Equity finance: Financing option for small businesses

Small and medium enterprises are the backbone of the Ugandan economy, accounting for a large percentage of private-sector employment, both in rural and urban settings. Data from the Uganda Investment Authority (UIA) shows that SMEs account for approximately 90 per cent of the entire private sector jobs in the country. The survey also revealed that SMEs employ more than 2.5 million people, generate more than 80 per cent of all manufactured output, and contribute 20 per cent of the Gross Domestic Product.

SMEs are critical for a country’s growth not only for their ability to create jobs, but also in stimulating economic growth. A 2017 World Bank report reinforced this fact, citing that the establishment of a competitive MSME sector can create a more diversified, agile, and resilient economy with enhanced productivity and competitiveness.

However, despite their significance to a developing economy like ours, small businesses face numerous challenges that hinder their growth and expansion. The recent economic crisis and the credit crunch triggered by the outbreak of the Covid-19 have exacerbated their woes, leading to the closure of most of them.

Unfortunately, the SME sector is growing and dynamic, and there is no official data about it.

But the coronavirus pandemic notwithstanding, access to affordable long-term finance has, for a long time, been one of the most significant barriers to the development of small and medium enterprises. Most of these businesses are started and run through bootstrapping - with entrepreneurs relying on their savings, time, and limited resources. More often than not, they keep their operating costs as low as possible, have a cash-only selling policy and have a high inventory turnover, because they have to rely on retained earnings to run their businesses.

Once the businesses are up and running, they turn to banks, and other financial institutions like Saccos, for short time loans, which are expensive and rigid. This kind of funding is referred to as debt financing. 

Unfortunately, most SMEs do not survive past their first anniversary. Reasons are varied as to why SMEs face hurdles in financing. They include lack of internal controls and poor bookkeeping, lack of audited books of accounts, non-tax compliance, limited assets to use as collateral, and most have one manager/owner who calls all the shots.

It then becomes challenging for such a firm to get financing from banks, which are in their nature risk-averse. Banks will demand collateral, often in the form of immovable assets, which most SMEs don’t have.

Yet there exist other funding options that are more suitable for startups and growing enterprises. These come in the form of angel investors, venture capitalists, and crowdfunding. These are referred to as equity financing options. In simple terms, in equity financing, an entrepreneur uses other people’s money (investors) to finance their business.
 The main difference between debt financing and equity financing is that with the former, you borrow a debt which you have to repay at interest, while in the latter, the small business owner gives up part ownership of his/her company in exchange for funds. 

Many large multinationals started as startups and only thrived after receiving a capital injection from investors. For example, Facebook, which Mark Zuckerberg formed together with his college mates, got off the ground after venture capitalist Peter Thiel injected an initial $500,000 investment into the startup. Today, the US company is worth billions of dollars. Though Zuckerberg owns most of the shares, he has had to cede part ownership to investors’ groups. 

Investors not only provide funds in exchange for equity but can also help in providing valuable advice and business linkages. Since they want their investments to grow, they come with a wealth of experience and provide sound management to the business.

However, equity financing comes with it’s a fair share of demands that may be challenging for Uganda’s SMEs. Before potential funders can invest their money, SMEs must first put their house in order by embracing good corporate governance, have proper structures, be open and transparent with sound financial discipline, be tax compliant, and have adequate documentation, which means they have to formalise their business. 

However, if these SMEs are to survive past infancy, the government must create policies that favour entrepreneurs. These include favourable tax laws and ease of business registration. The Ministry of Trade should also organise forums to sensitise small business owners about good governance and operational structures and how these ease capital acquisition. 

These measures will enable SMEs to continue to play their role in innovation, investment, job creation, and economic growth which is crucial because according to World Bank estimates, 600 million jobs will be required by 2030 to absorb the growing global workforce.

The author is the country manager at Business Partner Internal - Uganda.