By Saron Woldegabriel and Tefera Gezmu
Small and medium enterprises (SMEs) are the backbone of Ethiopia’s economy, accounting for most services across nearly every sector, contributing to job creation, and overall economic growth. In Africa, SMEs provide an estimated 80 percent of jobs across the continent, representing an important driver of economic growth. Most commonly, SMEs employ various strategies to access finance from the capital market. They may seek investment from venture capitalists or angel investors, who provide funding in exchange for equity in the company. Many acknowledge that credit constraints are a serious challenge for SMEs. Without reliable sources of working capital SMEs are incapable of making investments needed for growth, leading to stagnation may be even contributing to their failure.
SMEs are at the heart of the pursuit for inclusive growth in Ethiopia, thus all efforts to ensure that these small businesses have access to finance is imperative. Moreover, availing access to financing in the appropriate forms, and with equitable interest rates to help spur their development and growth is equally crucial for their success. And ultimately instrumental for the economic transformation of Ethiopia. Given the importance of SMEs as a source of employment, barriers to accessing financing become barriers to poverty reduction and economic growth.2 Some argue that blended financing can help business fill this critical gap. Unavailability of working capital is often leading for so many of the startups being stuck at the pilot stage and limiting their ability to flourish. In Ethiopia, some technical assistance grants have helped few SMEs begin, expand their capabilities and even improve their operations. However, what would help drive their confidence is the ability to attract funding without the need for a blended approach.
In Ethiopia, banks have historically dominated the lending market and have been the main source of finance for business, including SMEs. Given the long-established position of banks in Ethiopia, SME owners securing debt without large asset bases that can be used as collateral is unlikely. A report from the UNDP indicated that 7 out of 10 of MSEs in Ethiopia had no access to credit from any of the potential sources; thus, forcing them to rely on their own funds. Same data indicated that the majority of SMEs that sought debt finance did not receive funding in Ethiopia. For instance, for the 2020/21 calendar year, Ethiopian banks share of lending to SMEs is mere 2% of the total loan they have dispensed. This is a substantially lower rate especially when compared to the 16% lending SMEs received in the rest of lower income countries.
The fundamental question then is that, how can Ethiopia’s SMEs can secure access to much needed finance? And what would be the role of the soon to commence Ethiopian Capital Market (ECM) and Ethiopian Securities Exchange (ESX) in that regard?
In order to raise capital, most business often use a combination of debt and equity financing. Similarly, SMEs in countries with Capital Markets can go public by listing their shares on the stock market, allowing them to raise capital from a wide range of investors. Another option for those SMEs is to issue bonds or secure loans from financial institutions in the capital market. This allows them to borrow money for business expansion, research and development, or other capital-intensive projects. However, in countries where there is no Capital Markets, development and maturity of SMEs are often limited by various challenges, predominantly by the lack of access to finance. This lack of access to finance restricts their ability to expand their operations, invest on needed technologies and human resources, and even seize growth opportunities. Enter Capital Markets, ESX in Ethiopia and the opportunity for equity financing.
So, with opportunities ECM & ESX create, SMEs would now have a choice to either seek debt (borrowing from such financial institutions like banks) or obtain equity financing (provision of funding for part ownership of a business – selling shares to investors or listing your company on an exchange like the ESX with an initial public offering (IPO)). The choice often depends upon which source of funding that is most easily accessible for an SME, its cash flow, and how important maintaining control of the company is to its principal owner(s). Although, the challenge is often to determine which one of these funding sources to access and when, it is proven that Capital Markets offer SMEs an opportunity to tap into a broader pool of funding sources, including equity financing.
Equity financing through Capital Markets can provide SMEs in Ethiopia with the necessary capital to fuel their growth and development. Accessing capital markets can also enhance the visibility and credibility of these SMEs, making them more attractive to investors and lenders alike. Furthermore, capital markets can offer SMEs the opportunity to raise funds at a lower cost compared to traditional bank loans or debt instruments. By allowing SMEs to raise capital through the stock exchange, they can diversify their funding sources and reduce their dependence on personal savings, family assets or reduce the risk of being indebted no matter the outcome of their business. Objectively, it is self-evident such opportunities come with their own advantages and disadvantages.
Because the pros & cons of debt instrument are a common place in the Ethiopian economy, and in light of the establishment of the upcoming Ethiopian Capital Markets (ECM) and the Ethiopian Securities Exchange (ESX), we would like to address few of the pro and cons equity financing offer for your SME.
- Equity financing carries no repayment obligation and provides extra working capital that can be used to grow a business, like an SME.
- Equity financing does not have to be paid back – One of the major benefits of equity financing is that, unlike debt financing, you don’t have to pay back the money you receive from investors. As an SME owner, you are selling a portion of their company equity in exchange for the capital, so the financial risk is borne by the buyer, and
- Equity financing does not add any financial burden to that SME – Unlike other types of financing, equity financing doesn’t burden your company with repayments to meet each month, making it a suitable option for pre-revenue-stage companies.
- The major drawback involved in equity financing is that you’re partially giving up ownership of the business/SME – This means that important decisions that impact the future of your company need to be run past shareholders, which is not only a bit of a pain, but can be delay processes if you have multiple shareholders.
- You are also going to lose some of your profit – Let’s say you own 100% of the SME right now, you’re getting 100% of the profits. But if you split out 20% of your SME to investors in exchange for equity financing, you only own 80%, meaning you’ll only be entitled to 80% of any profits your company makes.
Of course, the pros and cons of these can be more nuanced and depends the type financing accessed and the particular SME, we recommend you consult a financial advisor before making any of these decisions. On our next piece we will discuss what SMEs must do, as well as avoid as they contemplate going public and reap the upcoming Ethiopian Capital Market and ESX.
Saron Woldegabriel is Sr. Officer of Communications and Investor Education at the ECMA.
Dr. Tefera Gezmu is Sr. Advisor at the ECMA working on Professional Development and Organizational Culture.