Financing SME Innovation in Australia – Challenges and Opportunities | Speeches

Introduction

Small and medium-sized firms (SMEs) are in many ways the backbone of the Australian economy. At the
Reserve Bank, the importance of SMEs has long been reflected in our analytical research agenda and our
liaison program. Indeed, last July the RBA hosted its annual small business financing roundtable event
for the 31st time, while our liaison program – which includes active year-round engagement with
SMEs spanning the breadth of the country – is now into its 24th year.

There are different ways through which to view the contribution that SMEs make to our economy and society.

The first (and most familiar) is through their central role in the daily life of our communities. Of the
2.6 million businesses in Australia, 97 per cent are characterised by the Australian
Bureau of Statistics as ‘small’ firms (comprised of less than 20 employees), with a
further 2 per cent of firms classified as ‘medium-sized’ (between 20 and
200 employees). SMEs are widely represented across the sectors of the
Australian economy. A particularly notable contribution they make is through the labour market, where
SMEs account for two-thirds of private sector employment. They also comprise just under
60 per cent of company profits. More than this, SMEs are integral to the social fabric of our
communities – whether it be sponsoring the local kids sporting team, community theatre production
or charity event. Nowhere is this more true than in regional Australia, where many SMEs are family-run
businesses that provide goods and services in areas where larger firms are less active. And who
doesn’t have a favourite weekend ‘local’?

Another way in which to view the contribution of SMEs to our collective wellbeing is narrower but no less
important – they are potential engines of innovation and dynamism in the Australian economy. SMEs
can introduce competitive tension to established markets that are typically dominated by larger
incumbents, driving them to be more efficient in the process. And in generating or diffusing new ideas
and better ways of doing things, they can create new markets for goods and services and facilitate the
reallocation of capital and labour to more productive use. This creative energy can be of sufficient
scale to directly impact our living standards. But unleashing this creative energy first requires access
to financing on reasonable terms. And for a long time, this has been easier said than done.

It is this innovation role for SMEs – one that has historically received less attention – that
I will focus on today. More concretely, I will begin by setting out some tangible markers of the ways in
which a cohort of SMEs, particularly those seeking to compete in global markets, are helping to fuel
innovation in the Australian economy. I will then discuss some of the longstanding financing challenges
experienced by SMEs, particularly those seeking funding for innovation-based investments that have a
large ‘intangibles’ component and a long and uncertain payoff. I will conclude by casting a
light on the evolving role that the Australian financial system is playing in supporting innovation among
smaller entrepreneurial firms.

The punchline here is two fold. First, SMEs have become increasingly important participants in the
innovation ecosystem in Australia, particularly in professional, scientific and technical services. In
some respects, they appear to be taking over the ‘innovation baton’ from large firms, including
in early-stage investment in research & development and intellectual property rights. Second, while
the Australian financial system and policy settings have interacted to lend more support to
innovation-focussed SMEs over the past decade, there is more to be done if the next generation of
innovative Australian firms are to have the wind at their back.

The contribution of SMEs to innovation in Australia

Why should we care about innovation, and the role of SMEs in it? One reason is that innovation is a
feedstock for productivity, which in turn drives national living standards. But as the Productivity
Commission has noted, Australia’s productivity performance in the 2010s was the worst in six
decades, and the picture has yet to improve in the current decade. If there is a blessing in disguise
here, it is that these outcomes have ignited a renewed sense of urgency about how we turn this around.
And as we will come to see, some SMEs have a large and growing role to play.

For our purposes today, I will generally refer to innovation as the development and application of ideas
and technologies that improve the quality of goods and services, or that make their production more
efficient. This encompasses not only the generation of entirely
new products and processes, but also the rapid adaptation and diffusion of other cutting-edge ideas and
processes across the economy. Innovation is closely tied to the concepts of ‘creative
destruction’ and ‘economic dynamism’, which can find expression in the entry of new firms,
the downsizing (or exit) of less efficient firms, and workers moving from lower to higher productivity
firms where wages are higher.

On first impression, a discussion of SMEs in this context might seem a bit out of step with today’s
international focus on large, winner-take-all ‘superstar’ firms – think BigTech. Here we
see a growing share of sales concentrated in a handful of large dynamic firms, whose high mark-ups allow
them to generate abnormal profits. This is no accident. Favourable ‘unit economics’ in parts of
the technology and data services industry mean that each additional unit of sales, generated from around
the world, costs little to produce and so flows straight through to the bottom line. A related theme is
that powerful network effects and high barriers to entry (‘walled gardens’) can further
entrench market dominance of large incumbents, where free cash flow is recycled back into ever-growing
innovation budgets, supporting the development of even more highly valued goods and services and thus
increases in profitability. This is the context for rising concerns from competition regulators around
the world.

