The Need for Alternative Finance for Small and Medium Enterprises

Accra, Nov. 03, GNA - While corporate firms may have the capacity and credit worthiness to access large amount of loans and other credit facilities from banks to expand their operations, same cannot be said of SMEs.







STRATEGY, RISK AND INVESTMENT SERIES
PART ONE

By the nature of their formation and the fact that majority of SMEs in Ghana are sole proprietorship businesses without a clear separation of management from owners, it becomes very difficult to list them on the GSE to access finance from investors who intend to have a stake in the SMEs. This poses a major challenge to SMEs accessing funds from the public through the issuance of shares on the stock exchange. Again, by their own characteristics and ownership structure, majority of SMEs exclude themselves from gaining entry into the capital market to access finance. Hence, they are left with limited access to finance in the financial sectors amid the intense competition from larger corporate firms who are deemed by banks to be of low risk and more credit worthy as compared to SMEs.

The major sources of finance for SMEs in Ghana are depicted in figure 1.
Sources of SME Financing in Ghana

Venture capital, though an important source for financing SMEs represents a very small part of finance in Ghana and is mostly the least considered by most entrepreneurs.

Alternative Financing Options
In its 2018 ministerial conference on strengthening SMEs and entrepreneurship for productivity and inclusive growth, the OECD (2018) indicated that despite the challenges encountered by SMEs in accessing bank credit, there are opportunities for SMEs to tap into a wide range of alternative financing instruments as an innovative means of meeting their financial needs. the alternative financial instruments for SMEs could be categorized into four major groups based on their risk/return relationship as follows:

1.Asset-based Finance
Asset-based finance may be defined as a financial arrangement whereby a business uses its non-current assets other than cash as collateral to obtain short-term credit without much emphasis on its credit history. Examples of asset-based financing instruments include asset-based lending, factoring, hire purchase, invoice discounting, and leasing.
This form of alternative finance is widely used by SMEs in developed countries to meet their short-term cash flow needs and in recent times has gained considerable attention in some emerging economies as an effective financial instrument for meeting the working capital needs of SMEs (OECD, 2018).

It must be emphasised that an SME’s qualification for asset-based finance depends on the liquidation value of its underlying asset, rather than on its credit history. The major examples of asset-based financing instruments have been discussed below to give an overview of the instruments and how SMEs can explore them in meeting their financing needs:

a. Asset-Based Lending
Asset-based lending is an alternative financial arrangement where a finance company grants a short-term loan to a business using the value of assets pledged as collateral occurs when a loan is granted to a firm solely on the value of assets pledged as collateral (Abor & Quartey, 2010). It must be emphasized that the terms and conditions of asset-based lending depend on the type and value of assets offered as collateral for the loan with lenders preferring highly liquid securities that can readily be converted to cash in situations where the borrower defaults on its payments (OECD, 2015). This implies that the higher the liquidity of the asset, the higher the loan-to-value ratio. However, it is worthy to note that the amount granted under asset-based lending is not equal to the full book value of the assets pledged.

b. Factoring
Factoring is a financial arrangement whereby a business entity sells its account receivables (invoices) to a third-party called a “factor” at a discount to meet its present cash needs.

Factoring has become a more widely used and accepted alternative to liquidity-strapped SMEs in many countries, with volumes expanding significantly over the last decade, especially in emerging economies (OECD, 2018). In a typical factoring arrangement, the business makes a sale, delivers the product or service, and generates an invoice. The factor then buys the account receivables of the firm to gain the right to collect the amount on the invoice by agreeing to pay the firm the invoice's face value less a discount normally in the region of 2 to 6 percent. With this type of arrangement, the factor takes full control of managing the sales ledger and credit control with the right to pursue the customers for settlement of their invoices.

The factoring process
There are three main parties to the factoring agreement. The client business will sell goods or services on credit and the factor will take responsibility for invoicing the customer and collecting the amount owing. The factor will then pay the client business the invoice amount, less fees and interest, in two stages. The first stage typically represents 80 per cent of the invoice value and will be paid immediately after the goods or services have been delivered to the customer. The second stage will represent the balance outstanding and will usually be paid when the customer has paid the factor the amount owing.

The underlying reason why firms adopt factoring as a short-term financing option is to reduce their debtors’ collection period by turning their account receivables into cash to build up their cash flow. Milenkovic-Kerkovic and Dencic-Mihajlov (2012) assert that a firm qualifies for factoring arrangement not based on its creditworthiness but rather on the ability of its customers to pay their debts with the stipulated debtors’ collection period. This implies that a firm with creditworthy customers may be able to factor even if it lacks the collateral and credit history to qualify for a loan.


