The funding of entrepreneurs and small and medium-sized enterprises (SME) is likely to become the next growth sector for bank lending globally, according to the ‘futurebankinglab’ conference, an international conference hosted in Madrid, Spainon the future direction of funding SMEs.
The conference was attended by 20 of the leading SME financiers in the world, with Standard Bank and Business Partners representing South Africa. Several differentiated models of funding were reviewed as to their applicability in other jurisdictions and by traditional banks.
One thing evident from this conference was that South Africa does not lag the rest of the world, and is ahead of many of the global banks. We have an increasingly strong entrepreneurial mindset when it comes to finding funding solutions in this country, and I came away highly encouraged.
Availability of finance
Under discussion was the poor availability of finance in the R400 000 to R20 million turnover space: called the ‘missing middle’ and which is the level of finance typically required by SMEs. This is a global phenomenon and by no means restricted to South Africa. Below and above that missing middle, finance is relatively freely available from various sources, including micro-lenders, banks and private equity investors respectively.
The funding gap is due primarily to the traditional way in which banks look at finance: typically requiring owner’s equity of anything up to 60 percent in the business, as well as collateral to cover the balance.
Given the high failure rate of SMEs, this traditional – and sensible approach if you’re a banker – does not cut it with the entrepreneur, a fact which is likely to become ever more the case as banks’ compliance with Basel3 kicks in. What entrepreneurs require is risk capital and capital to help manage their growth – not secured capital.
Risk capital is most commonly seen among development finance institutions (DFIs) when they offer what is often termed ‘patient capital’. This means structuring loans so as to preserve the cash flow of the fledgling business – with repayments ‘light’ at the beginning and increasing later on as the business stabilises.
The conference also emphasised the need to provide non-financial support such as: mentorship; business and financial skills development; and possibly even with the financier obtaining an equity stake in the business.
Essentially, what is needed for an entrepreneur is a tailor-made solution, one that especially offers a partnership approach and linkages to other institutions, like Raizcorp or Khula. However, such mentoring solutions are not at a mature stage in South Africa. Incubator models such as that done by Raizcorp, while very effective for individual businesses, do not scale up to the thousands, which is what is needed.
Those models that do scale up to the necessary volume are often inadequate for individual businesses. A voucher for two days of mentoring or writing a business plan is not going to fundamentally change a business.
There was a growing consensus reflected at the conference that SME lending is an asset class of its own requiring a different set of rules. Only once these are defined and entrenched in lending practices that SME financing will become the next growth phase for banks.
Lending to this category (R400 000 – R20 million turnover) demands a dedicated focus. It cannot simply be relegated to a Business Banking division. For one, the approach requires a much lower cost solution as the loans are of smaller value and the business cash flows are less predictable.
Finding new tools
To succeed in entrepreneur lending requires a new set of tools, and this is what the conference was investigating. Furthermore, while the lending has to be at a rate affordable to the SME it still has to be profitable for the lender.
There are typically two issues around repayment: ability to repay and willingness to repay. To assess the willingness to repay – at the approaches include assessments of the entrepreneur, particularly his character, capabilities, traits and past banking history, in the credit assessment process.
Standard Bank has recently undertaken a pilot using a detailed assessment of the entrepreneur and is currently already looking at the financial behavior of entrepreneurs prior to starting their business, as this allows us to draw up a set of assumptions regarding their likely subsequent behavior.
This reflects the need to develop the right lending products for this market, including unsecured loans for SMEs. Typically these include cash flow based lending solutions, supply chain finance and graduated loans.
The conference looked at several successful models from around the world, for their applicability in other markets. One model from Tanzania involved shifting the focus of financiers from inbound to outbound – in other words, getting out of the office and walking the streets of the local business community to finding viable businesses worthy of funding.
Another was initiatives in the business-to-business space, particularly in the US where peer-to-peer funding is being experimented with. I must emphasise that this model is in the very early stages.
Another theme was improving linkages between seed or risk capital partners and banks to provide more early-stage risk financing.
Niching is also going to be another part of the toolbox. This involves looking at a small geography, sector or community, and is currently most developed in the franchising market. By addressing the risks of a common activity or market, financing becomes more predictable.
The Ups And Downs Of Borrowing From The Bank
New businesses need access to funds, and banks are usually the first place that business owners approach.
New businesses need access to funds, and banks are usually the first place that business owners approach.
But getting a bank loan is not that easy as very few entrepreneurs fit the strict criteria that banks set. While some banks are trying to make it easier for SMEs to get loans, it is generally a lengthy process and will test your patience as you will be required to provide a wad of information.
Here are the pros and cons of approaching a bank for a loan:
Most of us have bank accounts and we are accustomed to and comfortable with our bank as our financial institution, so it is natural that we will usually think of this option first when looking for a loan.
There is some comfort to be had in knowing you will be probably be treated fairly by a big institution.
For new business owners and entrepreneurs, the banks have a variety of good loan plans to suit various SME needs. Check carefully – banks make their money from the interest charged on these loans, so make sure you know and understand the repayment terms of the loan plan you choose.
