conditions to be labelled an SCC. If, after 10 years from the

completion of development, the product/working method/service is judged to be a technological

or commercial failure, repayment of any remaining loan balance is abrogated. In the interim,

however, the firm was charged interest – at a rate determined annually by the Minister, which

has ranged between 4% and 9% p.a. – which is added to the principal each year. Given the risk-

bearing nature of TOK funding, the repayment performance has been very reasonable, in that

57% of the government contributions have been successfully repaid.19

18 specifically a project which is at the intermediate stage between research and commercial exploitation 19 Diederen et al. (1999) give a figure of 67%. However, recently acquired information from Senter indicates that 57% of the total amount has been repaid, but 69% including the amount of interest.

33

Although new TOK/TOP contracts have not been issued since 2003, approximately 400

contracts are still outstanding. In banking terminology, they are ‘performing’, i.e., yielding the

contractually-stipulated (SCC) repayments (see Table 1 below).

Table 1. TOK/TOP and repayment performance.

Year of demand Amount (mEur) % repaid

2000 34.4 3.2 % 1999 32.2 5.0 % 1998 36.2 9.1 % 1997 27.7 9.1 % 1996 68.0 76.0 % 1995 22.0 25,1 % 1994 73.4 35.4 % 1993 31.0 30.9 % 1992 42.3 90.0 % 1991 51.8 59.6 %

The decision to abrogate TOK/TOP in 2003 rested not on any inherent shortcoming in the

programme itself in an operational sense. The decision has been characterised as ‘political’.

Senter redirected its energies toward providing support in the form of subsidy, rather than in the

form of repayable finance. One commentator has summarised it thus: ‘SMEs like subsidy more

than a loan!’

In the brief period since new TOK funding has been curtailed, experience has shown that a

particular profile unites those firms that especially lament the winding-down of TOK: firms

that fall outside sectors perceived as ‘hot’ or ‘sexy’ from a capital gains perspective.

35

8. THE POLICY RECOMMENDATION

We start this section by bringing together the several streams of the argument above.

(i) Governments have shown that they wish to stimulate the growth, development and

innovative activity of SMEs. The justification for such stimulation may be based upon

the existence of various market failures, network externalities or less rational grounds.

(ii) There is considerable evidence to suggest that SMEs are financially constrained in their

activities and thus policies to improve access to finance are widespread, the two main

instruments being the public provision of, or support for the private provision of, debt

and equity (venture capital finance) funding to SMEs.

(iii) There is a third form of funding which we label SCC-backed finance which offers the

borrower a different risk profile to debt and equity instruments, does not necessarily

need collateral and will not necessarily mean loss of control – all characteristics that

would make it attractive to many borrowers.

(iv) SCC-backed finance is not generally available on the private market especially to

SMEs. This we have discussed in the context of aerospace projects as the result of the

nature of the uncertainty in that industry and/or the lemons problem. In general however

we may argue that as an SCC arrangement shifts risk from the borrower to the lender

the non existence of the market may reflect the high cost that financiers would charge

for carrying such risk and as a result the absence of an equilibrium in the positive

quadrant in the market.

(v) There are examples of governments offering SCC based schemes for project related

finance in a number of countries. These schemes do not necessarily represent a subsidy

to the project; it depends on the terms and conditions.

(vi) Existing schemes show that SCC-backed finance is attractive to innovators and

moreover stimulates innovation.

(vii) There is sufficient evidence from existing schemes that there is nothing inherently

unworkable in SCC-based schemes. On a practical level therefore they may be extended

to other circumstances. On a practical level it also means that obvious issues such as

moral hazard, actions in the face of bankruptcy and takeover can all be tackled

successfully. In addition there is a track record that may be used to determine

appropriate loan proportions, pay back periods etc.

36

On the basis of the above we make the proposal that in order to further stimulate innovation and

growth in the SME sector that governments establish institutions to provide or provide

guarantees to underwrite the private provision of SCC-backed funding to existing SMEs. In

pursuit of this objective we also suggest

a) That it is the provision of SCC-backed funding that is at the centre of this proposal (the

correction of a missing market problem) and not a back door route to subsidy provision

(although there may be a case for subsidy provision it is not our argument here). Thus

the SCC arrangements should be “priced” using realistic expectations and discount

rates that reflect either the government cost of borrowing or the opportunity cost of

government funds. As the government is able to pool risk, is more able to borrow

cheaply than the private sector, even without subsidy we consider that the government

will be able to establish a market with positive trades.

b) Existing examples of SCC-based schemes, e.g. Launch Aid and TOK, are designed to

provide project finance. In this proposal we consider that it would be more appropriate

to provide corporate rather than project finance. There are several reasons for this. First,

project finance in SMEs may be small scale and as such the search and evaluation costs

of providing finance may be too high. Second, the literature suggests that firms may try

to avoid repayment by closing one project (that being supported) and opening another

to exploit the results. Third, with most SMEs it will be the overall financial position that

is important and not the finance of individual activities.

c) We argue above that the situation where SCCs are most attractive to borrowers and also

where there is least likely to be a market is where risks are greatest and/or there is a

particular balance of idiosyncratic to systematic risk. This implies that government

involvement is more appropriate in some circumstances than others. Our argument is

that any such scheme should be confined to the higher risk sectors of the economy,

these essentially being the higher-tech sectors.20

d) Given that we do not see this scheme as representing a subsidy, it is to be expected that

government investments will be repaid and thus the long-term charge to the Treasury is

neutral. More speculatively, we see the possibility that any agency (be it a public

agency or a publicly supported private agency) offering such SCC-backed finance will

over time build up a portfolio of contracts with SMEs in different sectors in different

markets and market niches with a spread of idiosyncratic risks and thus perhaps lower

20 One might also argue that the scheme would be more appropriate in market-based as opposed to bank-based economies, the former having alternative relations that might overcome the problems.

37

overall risks. We see no reason why such an agency should not attempt to securitise this

portfolio thus enabling earlier repayments to the Treasury.

e) Whether the agency is publicly owned or whether the scheme should provide

guarantees to underwrite private sector lenders offering SCC-backed finance is largely a

matter of where one believes the expertise might lie. In general there is scepticism as to

whether civil servants have the necessary background to make the difficult selection

decisions that such a scheme might imply and/or may be subject to political pressure.

There may thus be some preference for the hands off guarantee system. Furthermore, it

is to be emphasised that the scope of the present proposal excludes start-up finance.

This lowers further the expertise and undertakings in futurology being asked of the civil

servants who are to administer this scheme.

39

9. CONCLUSION

In this paper we have argued that SMEs in Europe face financial constraints that limit their

innovative behaviour and as a result governments intervene actively. We discuss a particular

form of finance – Sales Contingent Claim backed funding – that offers different risk-repayment

profiles to debt and equity instruments and which is attractive to many firms and argue that if it

were available it would stimulate SME growth and innovation. However, for various reasons

such financial instruments are not available to SMEs on the open market. To overcome this

market incompleteness problem we argue that existing policy instruments could be

supplemented by an additional scheme that would provide, or guarantee the provision of, SCC-

backed finance to SMEs. We are not suggesting a subsidy, rather the correction of market

incompleteness. We have illustrated the workability of such schemes by looking at existing

examples aimed at project finance for larger firms and have also discussed some of the practical

issues. We favour a scheme that targets corporate finance for SMEs in higher risk (higher tech)

sectors with the government providing guarantees to private financiers rather than establishing

an in-house agency.

41

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