Innovation is the key to growing the economy and creating prosperity. It creates new industries, transforms old ones, and often generates well-paid jobs.
Today, innovation usually relies on the investment in and the growth of intangible assets, such as software, data, networks, and design.
But the financial system has failed to keep pace with innovation. Lending models, especially for smaller businesses, are not designed to support the intangible economy.
While value is built in intangible assets, finance is raised against tangible ones, which are diminishing.
Without change, old lending models based on providing a hard asset as security will restrict innovation and hurt growth.
What’s caused this issue? Well, over the last 20 years, business has evolved. To spur growth in the twentieth century, companies might have invested in property, machines, and hardware – tangible assets.
But to generate growth now, businesses are putting more money into software, research, design, and branding – intangible assets.
Just look at some of the most successful companies today: Google succeeds because of its algorithms; Apple has soared due to design and branding; and Uber is worth billions of dollars because of its network and data. These companies are valued so highly because of their intangible assets.
Albeit on a different scale, the same is true of many of London’s businesses. Service and technology-based firms dominate the capital’s economic make-up. Of the £37bn annual export of goods and services from London, financial and business services account for around £15.5bn.
And the principle applies as much to smaller firms as it does to larger ones.
Growing creative businesses, law firms, and even coffee shops rely on branding and intellectual property to help them stand out from the crowd.
Yet economies struggle to capture the value of these companies because accounting standards have not kept up.
The same is true of business finance. When firms take out loans to fund growth, those loans are traditionally based on the business’s tangible assets, such as its property or machinery.
If a business with tangible assets folds, a bank can recover its money by selling those physical assets. In such a situation, the bank is happy to take the risk. But if a company with intangible assets folds, those assets cannot as easily be sold off.
As a result, banks have reduced their lending to growing businesses that don’t have assets to put up as security.
Considering that growing businesses are a vital part of our economy, this creates both a critical brake on growth and a drain on productivity. The lack of lending also contributes to the broader issue of why the UK fails to generate new global behemoths.
Without access to suitable finance, the best outlook for a small but growing firm might be to sell to a larger counterpart. So rather than struggle to find funding that they need, business owners can leverage their new parent company’s financial clout and implement their growth plans – albeit at the cost of their independence.
So what’s the solution?
Traditionalists will say that equity funding – whether through venture capital or private equity – is the answer. Often that holds true, but third-party investment does not suit everyone. It also dilutes ownership.
Instead, lenders must look at the future of a business and assess what cash flows it will generate. It is the intangible assets in a business that drives future cash flows more than its fixed assets, and this free cash can be used to service debt instead of equity.
This type of financing, known as cash flow lending, helps to foster the growth of SMEs in our new economy.
When innovation is so important for growth and prosperity, we must do all we can to help fund that innovation in the intangible economy. We therefore need lending that is fit for purpose.