3. No ulterior motives
A bank loan is granted purely for the interest the bank will earn from the loan. Banks will not demand part ownership, decision-making powers, or a share of your profits, leaving you in peace to run your business.
4. Lower interest
Bank loans often have a much lower interest rate than other options like credit cards and last-resort money lenders.
5. Tax advantages
If you get a loan from a bank, your tax charges may reduce because the percentage of profit that is used to repay the loan is exempt from tax.
1. It’s Complicated
The mere volume of detail that banks require to consider extending a loan is problematic for many entrepreneurs. The process can be extremely frustrating and time-consuming. Be prepared for a lot of back-and-forth before the loan is granted!
2. Banks prefer to lend to functional businesses
Because it is easier to calculate credit history and profitability, banks give preference to businesses that are established and running. If you are trying to fund a start-up, you are not a preferred client, so be prepared for an uphill battle.
3. The arduous business of qualifying
It is not always possible to live up to the standards that the banks expect in order to qualify you for a loan. Their list of conditions is long and tedious.
Make sure your financials and other relevant documents are as comprehensive as possible.
4. Added Risk
Usually when taking out a bank loan, you need to put up some collateral – like your house! If you do this and run into trouble later, this collateral could potentially be lost. Do not fall into the trap of being so positive about your business prospects that you think this will never happen.
5. It takes so long
The application for a bank loan tends to be a long, drawn-out affair. Banks need to verify every detail, and this can considerably delay the application process. The more information and supporting documents you have, the better, but be prepared for delays.
6. Only a part loan may be granted
It is not uncommon for banks to grant a loan that is just a percentage of the amount requested by the business owner. This can be quite a set-back and you need to think about whether it is worth going through the application process with more than one lender to get the full amount you need.
7. Other options
There are other options out there, including innovative funding solutions. While many small business owners start off their search for funding with their bank, it may be worthwhile to do some research into whether there are easier options which are more applicable to your business, or to your stage of business development.
But be careful – make sure your repayments are sustainable as interest or repayment rates may be higher than those of the banks.
Why Banks Should Focus On Leveraging Trust To Maintain Its Space In Finance
Remaining relevant in the digitally savvy world of cutting-edge fintech solutions is an important consideration for banks. It is also one which should be prioritised, if financial institutions want to avoid losing their place in the market.
Banks have, arguably, built a proud legacy of trust, which has long secured its place and relevance in the world.
That could change, however, particularly if banks don’t embrace the demands of digitally savvy consumers, and contend more imaginatively with the cutting-edge alternative fintech solutions that are vying for the top spot.
The legacy of trust
Banks’ roles in managing and securely storing funds for individuals and businesses was long uncontested. Admittedly, consumers’ options may have been limited, but financial institutions excelled in what they did, and built long-lasting relationships with customers. This is evident in customer loyalty statistics.
The advent of the Internet and online banking services has shifted how people interact with their banks. As the technology becomes more user friendly and security becomes less of a barrier, more people are willing to engage with their financial institutions in this way, managing their finances remotely.
Their willingness to do so is testament to the trust their banks inspire, and the work they have done to promote new channels of communication and transacting.
This technological shift has been beneficial to banks that have embraced it. Online and mobile banking offer vastly reduced costs incurred by banks, through limiting the number of more costly in-branch transactions. The next shift is unlikely to be quite as positive, unless financial institutions look ahead and adapt.
The rise of a new generation
Although the current trend seems to be towards alternative banking solutions growing in popularity, when it comes to storing or investing large sums of money, the trust held in the more traditional financial institutions has largely endured.
This may, however, be shifting as the younger, more tech-savvy generation becomes the driving force of the economy.
Consumer scepticism of new fintech solutions will almost certainly diminish, and no longer will slow adoption of new banking and payments platforms be a challenge. The younger generation has grown up with digital technology and applies it to all aspects of daily life, without many doubts over security or privacy.
As this becomes the norm, the window of opportunity for banks grows smaller. Holding on to traditional banking and outdated approaches will only result in banks stagnating; giving rise to its greatest fear – becoming obsolete.
To prevent being locked out as the window closes, financial institutions must leverage the trust that is still its trump card, by providing innovative value-added services that engage older and younger generations in all sorts of new ways, daily.
(Directory) Private Sector Funding
We always have to remind ourselves that these are profit-orientated entities with a well-structured risk management model in place. Some of the offerings are more flexible than others, but keep in mind, they are also businesses.
- Business revolving loans (loans without re-application)
- Working capital solutions (cash flow assistance)
- Business overdrafts (no loan applications)
- Term loans (term loans for purchasing assets, eg. equipment)
- Development credit fund for those without sufficient security or collateral
- Absa Enterprise Fund (for 100% black entrepreneurs)
- Debtor financing.
Each offering contains very specific requirements and documents to complete. Collateral and surety are embedded requirements, but have a look at the new Development Credit Fund.
Call: 0860 040 302