Funding sources for micro, small and medium sized enterprises in Ghana (2)
In this section we provide an analysis of some of the benefits and drawbacks of these forms of rising capital.
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There are three forms of rising capital ; Equity financing; Debt financing; and Hybrid financing.
Equity financing
• No debt repayments: One of the primary benefits of equity financing is that there are no debts to pay off - and thus no potential risk to cash flow. Investors typically focus on the long term growth of the business without expecting an immediate return on their investment.
• Mentorship: Partners and investors can offer a wealth of expertise, advice, and experience that contribute to MSMEs’ growth. Debt financing is only able to connect businesses with financial institutions.
Drawbacks
• Potential loss of control and ownership: One of the main drawbacks of equity financing is that MSMEs must give up a portion of their ownership and dilute their control. Equity investors will also expect profit from their investment if the company becomes successful- thus a certain percentage of company profits must be paid in the form of dividends.
• More costly in the long term: This is because investors require a higher rate of return than lenders for the level or risk they are taking on. In addition, dividends paid to shareholders are not a tax-deductible expense.
Debt financing
• Retain company ownership and control: This is the main reason why MSMEs decide to finance through debt rather than equity. Debt capital is provided by a lender, who is only entitled to their repayment of debt plus interest, therefore obligations to the lender end once the debt is paid off.
• Tax deductible interest payments: Another key benefit is that the interest payment is tax-deductible.
Drawbacks
• Loan repayment: Depending on the terms of the loan, MSMEs may struggle to grow their businesses while making repayments. Business assets are also at risk when the business defaults on its repayments and the lender takes ownership of the assets.
Another risk is where businesses may not have the required assets to support their loan request and therefore will not be able to access the needed financing.
• Impacts credit ratings: Late payments and defaults can affect the business’ credit rating over the long term, making it difficult to borrow in the future.
Hybrid financing
• Long-term borrowing with limited or no collateral: Financing packaged in the form of debt and equity allows for long-term borrowing with limited or no collateral as the profile of the debt repayments is aligned to the profit of MSMEs.
• Stability and Mentorship: It provides MSMEs with stability and includes access to expertise and mentoring that is pivotal in helping MSMEs successfully run their businesses.
Drawbacks
• This form of financing is relatively complex compared to either pure equity or pure debt financing.
In deciding on the right capital raising method for MSMEs, businesses must consider the current economic climate, the business’ existing capital structure, the business life cycle stage, and future business plans, amongst others.
Startups or small businesses looking to expand can consider equity financing and well-established businesses that have constant sales, solid collateral, and are profitable can opt for debt financing depending on the type of project.
Ultimately, the decision must be taken with care and due diligence.
Key investor considerations
To secure investment from a potential investor, MSMEs must consider certain factors which would make their businesses or projects attractive for investment. Some of these factors include:
• Return on investment: Profits are typically high on the priority list of investors, and as such, businesses seeking investment must demonstrate to the investor that the company can return profits in the short to medium-term.
This can be done by presenting financial or non-financial reports to the investor to show the level of growth the company has achieved over the years and what it intends to achieve going forward.
This helps investors to get a better understanding of the financial health of the company and get a better appreciation of the likelihood of positive return on their investment.
Typically, capital raising is not free for MSMEs seeking either formal or informal sources of capital. Investors usually expect return on their investment, and, in some cases, a total repayment of the capital invested over an agreed period of time.
Repayment of capital is usually associated with debt capital raising. To stand a greater chance of receiving funding, MSME’s must demonstrate a clear and well-defined repayment plan.
A repayment plan gives the business sourcing for capital a greater chance of securing its targeted investment.
A repayment plan serves as a sense of security for potential investors, and as such, it is a factor that cannot be overlooked for MSMEs in particular.
• Use of funds: Companies that can provide a detailed breakdown of the use of funds for its investors stand a greater chance of receiving capital from such investors.
‘Use of funds’ can be demonstrated through a business proposal indicating the use of funds from past fundraising ventures, and how the new capital will be used to further expand the business of the company.
‘Use of funds’ offers an affirmation to the investor that the business is credible.
• Experienced management: Investors look out for MSMEs that have a track record of making sound judgement over a period and this can be a good indicator that the management of the MSME can do a good job.
Inability to demonstrate management’s experience and record of successfully implementing effective business strategies and sound governance practices can affect the decision regarding meeting a full monetary request or deciding otherwise.
It is therefore expedient that MSMEs ensure they have the right people leading the business at a managerial level and are able to demonstrate this ability if required.
• Good and robust financials: An investor looks out for a company that can demonstrate strong historical earnings and the capacity to sustain earnings growth into the future. Typically, investors prefer to assess the Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA) of target businesses or projects as EBITDA is used as a proxy for the cash profits generated by businesses.
MSMEs that show a healthy profit margin as well as a steady financial projection can get a bigger share of available capital from investors as they show a good standing pre-capital raise.
• Diverse product and services: Product diversification is a practice where a business expands the original market for its products and this practice is commonly adopted by businesses that are experiencing stagnation and a reduction in sales.
When an investor knows that a MSME is seeking to increase its sales and reach through diversification of its products and services, it can lead to a greater chance of capital raise.
MSMEs seeking to raise capital from investors, where applicable, are encouraged to consider diversification as a good strategy to have in their repertoire as it shows the investor that, as a company, you are willing to make the product and service relevant to your clients and customers.