One of the biggest constraints for Small and Medium sized Enterprises (SMEs) in Sub-Saharan Africa (SSA) is access to finance. In Africa, over a fifth of SMEs cite access to finance as their BIGGEST constraint ahead of lack of adequate electricity, poor business environment/investment climate and skills mismatch, according to the World Bank. Relative to other regions globally, the percentage of respondents highlighting access to finance as a key constraint was highest in SSA.
Source: AfDB report on private sector development strategy (2013-2017)
Financing for SMEs can broadly be placed in two categories – debt, which most African businesses are familiar with from banks and other non-bank financing institutions, and equity. Growth equity is where the cash injection is used to grow the business alongside existing owners and not buy them out.
Increasingly, a third category – mezzanine financing – which falls in between and has characteristics of the two is also rising in popularity.
The overall undersupply of finance in SSA is exacerbated by a perceived under-appreciation of equity. In effect, founders and business owners reject equity. This article will attempt to address what equity is and why, in the current under-supplied environment, it can be an important form of capital.
For many business owners, the issue with equity financing in return for a stake in their business is all to do with ownership dilution and decision-making. Owners are unwilling to allow third parties to own a part of their business. The question to pose to these entrepreneurs is why own 100% of one when you can own 50% of ten – what is wrong with owning a smaller percentage of a much bigger pie?
A part of the reluctance lies in the genesis of many SME businesses. Many of these businesses are established as small/lifestyle businesses where historically there is little separation between the business owner and the business. As an example, it is often the case that the personal bank account of the owner is one and the same as that of the business. It is therefore difficult mentally for owners to admit others into what was previously a party of one.
It is true that debt/credit is a cheaper form of capital and one that is better known across SSA. However, we note that across SSA there is a severe shortage of credit (excluding South Africa). This can be seen in various statistics including the credit availability score, domestic credit to private sector (as a % of GDP) and bank credit to the private sector (as a % of GDP). In all of these instances, SSA countries lag (in some cases, significantly) behind developed countries.
Due to this shortage of credit, SMEs are financing close to 80% of their capital requirements through internally-generated cash flows, according to the World Bank.
Some of the reasons why businesses just cannot obtain bank debt include (i) reduced appetite from banks due to attractive rates on government bonds, (ii) a preference from banks for large companies/ ”national champions”, (iii) onerous requirements placed on potential borrowers (i.e. client of the bank for x number of years, substantial collateral etc), and the list goes on.
The reality is that debt, when it is available and at the right terms (tenor, repayment profile etc), can be quite attractive and in many cases preferable to equity. However, when debt is not available or inappropriate, business owners should be open to growth equity.
The premise behind growth equity is that in return for capital, existing owners provide an incoming investor with an ownership stake in their business. The process for this, simplistically, involves (i) determining how much capital you need to raise for your growth needs (ii) preparing a valuation of the business, (ii) agreeing the valuation with the investor, and (iv) based on the amount they are investing and the value of the company, determine what percentage of the business they get.
It is usually advisable to engage an advisor to guide you through these steps (and also source potential investors) but it can be done without, if you have some financial acumen and access to High Net Worth Individuals (HNWIs), angel investors or institutional SME private equity funds.
Equity has a number of benefits and constraints. The main constraint is that, as a higher risk form of investment with no contractual cash repayments (unlike debt), it is expected to generate a higher return (reward). It is therefore “more expensive” than equity in that investors expect a return that exceeds that obtainable when investing via debt.
This does not mean that the equity investor requires cash repayment over time on his/her investment, although this is possible through the non-mandatory annual dividend.
In reality, equity investors expect the business to grow (as a result of the cash injection) and be worth more a few years down the line when they decide to sell their ownership stake back to a (now richer) founder or to another investor. However, if the business is performing well and generating excess cash flows annually (over and above the amount required for re-investment), the investor will expect to receive annual excess cash paid back as a dividend.
Equity financing means that business owners are not under pressure to make contractual repayments as is the case with debt.
They have breathing room to grow their business, reinvest cash generated by the business, and as a result (hopefully) grow the bottom line and the value of the business – yes, you own less of the business but in dollar terms your reduced ownership in a bigger business is greater than 100% ownership before the equity investment.
While it can be a pain to share decision-making and be accountable to a third party, by choosing investors who bring more than just cash to the table (e.g. experience in your market/sector, access to new customers/clients and new markets, access to cheaper inputs and strong relationships with stakeholders relevant to your business), your business may very well immensely benefit in the end.
Fadi Bassir is an investment executive at CDC group, the UK government's investment arm, focused on investments across Sub-Saharan Africa. He is also an adviser to Savant Capital Africa, an advisory firm focused on West Africa. He has professional experience in private equity, fundraising and corporate finance.