Getting what you pay for

I once sat secretly as a fly on the wall during a long dispute between a struggling small business and its bankers. It was a rare opportunity to disentangle from the inside the claims and counterclaims we are always hearing from angry businessmen and resentful banks about who is to blame when things go wrong. In this case, the bank behaved terribly.

The story was a familiar one, as common now as 10 years ago: deep recession, shrinking markets, heavy losses and cutbacks, followed by the glimmer of an upturn. The overdraft then rose sharply, because more working capital was needed to cope with new orders.

The bank was plain nasty. It was obssessed with the value of its security - the firm's properties - rather than the prospects for the business after the recession. A regional director personally threatened receivership.

In fact, the story had an unusually satisfying ending. Outside venture capital shareholders in the firm were extremely supportive during the worst of the crisis. And before the receivers could be sent in, the firm managed to stun the bank by paying off the whole overdraft, using cash raised in a hurry from the disposal of an office building. When it assessed its security, the bank had got the property numbers cockeyed and its bullying had been a waste of effort.

There was no apology: only an pounds 8,000 bill from the bank for the fees of the investigating accountants. The firm quickly returned to profit. Other borrowers were less lucky.

One obvious lesson was the importance of having outside investors with an understanding of the business. But that also highlights a fundamental problem in the relationship between small businesses and banks.

Outside equity investors are assured of a return linked to the success of the business, if it survives, though they get less than anybody if it fails. A bank is paid a constant interest margin, whether or not the firm makes bumper profits.

That is the reason why businesses and banks are likely to fall out every time there is a recession. Despite all the public relations blather we are hearing now about improving the relationship, the fact is that a bank is acting perfectly rationally when it gets tough over an overdraft or short-term loan to a company in difficulty.

There is no reason to believe there will ever be any real change of behaviour. Indeed, why should there be, unless the bank's own rewards from lending to small businesses reflect the risk?

The banks lost pounds 4m a day last year on small business lending. One in three small businesses ceases trading in the first three years.

If there is to be small reward, then logically there must be low risk, and that is often likely to mean calling in security as soon as the danger signals go up. Otherwise, a bank loan becomes a quasi- equity shareholding, but without the compensation of high rewards for those investments that do become successful.

There has been a profusion of ideas to cope with this problem, going back more than 20 years to the Bolton report on small firms. A common theme has been the need to persuade firms to seek outside equity and long-term loans to reduce their reliance on brittle relationships with banks.

But after all the effort, 60 per cent of small business lending remains short-term, and 90 per cent is at 4 per cent or less over base rate.

Such a modest return is not a reasonable compensation for equity investment, where a minimum return should be about 20 per cent. It makes sense only if the loan is backed by the best security, which is normally property. So we are back where we started.

Entrepreneurs will continue to complain that they are asked to risk all by putting up their houses as security. They will also refuse to pay an interest rate that recognises that a loan to a small firm, especially a start-up, is often disguised risk capital.

One entrepreneur complained recently that when he tried to raise a bank loan, two clearers demanded his house as security, but he was not prepared to jeopardise his family. A third bank offered an unsecured loan 8 per cent over base rate but 'we were out the door before they had poured the coffee'.

There is clearly lots of room still for confusion about the difference between risk capital and lending. But the alternative of turning to specialist venture capital investors has proved just as much of an illusion for many companies. Venture capital firms' standards are high, accepting only one proposition in 20.

In any case, the clearing banks remain the only organisations with the capital resources, the extensive branch networks and the number of staff to cope with the demand for finance on anything like the scale required.

A few of them, notably Midland, have been experimenting with new types of venture capital funds, but these are modest in size and growing slowly. Something more comprehensive is needed.

So why not concentrate on a half- way house between equity capital and straight lending, in which the bank's returns are linked directly to the business's success over a fixed period of years?

In the current climate of suspicion, small businesses will reject packages of that type as yet another bankers' rip-off, robbing them of the future rewards of their efforts. But human nature being what it is, the brutal fact is that better returns for the banks are the best way to persuade them to change their spots and become more supportive when times are hard.