PART TWO

ALTERNATIVE FINANCING

2.Invoice Discounting
The need for alternative ways of financing small and medium enterprises (SMEs) could not be over emphasized. We have discussed asset-based financing which we covered Asset-Based Lending and Factoring.

Just like factoring, invoice discounting is a form of short-term borrowing where a business pledges its account receivables (typically 80% of invoices less than 90 days old) to a third party as collateral for cash to enhance its present cash flow (Milenkovic-Kerkovic & Dencic-Mihajlov, 2012). After collecting its debts, the firm then pays back the finance company the amount borrowed plus interest charge which is normally a percentage of the account receivables. Invoice discounting is almost the same as factoring except that in this arrangement, the business retains control of its own sales ledger and pursues its customers for payment without the third party been known to the customers. Thus, the key difference between invoice discounting and factoring lies in who takes control of the sales ledger and the responsibility for collecting payment from customers.

3. Leasing
Leasing is a form of financial agreement whereby one party conveys to another party the right to use an asset for an agreed period of time in return for specified rental payment while retaining the legal ownership of the asset. In a typical lease arrangement, the lessor (owner) transfers the right to use a property to a lessee (user) in exchange for rental payment for a specified period after which the lessee can do three things:

a. Buy the property outright,

b. Return the property to the original owner,

c. Extend the leasing period.

There are two types of lease agreements - operational lease and finance lease.

In an operational lease, the lessor supplies the property or equipment to the lessee; the lessor is responsible for servicing and maintenance of the leased equipment; and the period for the lease is fairly short, normally less than the economic life of the asset so that at the end of the lease period, the lessor can either lease the asset to the same person or someone else and obtain a good rent for it; or sell the equipment. In an operating lease, the lessor (often a finance house) purchases the asset from the manufacturer and then leases it to the user (lessee) for the agreed period. On the other hand, a finance lease is an agreement between a finance house (lessor) and a lessee where a finance house agrees to act as a lessor in a leasing agreement and purchases the asset from the dealer and intends to lease it to the lessee. Here,lessee takes possession of the asset from the seller and makes regular payments to the finance house under the terms of the lease.

4. Hire Purchase

Another alternative form of asset-based finance is hire purchase. Under a hire purchase form of financing, the business agrees to make payments in installment for a non-current asset over a period of time within which the legal ownership of the assets still resides with the seller until the final installment is paid for the asset to be legally transferred to the buyer.

Thus, under a hire purchase agreement, the business or buyer possesses the asset after the initial installment payments while the legal ownership of the asset remains with the supplier/finance house until the last installment payment is made.

5. Alternative Debt Instruments

Alternative debt instruments comprise an external financing option that grants businesses access to credit from the capital market through the issuance of various forms of bonds.

Examples of alternative debt financing instruments include corporate bonds, covered bonds, securitized debt, and private placement. The difference between alternative debt and bank credit or other traditional forms of debt is that alternative debt instruments are issued in the capital market while bank credit is issued by banks and other financial institutions. In a report of OECD (2018) on alternative financing options for SMEs, it was revealed that despite the various forms of alternative debt instruments available to SMEs, it appears that SMEs do not utilize these financing options and tend to rely on traditional sources of finance.

PART THREE

ALTERNATIVE FINANCIANG FOR SMEs

6.Equity Instruments

Over time equity finance has become a major source of finance for medium-sized and large firms who are listed on the stock market and have the license to obtain finance from the capital markets in the form of equity. Equity financing is a strategy for obtaining capital that involves selling a partial interest in the company/firm to investors. The equity, or ownership position, that investors receive in exchange for their funds usually takes the form of shares in the firm. In contrast to debt financing, which includes loans and other forms of credit, equity financing does not involve a direct obligation to repay the funds. Instead, equity investors become part-owners and partners in the business and thus can exercise some degree of control over how it is run. Equity finance holds particular promise for new and innovative SMEs who are deemed to have a high risk-return profile.

However, raising finance through equity requires a much harder effort as investors need to be convinced of the market potential, the business and expect good returns. Admittedly, access to equity finance for SMEs in developing countries remains a major challenge.
Some examples of equity finance instruments are as follows:

a. Venture Capital Financing

Venture capital refers to the financing of a start-up, development, expansion, and purchase of a firm in the act of which the Venture Capital Investment (VCI) acquires by agreement a proportion of the share capital in the business in return for providing funds.
A model structure of a venture capital fund is depicted in Figure 2`.

