How good an investment is your own small business?

Posted by mjs76 at May 29, 2012 12:23 PM |
Academics in School of Management calculate groundbreaking ROI model for SMEs.

Financial investment models generally look at the behaviour of an investor who is interested in maximising the return on their investment in a business. However, they tend to fall apart when applied to SMEs (small and medium enterprises) where the investor and the entrepreneur running the business are the same person and where maximising profits is not necessarily the main driving force behind the investment.

But if traditional investment models don’t work for SMEs, how is an entrepreneur to know whether their SME represents a sound business opportunity?

Now two academics in our Institute of Finance, part of our School of Management, have developed a mathematical model that solves this problem, which they will present at a major financial conference in Spain next month.

Dr Andrea Moro

Dr Andrea Moro and Dr Sandra Nolte point out in their paper, which is available online, that “it is essential for the entrepreneur to work out the return on their investment and thus the overall cost of capital and the capital structure. Traditionally, there are two possibilities to figure out the return of their investment: the accounting figures and the market.” They then go on to show why neither the accounting figures nor the market are appropriate in the case of SMEs.

In the standard models an investor has a ‘diversified portfolio’ of investments and by judiciously building this portfolio they can maximise the return by minimising the risk. But SMEs are very ‘illiquid’ and entrepreneurs can hardly sell up if the business is not doing well, because the entrepreneur is the business. In addition, entrepreneurs are ‘under-diversified’ because all their investment is concentrated in one business.

Dr Sandra Nolte

On top of these aspects, there are “psychological and social benefits uncorrelated with the amount of money invested in the venture [which] add an additional layer of complexity to working out the expected financial return on equity for the entrepreneur.” SMEs, by their nature, tend to be personal projects. The entrepreneur has much more ‘invested’ in the business than just money. There’s pride, passion, independence, dreams, determination, even love. You can’t show those on a balance sheet! And if the business does go belly-up, it will take with it more than just a (usually very large) slice of the entrepreneur’s personal wealth.

Based on these considerations, the Leicester academics worked out the minimum return on investment for an SME, approaching the issue from a completely different perspective:

The ‘minimum’ rate of return on the funds provided by an entrepreneur is the remuneration that compensates for the risk of bankruptcy of the venture in which the entrepreneur has invested, weighted for the impact the loss at liquidation would have on the entrepreneur’s personal wealth. [This value] does not necessarily represent the expected return of the specific entrepreneur. It represents what the entrepreneurs have to require from their investment because of the risk they incur.
Moro and Nolte

Across several pages of mathematical formulae, Moro and Nolte then set out a model which is surprisingly simple, requiring as it does just two inputs, both of which are easily accessible to entrepreneurs (or other investors):

  • The survival rate of SMEs in the appropriate ‘business cluster’
  • The history of the entrepreneur’s previous success up to this point.

In other words, at the risk of gross over-simplification, the financial soundness of an SME venture is dependent on how well businesses of that sort normally do, and how well the individual entrepreneur’s previous businesses have done. Though there is, as the saying goes, a bit more to it than that.

Andrea and Sandra will present their paper 'Industry Survival Rate, Entrepreneur Historical Performance and Personal Wealth: A Probabilistic Model for Optimizing SMEs Capital Structure '(doi:10.2139/ssrn.2021011) at the 21st European Financial Management Association Meeting in Barcelona over 27-30 June 2012.