But while the concept of innovation might have become, in the public imagination at least, more closely
tied to the largest global firms, part of what I want to discuss today is a less covered story –
and that is, the pulse of innovative intent that is running through parts of the Australian SME
ecosystem. This pulse might be less visible than the latest edition of the iPhone, but it is happening
nonetheless.

Consider, for instance, spending on research and development (R&D), which is an integral feature of
any economy with innovative aspirations, including where firms seek to compete in global markets. SMEs now
spend around 25 per cent more on R&D than large firms in Australia, the largest
differential in decades. The SME share of R&D spending in Australia oscillated between 30 and
40 per cent for many years; today that figure stands at 55 per cent (Graph 1).
All of the real decline in national R&D spending over the past 10–15 years can be attributed to large firms, which was initially
concentrated in the mining industry before broadening in scope to the non-mining sector. While real
R&D spending by large firms has retreated to levels observed in the mid-2000s, for SMEs it has more
than doubled over the same period and increased as a share of GDP. Today the biggest contribution to
R&D spending in Australia comes from SMEs in professional, scientific and technical (PST) services,
comprising 26 per cent of the national total; large firms in this sector comprise
8 per cent of the national total.

While just over half of surveyed Australian SMEs are likely to be innovating at any one time, compared
with around 70 per cent of large firms, the intensity of innovation is much higher
for the SMEs that are innovating. Put bluntly, these SMEs are more likely to be throwing the kitchen sink
at innovation. Beyond R&D, this includes by investing in intangible assets such as intellectual
property (IP) rights. Similarly, among firms that are active in innovation,
the effects on income tend to be far more consequential for SMEs than larger firms that typically have
more diversified revenue sources (Graph 2).

In the United States, recent research has pointed to a trend of declining in-house R&D spending by
large established firms. This has occurred alongside the repurposing of innovation budgets to fund
buyouts of smaller firms that are better placed to commercialise the best-of-breed ideas from their
interactions with the university system. Some preliminary research at the RBA has also
identified that Australian firms with IP assets are disproportionately likely to be the focus of the
buyout decisions of large established firms, over a period where the direct R&D spending by large
Australian firms has contracted. This is not to suggest that large Australian firms no
longer have an interest in innovation, only that it may be taking a different (acquisition-based) form to
the past. I will return to this later.

The Australian economy, like most others, tends to be an importer of ‘new-to-world’ innovations
rather than a large-scale producer like the United States. But in the case of firms that are engaged in
innovation in Australia, SMEs are almost twice as likely to have introduced new-to-world innovations
compared with large firms (Graph 3). These types of innovations are harder to produce and so are
typically riskier to finance. But they are also likely to generate large positive externalities for the
economy and society. Australian SMEs that sell into global markets and that collaborate on innovation,
particularly in the manufacturing and PST sectors, are among the most likely to innovate.

Patents and trademarks can be important markers of innovation, and the IP rights conferred by holding them
can be highly valuable intangible assets. As IP Australia has noted, patents and trademarks can provide
vital tools for entrepreneurship and the creation of high-growth businesses.
Labour productivity in Australia is around 30 per cent higher in the median patent-holding
business compared with the median business without patents. SMEs now hold almost all
patents and trademarks filed by residents in Australia (Graph 4). Perhaps more interesting is
that, as with R&D spending, there has been a significant relative shift in the holding of IP rights
between SMEs and large firms: over recent years the number of patent-holding SMEs has increased at a rate
five times faster than the increase in the number of SMEs in the economy – a pattern not apparent
among large firms. Australian SMEs that file for patents, trade marks
and design rights are more than twice as likely to achieve high turnover growth than their peers with no
recent filings. This broadly aligns with the experience in the United States where the holding of IP
rights has been shown to substantially increase investors’ estimates of the value of a start-up
enterprise.

It has been well documented internationally, and more recently in Australia, that economic dynamism
supports productivity-enhancing resource reallocation in the economy. This can be seen in wage and
productivity differences across firms (which promotes job switching) and in business entry and exit
patterns. For Australian firms of all sizes, there is a positive wage differential between firms that
hold IP rights (such as patents) compared with those that do not. But the differential is especially
pronounced for smaller firms (Graph 5). Over the past two decades, firm entry and exit rates have
generally declined in Australia, though the entry rate for small firms has tracked sideways over the most
recent decade (Graph 6). It is possible that lower transition rates (from smaller to larger firms)
and acquisition activity may have contributed to some of the sustained decline in entry rates for
medium-sized and large firms, but it is an area our researchers are looking into.