Figure 2: Model Structure of Venture Capital Fund

The main actors in any venture capital financing model include: the investor, the limited partner, the general partner who is also known as the venture capital firm or venture capitalist, the entrepreneur or the investee organization, and the Public Market. Occasionally, a sixth actor becomes necessary as an investment advisor, when the venture capitalist needs consultation

The Venture Capital Trust Fund (VTCF) was set up in 2004 with the main objective of establishing a fund capable of supporting and assisting SMEs in terms of access to investment capital. The initial capital fund to kick-start the operations of the VCTF was USD 22.5 million (VCTF Report, 2007). The VCTF was set up against the backdrop of the financial constraints confronting SMEs. Essentially, the arrangement of the VCTF is such that VCTF gives credit and equity financial assistance to qualified venture capital financing firms who subsequently assist eligible SMEs for equity and financial assistance. Again, the venture capital financing firms provide other assistance and support such as the provision of funds to facilitate the development, dissemination, and promotion of venture capital financing in Ghana.

Venture Capital Investment Criteria
Venture Capital investors normally invest in SMEs/companies that provide good prospects for capital growth over a 5 to 15-year time horizon. They undertake investments based on a well-thought-out investment criterion. Investment decisions may be based purely on viability, growth potential, and sustainability of returns of the target portfolio or investee company.

To invest in an SME or a Company may be based on the following:

* Viability of the Company/Project: This may be determined based on product/service assessment, market assessment, distribution/channels assessment, and management capacity/operational sustainability.

* Business Plan/Investment Memo: Detailed due diligence and a comprehensive business plan for the Company/Project to be invested in.
* Off-taker Agreement/SLAs: Acceptable contractual arrangements with key suppliers or buyers of the products or service to be produced and service(s) to be offered.

* Track Record: Demonstrable track record and technical expertise in the particular sector, as well as the professional reputation of the entrepreneur/project promoters.

* Availability of satisfactory exit mechanisms. The exit strategy for investments will typically be negotiated with the entrepreneur/project promoter before the investment closing.

* Adherence to best Business practices: Companies’ consistent adherence to international standards of corporate governance and local environmental standards. This also includes Environmental, Social, and Governance (ESG) issues affecting the sector or business in question.

SMEs have been found to contribute immensely to the socio-economic development of every nation in both developed and developing countries all over the world. Venture Capital companies have found it necessary to finance or assist the SMEs which are known to be the potential to grow; if they are assisted financially and technically in other improve the nation.

Venture capitalists provide long-term capital in the form of share and loan finance for different situations, including:
* Start-up capital. This is available to businesses that are not fully developed. They may need finance to help refine the business concept or to engage in product development or initial marketing. They have not yet reached the stage where they are trading.

* Early-stage capital. This is available for businesses that are ready to start trading.

* Expansion capital. This is aimed at providing additional funding for existing, growing businesses.

* Buy-out or buy-in capital. This is used to fund the acquisition of a business either by the existing management team (‘buy-out’) or by a new management team (‘buy-in’). Management buy-outs (MBOs) and buy-ins (MBIs) often occur where a large business wishes to divest itself of one of its operating units or where a family business wishes to sell out because of succession problems.

* Rescue capital: To help turn around businesses that are in difficulties.

Private Equity and Private Placement

Private equity financing has emerged as a widely accepted form of financing for SMEs in developed countries. This development has somewhat led to a decongestion in the mainstream capital market and serves as an avenue for SMEs who cannot access finance from the capital market.

A private placing does not involve an invitation of the public to subscribe for shares. Instead, the shares are ‘placed’ with selected investors, such as large financial institutions. This can be a quick and relatively cheap form of raising funds, because savings can be made in advertising and legal costs.

However, it can result in the ownership of the business being concentrated in a few hands. Sometimes, unlisted businesses seeking relatively small amount of cash will make this form of issue.

Business Angel Investments

Business angel investors are individual or informal investors who are interested in investing locally and in projects, they understand and believe in their growth potentials. Business Angel investment plays a very crucial role in terms of bridging the financing gap of SMEs by serving as an alternative financing option.

Business angels provide not only finance but also managerial experience since many of the investors have made their fortunes in the same industries that they subsequently invest in. Due to special knowledge and experience, they may have a higher ability to screen for higher quality projects, increase the survival probability of the company, or both at the same time.

Crowdfunding

It is a type of financing option which provides the platform where several individual investors and entrepreneurs come together through social media, internet, and informal social networks to pull financial resources together towards a common goal. While the concept of crowdfunding is still in its embryonic stage in sub-Saharan African, it is believed that this form of financing for SMEs has a greater potential of bridging the financing gap of SMEs when this instrument becomes more regulated in developing countries.

