Effort should be directed to improve financing startup and small business to sustain their development. Startup businesses are a driving force in the economic development of any country, in terms of job creation, innovation and export potential. In developing countries, especially, small businesses have contributed to boosting the development of the economy and growth process required in such fragile economies. According to the International Trade Centre, small businesses forms 92% of registered business in Ghana and they contribute 70% of Gross Domestic Product (GDP).
The main sources for small and growing businesses to raise capital have been either personal funds, retained earnings, and support from family and friends. However, the majority of entrepreneurs in Africa rely on loans or support from family to finance development of their business. The challenge is that once funding from such a source is exhausted, the entrepreneur has limited access to other funding sources – such as Bank loan. According to a World Bank Enterprise Survey Data, small businesses in sub-Saharan economies, such as Ghana, prefer debt as external financing than equity. However, the International Finance Corporation indicated that about 84% of small businesses in Africa have no or limited access to credit financing.
The availability of finance is an important factor to improve small enterprises’ access to other resources – such as human, information and physical resources. Access and availability of finance have a tremendous impact on small enterprises. Capital from formal and informal markets plays a significant role in business development, and it enables effective running of small firm’s business activities – which leads to job creation, government revenue increment through taxes and business growth as well as expansion.
However, access to finance has been a major constraint facing small business development. For instance, the former HFC Bank in 2004 reported that in Ghana small businesses tends to have limited access to credit, and the UNIDO also reported there is equally limited support available from informal sources such as business angels and personal savings, which affects growth of small businesses.
In Ghana, there have been various financial schemes such as MASLOC, Business Advisory Fund, Export Trade, Agricultural and Industrial Development Fund/Ghana Export Import Bank and the Venture Capital Trust Fund which have been established by both government and the private sector to support growth of small enterprises. However, various research studies still identify access to finance continuously being a major challenge for small enterprises.
In a recent research conducted by the writer – to investigate the difficulties entrepreneurs encounter raising capital to develop their businesses at the early stage and provide solutions to overcome the challenges of accessing capital – the following challenges were identified.
Challenges in accessing financing for Ghana’s Startups and small businesses
Lack of Securable Assets
The major cause is lack of collateral. In Ghana, startups rely on internal sources of finance which are often unreliable and inadequate. The most available external sources have been bank loans. However, it is difficult for an entrepreneur to easily access credit because they typically do not have tangible assets to pledge as collateral. According to the World Bank, the collateral requirement from businesses in Ghana averages 240% of the loan value compared to an average of 80% in advanced economies, which particularly affects young entrepreneurial firms.
Perceived high Risk
Another cause is that commercial banks perceive startups and small businesses to be high-risk businesses because of poor guarantees and lack of information about their ability to repay loans, according to the World Bank. Because small businesses are perceived as high-risk, they tend to suffer from high level of risk associated with riskiest business. This gives rise to a systematic bias against startups, and they tend to attract high interest rates. The unfortunate result is that good business tends to be driven out of the financial market.
Inadequate information on small businesses
Again, inadequate information between finance providers and startups has contributed to access-constraints. It is assumed that business owners possess information about their business that providers of capital do not have. The value of assets is usually based on knowledge exclusive to the founder, which is usually difficult for investors to verify. This causes investors to demand a premium for investing into the business.
For investors and lenders to be able to make sound credit and investment decision, it should be based on adequate financial information about the borrower. However, startups do not have the same quantity and quality of financial information as matured companies. Therefore, debt providers may deny credit because the financial information on the business earnings may be incomplete and inaccurate. The alternative, with the appetite to invest regardless of such risk, will request high returns to compensate the risk.
The absence of adequate and reliable information creates moral hazard and adverse selection costs, leading to credit market failure. Moral hazard and adverse selection is a situation wherein lenders are unwilling to provide credit at price. According to Dr. Sam Mensah of SEM International Associates Limited, moral hazard and adverse selection is a severe problem in Ghana, and it is affecting creditworthy businesses’ ability to access credit from financial institutions.