The longstanding challenge of SME innovation financing

The investment environment for firms is shaped by a number of factors, with the financial system and
policy settings key among them. As internally generated free cash flow is often in short supply for SMEs,
particularly younger firms, access to external financing can make all the difference. At the RBA,
we’ve consistently heard this message through our liaison program. It also accords with surveys of
Australian businesses indicating that a lack of financing is a key barrier to innovation for small firms
(Graph 7).

There are a number of factors at work here, some of which apply to SMEs in general, while others relate
more specifically to SMEs that are active in innovation-based investment.

The highest order problem is that small firms are riskier propositions for suppliers of capital. Survival
rates bear this out – whether new or established, small firms are more likely to go out of business
in any given year than their larger counterparts (Graph 8). Particularly low survival rates among
young small firms are consistent with the ‘up or out’ stage of their development, where they
are experimenting and succeeding, or failing and exiting – they either crash through or crash.

While bank loans to SMEs comprise half of all business lending in Australia, many SMEs report experiencing
tight financial conditions in the form of credit-rationing and/or high borrowing costs. This is partly
linked to risk-weights that are relatively higher for SME lending, reflecting banks’ risk modelling
where SME loans are expected to be around twice as likely to fall into arrears as large firms
(Graph 9). And loans to SMEs almost always require collateralisation, unlike those to large firms.

Prospective lenders and investors also tend to be more circumspect in financing SMEs for any number of
reasons, including that: there is a lack of scale in financing smaller entities; their revenues are often
more volatile; and informational asymmetries are more acute compared with larger firms where more
information on their finances is publicly available.

And if many SMEs feel as though they are kicking into the wind when it comes to access to financing, those
winds can blow stronger still for SMEs seeking debt funding to support their innovation priorities. There
are at least two reasons for this.

One issue is that innovation-based assets are often largely (or exclusively) intangible, and therefore are
not of a standardised form that most traditional lenders prefer. Given that almost all SME lending is
secured, and residential property has an outsized role in collateralising the loans of small businesses,
access to innovation-based debt financing is not straightforward. This is particularly the case for
younger entrepreneurs struggling to get onto the housing ladder. We also hear through our
liaison program that even if small business owners do hold residential property, some are understandably
reluctant to post it as collateral given the stress involved; and, if they do, they are more likely to be
more risk averse in their business investment decisions when their family home is on the line.

Survey data suggest that banks are much less likely to finance the innovation-based investments of SMEs
compared with large firms (Graph 10). SMEs are therefore more likely than large firms to fund
innovation-based investments from family and friends, and non-bank institutions like venture capital (VC)
and private equity (PE) funds who are better placed to bear such risk. I should note here that this
pattern has not been unique to Australia, but rather has been widespread across advanced economies and is
one of the factors supporting the growth of technology-focused VC funds and PE funds focused on
early-stage funding rounds.

Another funding issue that is felt acutely by innovation-focused SMEs is navigating the ‘valley of
death’ – the long lead time between converting greenfield research ideas into commercially
viable propositions, during which time firms can burn through their initial funding. This valley can
appear prohibitively deep and wide for many lenders.

Overcoming the financing impediments to SME innovation

While funding challenges will likely remain a fact of life for many SMEs, private and public capital is
now being mobilised in Australia in ways that are beginning to ease some longstanding constraints on
innovation financing, at least for some firms.

One of the most material developments has been the emergence of an institutional-grade domestic VC
industry that, over the past decade, has channelled long-term equity capital into some of
Australia’s more innovative and scalable businesses. This capital can support small firms that are
loss-making during an intensive period of ideation and prototype development. The past decade has marked
a ‘third wave’ for the domestic VC industry, after nascent upswings in the late 1990s and just
prior to the global financial crisis were followed by industry shakeouts. Investment in the Australian VC
industry (as a share of GDP) is now in the range of peer economies, though still considerable distance
behind the United States and Israel. Over the past decade, assets under management in Australian VC funds
have grown from $2.5 billion to $20 billion; their share of institutionally managed private
capital in Australia has doubled; and the number of VC deals written each year has increased
significantly (Graph 11). This is despite a challenging period for SME technology valuations over
the past two years as interest rates have risen. This capital is in search of the far right tail of the
distribution of young small firm returns, where a minority of enterprises can break out with innovations
that can be readily scaled into global markets, more than making up for losses incurred on those that
don’t make it (Graph 12).