Peer-to-Peer Lending

Peer-to-peer lending provides alternative sources of financing and has experienced rapid growth in many parts of the world, as they enable investment projects that are too small or too risky for traditional banks to address. While this form of financing represents a small share of the alternative financing option utilized by SMEs, it appears to be rapidly expanding from the starting non-profit and small-scale entertainment niche to for-profit activities and businesses.

Hybrid Instruments

Another group of alternative financing instruments for SMEs is a hybrid financial instrument that combines debt and equity in a single financing vehicle. In recent times, hybrid instruments are gaining considerable attention in developed countries and other emerging economies. Examples of hybrid financial instruments include subordinated loans, silent participations, participating loans, convertible bonds, and mezzanine finance.

PART FOUR
STRATEGIC BUSINESS PLANNING

Need for Strategic Planning

Business environment is increasingly and constantly changing. There is therefore uncertainty about the future as new situations such as technological advancement, new societal trends, new economic forces newly enacted government regulations or new pandemics such as COVID 19 emerge. Businesses, small or big, local or international are also operating in markets where competition is keen and many large competitors are present. In order to survive in a dynamic and fast changing turbulent environment and therefore succeed in competition, forward –looking managers must diagnose the changing situation or circumstances and accordingly put in place strategic measures.

How do people and organizations plan for their future when they do not know what will happen?

Forward-looking managers seek answers for more important questions such as “What will we do if a particular event happens?” In addition, managers and their organizations ought to be prepared to make fundamental and painful changes to match the outside world. These and many other similar questions or anxieties about the future are what strategic planning seeks to provide answers for.

What Strategic Planning is About

The concept of strategic planning is amenable to different definitions depending on the preferences of the author. According to Stoner and Fry, strategic planning is a management tool designed to enable organizations competitively adapt to anticipated or future changes in the environment.

Strategic planning determines where an organization is going over the next year or more, how it is going to get there, and how it will it know if it got there or not. The key points to note are;

* The process is strategic because, it is concerned with the best way of enabling an organization to respond to the dynamic and turbulent environment of business.

* The process is concerned with planning in the sense that it involves making decisions about what objectives to pursue during a future time period and what to do to achieve those objectives.

* Strategic planning is concerned with fundamental decisions and actions because critical choices must be made about what an organization must do why it does it, and how it must do it. The choices entail organization - wide and long - term implications.

What Strategic Planning is and What Strategic Planning is Not

Before we look at how to plan a business strategically, it will be very useful to know the differences between strategic planning and other related concepts.

* Strategic Planning and Long-Range Planning

There is a distinction between strategic planning and long-range planning although the tendency is for many people to use the two terms interchangeably. The distinction between the two terms lies in the differences in assumptions placed on the organizational environment.

Long-range planning refers to the formulation of a plan for accomplishing a goal over a period of several years. It is based on the assumption that present knowledge about future environmental conditions impacting on business is adequately reliable to guarantee the implementation of the plan during its life span. Long-range planning was the order of the day during the late 1950s and early 1960s in the United States of America (USA). This was a time when the American economy was relatively stable and therefore somewhat predictable.

Strategic planning, by contrast, means that a business must take long-term decisions that will enable it to respond to a dynamic, or constantly changing business environment. The key idea is that the business environment is always changing and will continue to change. This assumption contrasts with the relatively stable environment assumed for long-range planning.

* Strategic Planning and Strategic Thinking

Strategic planning deals with how a business will achieve its vision. It is basically about gathering and analysing information about the present with a view to determining an organisation’s future short-term and long-term goals and the formulation of an action plan to achieve those goals.

Strategic thinking on the other hand, is basically a synthesis of information aimed at producing a profile of what a business wants to become in future, for example, ten years ahead. It reflects on the purpose of the business, and seeks an understanding of the business environment, especially of the forces that impact the achievement of that purpose.

It aims at creativity in developing measures to effectively respond to those forces.

* Strategic Planning and Operational Planning

Strategic planning is the process of determining an organisation’s long-term future direction. It includes analysing the organisation’s environmental opportunities and threats, strengths and weaknesses, formulating overall objectives and deciding on means to accomplish those objectives. Strategic planning is the responsibility of top management.

Operational planning by contrast is making detailed decisions about specific goals and the means of implementing the strategic plan. It is short-term and normally covers a period of one year. Operational plans are prepared by first-line managers in consultation with middle-level managers to support the implementation of the strategic plan. Thus, the key to the distinction between strategic planning and operational planning lies in their differences in terms of time frame, scope, and management hierarchy. However, the two forms of planning are linked by goals and objectives that reflect the organisation’s mission statement.

GNA

A Ghana News Agency feature By Prof. E. Ofori Asamoah

Certified Management Consultant and President, Regent University College of Science and Technology