Inadequate alternative funding sources
Most entrepreneurs go into business without adequate capital, hoping to secure additional funds when the business takes off. However, according the World Bank, the financial system in most African countries is under-developed and thus provide few financial instruments. Capital markets are immature, shareholding is rare and long-term financing is barely available to small businesses.
In Ghana, private equity is scarce because investors find startup ventures to be high risk and are not satisfied with potential returns on the investment. In an interview with a startup financing expert in Ghana, he stated that: “Most banks have their focus away from startups, government policies are yet to provide the environment to create other funding avenues, and the high net worth individuals are not interested in angel investing because, culturally, people do not want to show opulence and they see angel investment as a way of showing off”.
In addition, the World Bank reported that non-bank financial intermediaries – such as microfinance institutions, venture capitalists – could be significant providers of capital to startups, but they are not well-resourced to provide follow-up funding that facilitates the growth of startups and small businesses.
Poor legal and regulatory framework
Compliance with international standards and regulations is important in improving access to Foreign Direct Investment (FDI) and has a positive effect on firm entry and growth. The World Bank’s ‘Doing Business’ reports have been advocating for financial sector reforms as a way to enhance easy access to entrepreneurial finance. However, in Ghana the absence of supportive laws and regulations have severely limited the availability of financing to small enterprises. Government policies toward small businesses have often not favoured startup businesses.
Data from the writer’s research indicated that businesses in Ghana are all classified as the same without any special dispensation for startups, and this is crippling the sector sector’s growth. For instance, the high cost of registration and licencing fees, as well as high taxes, makes the cost of doing business high for entrepreneurs; and some of the entrepreneurs feared this may put them out of business.
In a recent radio interview on Citi FM, an entrepreneur lamented: “There are a lot of fees, levies and taxes charged on startups. You have to pay for income tax, pension contribution for staff, etc. If I am not able to get money to pay these fees then I will have to stop, because the business is still growing and currently not generating much revenue”.
Inadequate knowledge, skill and experience
Lack of knowledge on fundraising, as well as inadequate expertise and experience of entrepreneurs on the job and business environment, has been identified as among the reasons limiting the ability of small business owners to raise capital in Ghana. A research by Professor Samuel Owusu-Mintah, on entrepreneurship education and job creation in Ghana, reported that lack of entrepreneurship education was a problem inhibiting the development of entrepreneurship in Ghana.
A participant of the writer’s study cited that “most entrepreneurs, aside from those who have been through incubation, lack any knowledge on fundraising and do not know how to prepare and the approach fundraising process”. Therefore, having knowledge and experience can be a resource for the entrepreneur to create opportunity and also exploit for their benefit.
Measures to Overcome the Challenges
A critical factor for the sustainability of entrepreneurial development and economic growth is the supply of and access to capital. The International Financial Corporation (IFC) estimates that about 84% of small business in Africa are unserved or underserved, which represent a value gap in credit financing between US$140- 170billion. There have been various approaches suggested to overcome the challenges of accessing financing in development by prominent researchers, experts and institutions like the World Bank, which are discussed below:
Improving Business Conditions
Proper information is a key deciding factor to provide funding. This, according Céline Kauffman of the World Bank on financing SMEs in Africa, would be improved by adopting clear business operating standards; setting up independent, competent and reputable accounting firms; and creating more credit supply data on the solvency of firms. In addition, a country’s tax laws can either persuade small businesses into the formal sector of the economy or prevent them from enrolling in the formal system.
In developed economies, tax reforms and incentives have been used by governments to attract investment and help finance startups, create jobs and diversify citizens’ investment portfolios as well as protecting investors, without materially affecting tax revenue generation. For example, the UK’s Enterprise Investment Scheme (EIS) and the Seed Enterprise Investment Scheme (SEIS) allow investors to deduct 50% or more of qualified investments from their income tax, and pay no capital gains on any appreciation. In a situation where the investment fails, investors are allowed to deduct part or all the loss from their tax bill. Such incentives have attracted business angels to provide a maximum investment of £150,000 into British startup business.
