A new breed of finance options are creating opportunities for more small businesses
As any business owner will tell you, the entrepreneurial journey is no easy feat. It can be demanding at the best of times and, quite often, it can also be expensive. Transforming a ground-breaking idea into a thriving business requires capital — to build a product or service, establish operations and launch marketing efforts. Traditionally, entrepreneurs have relied on a limited set of financing models, primarily bank loans, friends and family, angel investors, venture capital (VC) and funding from personal savings. As governments prioritise small, medium and micro enterprises (SMMEs), more creative and accessible options for finance have appeared.
While conventional financing has a place in the financing landscape, it also has limitations, especially when it comes to entrepreneurs operating in the ‘missing middle’, which Chris Jurgens describes as “too big for microfinance, too small or risky for traditional bank lending, and lack[ing] the growth, return, and exit potential sought by venture capitalists”. Bank loans and VC capital generally have strict restrictions on how the money can be used and prioritise high financial returns that favour quick growth over long-term sustainability. A bank loan also involves a long, arduous process and early-stage ventures, businesses in niche markets or start-ups with unconventional revenue models may struggle to secure a loan due to stringent criteria.
Out With The Old, In With Alternative Financing
These limitations have paved the way for innovative finance options that cater to a wider range of entrepreneurial needs. Speaking at the Motse Collective Impact Entrepreneurship Ecosystem Gathering 2023, hosted by Allan & Gill Gray Philanthropy South Africa in partnership with the African Institute for Entrepreneurship and the Hasso Plattner d-school Afrika at the University of Cape Town, Impact Intelligence founder Aunnie Patton delved into a few of the most promising alternative finance models that can unlock additional capital for entrepreneurs within entrepreneurial ecosystems.
Bootstrapping
A self-funded approach where the entrepreneur uses personal savings, revenue from initial sales and creative cost-cutting measures to finance the business. “A lot of times, entrepreneurs think, ‘I have an idea; I need someone else to fund me’ when, particularly in Africa, a lot of organisations don’t need outside funders right away,” Patton shared. “You need to fundraise only as much as you need [in the beginning] and focus on growing a sustainable business model.”
Crowdfunding
This type of fundraising enables entrepreneurs to raise capital from a large pool of online backers, predominantly through online platforms such as Kickstarter, GoFundMe, Fundable and Indiegogo. Crowdfunding allows entrepreneurs to test whether their ideas are bankable, build a loyal customer base and generate pre-orders before the product is available. The largest component of crowdfunding is effectively marketing the concept and engaging with the community to obtain buy-in.
Grants
For entrepreneurs seeking funding for proof-of-concept, which can be very risk-capital intensive, grants can provide crucial funding without diluting ownership or incurring debt. Government agencies, non-profit organisations (NGOs) and foundations often award grants to support innovation, social impact initiatives or business development in specific sectors. Winning a grant can be a competitive process but entrepreneurs also have the option of grant-like hybrids. Patton provides the example of a recoverable grant, where the money is re-granted if certain criteria are met during the grant period. “How it’s used most effectively is from foundations to on-lending and on-investing organisations,” explained Patton. ‘For example, if The Clothing Bank, which is a non-profit, is trying to work with 100 female entrepreneurs and needs debt capital that is not at prime +5%, a foundation could grant [the organisation] the money with a side letter that says, ‘As this principal is repaid, you can pay back just the principal or the principal +3%’.”
Convertible Grants
A convertible grant is a type of grant that can convert into equity. The initial grant is similar to traditional grant funding where the investor provides an upfront sum that typically has no interest or repayment obligation. Unlike other grants, the grant includes a conversion trigger, which, when met (for example, if the company raises a certain amount of capital), the grant amount converts into equity in the company.
