77% of Sub-Saharan entrepreneurs find access to debt financing - also known as loans - difficult (Viffa Consult, 2018). But why is it so hard for business owners to get the capital they need? Reviewing the main financial services options available to entrepreneurs, we find that while various benefits can be derived from them, they often are not perfectly tailored to the small and medium business owners’ needs.
Family and Friends
Most entrepreneurs getting started often begin by asking their network to access the financing they need. In fact, borrowing money from a family member or from a friend is a widely used practice: over 40% of entrepreneurs in Kenya source funds from family and friends (Viffa Consult, 2018). While it is a simple and quick way to receive financing, the benefits are short lived for entrepreneurs looking to grow their businesses, as fund availability is generally limited. For entrepreneurs who don’t come from overly prosperous circles, they might not be able to obtain the financing they need to bring their business to the next level. Additionally, providing capital adds financial stress on friends and family members, already juggling with their own financial responsibilities, and comes at the risk of jeopardizing personal relationships. As such, while friends and family are usually happy to help out, this comes at the cost of potentially insufficient funding size and added stress.
In Sub-Saharan countries, commercial banks remain a widely used source for business financing. In 2018, 22.5% of entrepreneurs in Kenya obtained financing through commercial banks (Viffa Consult, 2018). These banks are ultimately a one-stop shop, offering a variety of financial services to its individual and commercial customers: loans, checking and savings accounts, investment products, etc. Despite having a large amount of resources to help businesses with their financial needs, their often bureaucratic approach and risk averse mentality prevent many entrepreneurs from accessing their services. Entrepreneurs without a credit score or insufficient collateral, for example, would not qualify for a loan with a typical commercial bank. Even for those who qualify, entrepreneurship contains a certain level of risk that most banks are not willing to take, even when relatively safer ventures approach them. Therefore, banks tend to offer appropriate solutions for more established businesses, and less for entrepreneurs who are starting.
Micro-lending applications gained in popularity a decade ago. Their goal was to offer financial services to the unbanked while leveraging technology to do so. Since then, the micro-lending space has boomed, partially thanks to the emergence of mobile phones in developing countries. In Kenya alone, there are over 50 regulated micro-lending companies (Bloomberg, 2020), and 500 unregulated ones, based on the latest estimates (Business Daily, 2018).
These mobile applications are now able to treat loan applications in a matter of minutes: based on the applicant’s credit score - or a proxy for it - and sophisticated financial or machine learning models, a loan tailored in size and rate can be quickly disbursed. While these apps have the benefit of quickly issuing loans and targeting populations that previously could hardly access any financial services, they offer a few challenges for small and medium business owners. The high APR, sometimes even up to 180-200% (Bloomberg, 2020)(Business Daily, 2018), limits the impact of the loan and increases the risk of these individuals falling into a cycle of debt (Microlending: the price of financial inclusion, 2020). Additionally, most micro-lending players offer loan amounts usually better suited for individual needs, and thus are often insufficient to accommodate business ones. As such, while micro-lending applications provide timely extension of loans, these loans are not always a suitable debt financing solution for entrepreneurs.
Micro-finance institutions (MFIs) aim to provide impoverished people an opportunity to become self-sufficient, by offering a banking service that serves individuals with loans, ranging from $100 to $25,000. While MFIs operate in a variety of ways, one of the most common ones is to leverage a community model, whereby neighbours pool their money together. Each week, all members of the community contribute to a pool of money, and the pool is then lent to an individual for a specific usage approved by the community itself. While it provides relatively easy access to capital, the community-centric model might refrain participants from taking additional risks necessary for business growth to avoid the possibility of non-repayment, and thus the accidental penalization of other members who wouldn’t have as much capital left available to them.
From risk to business metrics
While each institution serves a valid purpose, small and medium business owners find themselves with unsuited financing options. Insufficient funding, unmet requirements, or high interest rates are only a few of the reasons why an entrepreneur wouldn’t seek any of the above-mentioned options.
When deciding whom to disburse loans to and in what amount, some of these debt financing options tend to use typical risk metrics (e.g., credit risk) and base their decision primarily on the risk level. While risk measures are important to take into consideration, they don’t always adequately reflect the potential success of an entrepreneur. Business metrics - such as product demand, cash flows, margin - should also be considered in making loan allocations. While business metrics could inform an institution in the loan-making decision process, they could also inform it not to make a loan if they see that the entrepreneur, despite a strong credit score, doesn’t need additional debt to grow his/her business.
While individuals tend to take out loans to finance large purchases - appliances, a house, emergency expenses - that do not generate a return on capital borrowed, entrepreneurs, use loans to invest them in their business. This potential for growth commands the use of metrics that would evaluate it, and its impact on the entrepreneur’s ability to pay back a loan. While it isn’t easy to predict the future, we can at least try if we are to adequately support the small and medium business owners.