In Ghana, industry players have suggested government should assess the startup environment and formulate policies that will provide flexibility and ease the difficulties startups go through to register and licence their business. It has been suggested that the process of regularising new business in Ghana should be simplified, because too many agencies and levels of the process makes the process cumbersome and costly to a startup.
In addition, some entrepreneurs have suggested that tax holidays should be provided for new business and certain fees and levies should be waived or subsidised for new businesses. Such policies can be used as a favourable means to entice small businesses into the formal sector.
Making the financial system more accessible to startups and expanding supply of finance
The inadequate funding for small businesses has partly been made up for by microfinance and saving and loans companies, which have been more flexible in the provision of loans to small business in Ghana. Similarly, in other African countries, such as Angola, the Novo Banco provides loans free of bank charges, without minimum deposit and accepts informal guarantees (guarantor).
The World Bank’s ‘Early Stage Innovation Finance’ provides equity and debt/quasi-debt to startups or high-growth firms which may otherwise not be able to access bank financing. For instance, this was implemented in Lebanon where a US$30million investment lending operation provides equity co-investment in innovative young firms, in addition to a grant funding window for seed-stage firms. The project has helped startups to attract co-finance from private sector financing and expand the market for early-stage equity finance in Lebanon.
In India, a credit line of US$500million was provided to the Small Industry Development Bank of India (SIDBI), under the World Bank’s Innovation and Inclusive Finance Project, to improve access to finance for startups, services and manufacturing. Through the Project, SIDBI managed to scale-up the Fund of funds for startups and aims to indirectly disburse US$1.5billion to startups by 2025. SIDBI has leveraged on the project to launch a ‘Contactless Lending’ platform and has crowded-in US$1.9billion of private sector finance for SMEs and startups, according to the World Bank.
There are other European models which have been adopted in Africa. For instance, Initiative France provides interest-free loans on a large scale from US$20,000 to US$150,000 for entrepreneurs at the idea stage, and also support them technically and connects them with potential seed investors. The model has facilitated the financing of 16,000 businesses and created over 40,000 jobs in France during 2016. This model is being replicated in Tunisia, Burkina Faso, Chad and Mali, with repayment rates above 90%.
Another alternative source that can be leveraged to provide financing to Ghanaian startups is ‘crowdfunding’. Crowdfunding is using an online platform to raise money from a large base of people, and it’s becoming popular in Africa even though it currently lacks the legal and regulatory framework. For example, in Mauritius entrepreneurs pitch their ideas on ‘GoomFund’ to raise a few thousand US dollars through mobile network platforms.
To bring startups to an attractive level for follow-up investment in Ghana, Innohub Ghana has partnered with the World Bank to establish a Fund that provides early-stage investment for viable startups – to develop and make them attractive to follow-up investors and commercial banks.
Helping Small Businesses meet the requirements of formal financing
Some financial instruments have been leveraged by other African countries to help provide mission information or reduce the risk stemming from some small enterprises ‘lack of transparency’. For instance, the World Bank identifies franchising as a popular strategy used in Southern and East Africa, where the use of brand name or know-how has reduced the risk of failure. Similarly, warehouse-receipt financing, guarantees are popular in South Africa, Kenya and Zambia. Other financial instruments recommended by experts include leasing and factoring, and can reduce risk effectively for credit institution but are still little-used in Africa.
The World Bank has championed and introduced innovative instruments in small business financing: such as e-lending platforms; use of alternative data for credit decisions; and e-factoring and supply chain financing. For instance, in Morocco the MSME Development project aims to improve access to finance for small enterprises and startups by supporting the provision of credit guarantees. The project assists partial credit guarantee companies to scale-up their existing finance to small businesses and startups. It has increased the number and volume of credit finance to small and new businesses by 88% and 18% respectively since 2011.
