Funding very Small Companies: A proposal for Building Trust and Scaling-up
Growing a small company - say of fewer than 20 employees - is extremely tough. In the US, according to Dun & Bradstreet reports, such businesses have a less than 40 percent chance of surviving four years. Conditions in low-income markets are even tougher. Access to funding is clearly critical to starting-up and growing firms, but remains a major challenge. Over the past half-century, government and philanthropic programs addressing this challenge have had mixed results and reached only an extremely small proportion of emerging markets SMEs.
Why is this so, and what might be done about it ?
In countries with predictable legal and regulatory environments, banks and other funders are generally able to collect reasonably credible standard information about SMEs seeking funding, and to do so at low cost. Such impersonal processes make it largely unnecessary for would-be funders to nurture trust with SME owners, a longer more costly process.
In weaker institutional environments, collecting information can be a much more expensive process for funders. For one thing, in many societies the line between enterprise assets and an owner’s and her relatives’ personal assets is often blurred. It is not uncommon, for example, for relatives to “borrow” from a store’s cash register in order to attend a funeral, or for owners to “pay themselves” undefined salaries. In such circumstances financial projections lack credibility.
It is also often the case in traditional societies that various members of a family operate a number of different businesses – a car wash, tailoring, a farm – where funds move among businesses without proper documentation.
Partnerships with stronger institutions may help owners build trust that funders need: for example a franchise arrangement with a larger company; or vertical integration - becoming part of a larger company’s value chain; or joining a business association where this exists; or linking up with a reputable nongovernmental organization focused on SME growth. In advanced economies, angels also play a trust-building role.
As only a small number of SME owners are able to establish such partnerships, a practical alternative might be to shift the SME financing paradigm from enterprise to individual. Rather than having to struggle with often ill-defined “enterprises” with elusive accounts, why not consider SME financing “character lending” rather than “enterprise financing” ?
The proposal is that ways be explored to extend the reach of credit cards to the small business sector. A special instrument – say “Small Business Credit Cards” – could be developed. Initially the credit limits would be quite low, and later then cancelled or increased depending on payment performance. There would be only a minimal need for any business plans, financial projections, etc. Instead, periodic site visits to SMEs would corroborate the bona fides of borrowers. This was a track record would be established without funders having to cope with institutional uncertainties surrounding “enterprises”. Instead, the process would engage the individual SME owners’ personal credit and reputation. This would differ from microcredit, which is usually limited to smaller loans.
Efforts would be needed to encourage the growth of credit cards in emerging markets. In quite a number, fraud is pervasive, and vendors are reluctant to accept credit card payments. Furthermore interest rates are often prohibitive. Perhaps one approach might consist in banks working with businesses that supply SMEs, and so to “ring-fence” use of the instrument ? If this is impractical, cell phone banking may offer a secure alternative. As for high interest charges, governments might be willing to enter public-private partnerships with card-issuing banks. Governments and IFIs might even offer banks some risk-mitigating comfort for such instruments.
Premier MNCs such as Visa and MasterCard might also find innovative ways to encourage the use of credit cards in order to help finance emerging markets SMEs. If a pilot operation with a bank in one emerging market is successful, the approach can be replicated, offering a way to really scale up SME funding.
Last but not least, since 2003 the Global Business School Network (www.gbsnonline.org) has been collaborating with local business schools and entrepreneurship centers in emerging markets , and the evidence shows that SMEs whose owners graduated from such institutions are growing faster than others. Whether improved business skills translate into easier access to financing remains an open question.
In sum:
• SMEs need credit
• Commonly, the data don’t exist to support making a loan
• Life of entrepreneurs is complicated – things they juggle are too many to report on a loan application
• There are creditworthy entrepreneurs, the challenge is to identify them
• Let them do it using personal track records; determine that they have a legitimate enterprise(s), but focus on the payment history
• Design loan programs that permit increased borrowing with evidence of timely repayment
• Trust is created through formal and informal mechanisms. In the absence of formal mechanisms, a payment history can turn informal mechanisms into formal credit histories.