Forgivable Loans
This type of loan can range in size, depending on the organisation and the sector or whether certain performance benchmarks are met. The borrower is not obligated to repay all or part of the principal amount and can be used to incentivise growth in specific sectors. According to Patton: “If a company wants to work with a set of social enterprises to create additional jobs, the company can provide loans to the enterprises stipulating that at the start, the enterprises owe the loan at prime +2%. However, if an enterprise creates 150 additional jobs by the end of year two, that enterprise only owes 80% of that capital.”
Revenue-Based Financing
Revenue-based financing or revenue-based loans are becoming more prevalent as an alternative financing model. “An organisation borrows money based on its historical revenue and repays it based on a percentage of its future sales,” said Patton. “It works exceptionally well for tech companies that don’t have collateral and organisations that need more risk capital but are not trying to grow exponentially.” Patton warns against revenue-based financing disguised as merchant cash advances, which are essentially micro-loans based on alternative credit scoring models. Examples of these could be loans advertised as approved in 24 hours by companies such as Lulalend and Vodacom.
Venture Debt
Venture debt is a complement rather than a replacement for equity financing. During her workshop, Patton mentioned that these days, venture capitalists seek to do more down rounds as valuations are currently down. Venture debt is typically provided as a term loan with a fixed repayment schedule, focuses on the company’s ability to secure future equity financing, generally has higher interest rates than traditional loans and can include restrictions on how the money can be used.
Supply Chain Financing
Supply chain financing has many similarities to trade finance practices that can be traced back to 3000 BC and was created to improve cash flow and working capital within a supply chain. “This type of financing has historically been used exclusively for medium-sized businesses and mostly for cross-border transactions but there is a huge opportunity for small businesses with large customer bases,” Patton said. “There are various supply chain financing models but how it works is that a business has an order, for example, from Pick n Pay for R500,000. The business needs R200,000 upfront to source the inputs for the items sold to Pick n Pay, so it borrows against those items or receives an early payment from the provider. This is also often referred to as purchase order financing.”
Choosing The Correct Financing Model
Selecting the correct financing model will depend on various factors and Patton presented a few questions for entrepreneurs to consider as they explore financing options:
- Which business milestones are necessary for your company? Where is the business going?
- What is your [financial] strategy to get to the next milestone?
- How much do you need? Where will your funding come from? What is your timeline for securing funding?
- What type of funding do you need?
- How do you value your business? This can be broken down into:
- Who are we? Are we for-profit or non-profit? Do we have steward ownership or co-operative ownership? Where are we — super-early stage, growth stage, etc.? How long have we been generating revenue or how recurrent are our revenues? What are our profit margins? What are our growth projections?
- How mission-driven are we? Do we have an impact track record?
- What are our funding needs? What is our burn rate or capital expenditures? What type of funding are we looking at — proof of concept, working capital, growth capital, assets? Do we have collateral?
- How do you want to repay this funding?
- Do you want to own the company or have other people, such as employees or stakeholders, own the company and when?
- What type of capital are you going to raise in the future?
By carefully assessing their needs and exploring various options, entrepreneurs can build a comprehensive funding strategy that empowers them to achieve their vision, lower their risk tolerance and meet their long-term goals.
The Abaca Capital Explorer tool is a free online tool that provides entrepreneurs with access to information surrounding funding options at their disposal, evaluated based on answers to a set of questions, such as those in this article, about the company. Access the Capital Explorer tool here.
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This article is based on a masterclass on finding innovation solutions to financing entrepreneurs presented by Intelligent Impact founder Aunnie Patton at the Motse Collective Impact Entrepreneurship Ecosystem Gathering 2023, hosted by Allan & Gill Gray Philanthropy South Africa in partnership with the African Institute for Entrepreneurship and the Hasso Plattner d-school Afrika at the University of Cape Town. The inaugural two-day gathering provided a space for ecosystem builders, policymakers and entrepreneurs to collectively reflect on the state of entrepreneurship and the actions required to enable an equitable society in South Africa.
To read more on Financing Entrepreneurs, click here.
Sources:
MCI EE Gathering 2023 Break-away Session 3 (video)