At the same time, there are limits to what the private domestic VC industry alone can achieve in
supporting innovation in Australia. In any given year only a small fraction of innovating firms that seek
VC funding actually obtain it, the average deal size has clustered in the range of
$10–20 million over recent years (which may be too large or too small for some firms), and the
sectoral focus of VC funding is more narrowly skewed vis-à-vis other traditional SME funders (toward
software, information technology applications in financial and health services, and manufacturing). This
sectoral skew in investment is broadly consistent with the sectoral skew in R&D spending.

Over the past decade or so, government has also had an important role – direct and indirect –
in easing constraints on innovation funding through long-term equity and cash flow support. Tax benefits
for fund managers and investors have been made available through three different VC programs supported by
the Australian Government, and in 2017, CSIRO Australia founded the Main Sequence VC fund to serve as an
incubator for scientific entrepreneurial talent (particularly in ‘deep tech’) in Australia.
SMEs that are further along the commercialisation journey might be eligible for funding from the
Australian Business Growth Fund, which was established just prior to the pandemic to provide both
long-term growth capital and strategic advisory services for expanding SMEs. A range of government-backed
initiatives have also been introduced over recent years to support SME cash flows more generally,
including by shrinking the payment times for SME invoices. Arguably the most valued and direct source of
cash flow support for innovating SMEs has been the R&D tax credit, which has been in effect for just
over a decade. Indeed, recent analysis has found that the ability of Australian SME firms to compete in
export markets is linked to their incentives to innovate through R&D.

Debt market financing is available to innovating SMEs, though those that are cash flow positive (through
the ‘death valley curve’) typically have more options. VC debt funds have sprung up in recent
times, with expertise in valuing intangible assets and extending ‘growth credit’ aimed at
lengthening the runways for SMEs so they can get through to the next funding round. More generally, the
difference in variable rates between SME loans and large firm loans has compressed in recent years, and
it is possible that reductions to bank capital requirements for SME loans, which became effective from
January 2023, contribute to slightly more accommodative financing conditions for SMEs. Similarly, over
time, the comprehensive credit reporting and open banking regimes might help in reducing informational
asymmetries that can make it difficult for startups to access debt financing. The Australian Business
Securitisation Fund, which was established prior to the pandemic and invests in securitisations that are
backed by SME loans issued by small banks and non-bank lenders, is also aimed at easing financing
constraints for SMEs in general (though only a small number of investments have been made so far). And
non-traditional lenders, including technology and payment companies, are using transactions data to
rapidly identify and make unsecured credit available to SMEs using their own balance sheets. However,
these direct lenders comprise a very small share of the small business financing pie and, like most
lenders, don’t target innovating firms per se.

It is worth highlighting that it is not just increased access to capital that can support
innovation-focused entrepreneurs – access to networks and forums for providing strategic advice are
becoming commonplace. There is growing recognition across the community of former company founders,
experienced private VC investors and managers of public-private growth funds that strategic advisory
support – both formal and informal – also has a key role to play.

Conclusion

Our national living standards will turn in part on the propensity of firms to generate and rapidly
integrate innovative practices into their operations. It has been troubling therefore to observe that our
aggregate productivity outcomes have been lagging for a considerable time. We should also be under no
illusions that financing constraints for many SMEs remain substantial. And they can be even bigger for
SMEs that are trying to innovate aggressively, with little in the way of tangible collateral to pledge as
security for financing, and where it can take years to generate positive cash flow on the back of
investments in greenfield ideas and untried technologies. These types of investments are not for the
faint of heart.

But in recent years there have been signs, including in R&D spending and IP rights, to suggest that
the contribution of SMEs to the innovation economy has been rising. A cohort of Australian SMEs are
innovating intensively, including those with ambitions to compete on the global stage. And, as in the
United States, it is possible that a division of labour is beginning to emerge in the Australian
innovation ecosystem, where large firms increasingly look to acquire and scale up the innovative ideas
and practices first developed by more nimble, IP-rich smaller firms. Time will tell here. But if we do
follow the pattern in the United States where many large firms are looking to innovate through
acquisitions of dynamic SMEs rather than through in-house R&D, then it will place even further
importance on our SME sector as an engine of innovation in Australia. Either way, we also need large
firms playing their part in the innovation and productivity challenges facing the country. We need both
engines firing.

Of course, it is not feasible to expect anything like a majority of SMEs to operate on the global
innovation frontier – most understandably have more modest, local ambitions. But given the
overwhelming majority of firms in Australia are SMEs, it would only take only a small increase in the
share of these businesses to successfully innovate to have a material impact on the Australian economy.
It is therefore in our collective interest for the financial system and policy settings to interact in
ways that continue to support innovative Australian entrepreneurs. If history is any guide, the positive
externalities could entail benefits to the Australian economy and society extending well beyond just the
firms producing them.