In terms of helping startups in Ghana to meet collateral requirements, it is suggested that financial institutions, mostly state-owned banks such as the Ghana Export Import Bank and the proposed Development Bank, should be flexible to startups with potential but lacking relevant requirement to provide in-house advisory and technical assistant for a period to enable them meet primary requirements.
In doing so, some industry players proposed that the banks could interview entrepreneurs to understand the structure of their business model in order to determine how best to support them financially, even if they cannot provide all the requirement in the short-term. In additions, sales proceeds can be considered by commercial banks as security without requesting for additional tangible collateral from startups that have secured orders and require not more than US$50,000 as working capital financing.
De-risking mechanisms can play a significant role in solving the gap in access to finance. Experts have suggested that startup development agents such as Incubators and Accelerators can partner banks, with the support of government, to provide non-secured loans to startups. The incubators and accelerators can prepare the startups to be investment-ready before banks provide the funding. In addition, development Financial Institutions (DFIs) can partner private investors to finance startups. For instance, on a 20/80 basis where the 20% funding from DFIs could go into technical assistance to limit the risk inherent in startup business.
There have been various interventions by government to bridge the gap in small business financing in Ghana. However, access to finance continues to be a major hinderance to growth of small businesses in Ghana. Considering their significant contribution to growth of the economy, deliberate interventions should be made to ensure sustainability of their growth.
To expand the supply of finance to improve on the existing funding streams to startups, there is need for the establishment of a startup-focused funding institution. There have been calls from stakeholders for the establishment of a ‘Startup Fund’. Therefore, as a strategy to sustain the Fund, it can be established by an Act of Parliament.
Government can consider introducing a startup tax or levy on high profit earning companies to support startups by funding the proposed Startup Fund. In addition, donor partners and development banks, such as the World Bank, can be partnered to provide additional financing to the Fund. The Fund should be mandated to fund development of the startup ecosystem and create innovative financial instruments to support startup financing.
Also, a comprehensive policy and regulatory framework should be developed to attract investors and create the enabling environment for the use of other alternative sources to finance startups growth. Incentives, similar to those provided by the UK’s EIS and SEIS should be provided to attract angel investors to be interested in financing startups.
Tax rebates can be provided to financial institutions, especially the private sector, that provide a percentage of their lending/investment portfolio to startups. For instance, 10% of the portfolio to startups can benefit by a 5% tax discount on profit. Mobile money and e-payment platforms developed by government should be leveraged to promote crowdfunding as an alternative source of finance, and a regulatory framework can be developed to support the credibility of such platforms.
Incubators and accelerators are playing major roles in Ghana to develop and improve startups’ ability to access financing. However, the existing ones have not had significant support from government. As part of government’s intention to invest in building an entrepreneur culture in Ghana, the NPP 2020 manifesto promised to inject US$200million into providing apprenticeship, entrepreneurship, and skills development training – as well as grants for entrepreneurship projects.
Government recognised access to capital, among others, as a major constraint facing small businesses and intends to establish fully entrepreneurial hubs in partnership with the private sector. Government should partner or directly give support to the development of incubators and accelerators to help facilitate the development of startups in their early stages.
The entrepreneurial hubs can be developed in the form of incubators at tertiary schools to support entrepreneurial education. In addition, government and its agencies, such as the National Entrepreneurship and Innovation Programme (NEIP), should partner and provide financial support to incubators and accelerators for onward investment into startups. This will enable the development and sustainability of new businesses and prepare them to be more attractive for investors, and also help reduce the risk inherent in new businesses.
Small businesses have contributed to boosting development of the Ghanaian economy. However, access to financing caused by lack of collateral, high interest rates and inadequate capital sources, among others, have been a hindrance to startups’ development and growth in Ghana. Therefore, it is important for policymakers and government to pay attention and provide pragmatic solutions to improve small business financing in order to sustain their development, which in the long term will be beneficial to the economy at large.
The writer is a Chartered Accountant (ICAG) and an MBA holder from the University of Warwick Business School in the United Kingdom. A Staff of Ghana Export Import Bank and a freelance entrepreneurship trainer. email at [email protected].