Venture capital financing alternative for reviving SMEs

Small and Medium-sized Enterprises (SMEs) in Uganda suffer from a lack of finance for their survival and growth. 

This liquidity emergency, according to Ian Nvula, an expert in capital markets and founder of T.E Markets, has motivated struggling start-ups to find alternative financing sources different from conventional bank lending.

According to Nvula, venture capital financing is now a popular and viable financial mechanism to revive SMEs’ performance. 

Although it is well documented that SMEs are the teamsters of economic growth, stimulating National Gross Domestic Product (GDP) and the principal employment sector in both industrialized and emerging economies, Nvula says the rate of start-up business failure in Africa remains high, triggering an enormous threat to entrepreneurship and sustainable development.

In Uganda, the SME sector accounts for over 2.5 million jobs, provides 90% of the private sector jobs, produces 80% of the manufactured output and endorses 70% of the national GDP according to data from the Micro Small and Medium Enterprises (MSME) sector Policy, 2015.

According to Nvula, the failure rate of SMEs is attributable to a lack of finance, the topmost stumbling block for start-up survival and development, according to the World Bank data 2010.

Finance Expert, Lawrence Kiiza in his comment in the 2016 Venture Capital (VC) conference whose theme was “Enhancing the growth of SMEs through alternative financing”, recognized that SMEs find accessing affordable capital a challenge and decried the high-interest rates which contribute to the high cost of doing business, and stressed the need to seek alternative sources of funding.

According to Kiiza, SMEs struggle for external debt capital to bridge the financing gap because financial intermediaries consider them as high-risk investment ventures and are reluctant to provide them with bank loans or financial credit.

However, according to Asher Namanya, aTech-Preneur, even the available capital is very costly to attain, characterized by very high-interest rates that end up suffocating starting businesses.

In this context, VC financing has emerged as an alternative source to conventional funding to fill the equity gap and benefit the missing middle.

This finance mechanism upholds the legitimacy in supplementing the growth of SMEs in a way that fund managers provide patient capital to start-up firms, and consistently provide technical skills and add value to the portfolio of companies, expecting good returns on investments.

Why Venture Capital financing

According to Uganda Investment Authority (UIA), MSMEs are encouraged to opt for this means of equity financing which is more long term than debt and a better option because the well-equipped businesses are exposed to mezzanine financing options.

Some of the importance of VC Prof. Augustus Nuwagaba, an international consultant on economic transformation gave are;

They provide large amounts of funding, generate high returns, active involvement of financiers where experienced professionals get involved in the business hence resulting in major improvements.

State of Venture Capital Financing in Uganda

Prof. Nuwagaba characterized VC in Uganda as small and underdeveloped, without much upstream private equity (PE) activity.

Nuwagaba says that in order to boost SMEs, private equity would have been a good alternative, but that sector is still undeveloped and gave the sectors in which PE/VC firms can invest in as infrastructure, energy, construction, manufacturing, pharmaceuticals, health care services and health care products, retail as well as financial services.

In his comment, Nvula said, “There is a tremendous growth of venture-capital-backed companies in sales turnover, profitability and return on assets matched to the non-venture-capital-backed firms.”

“Last week we launched Africa Consolidated Exchange (ACEX) to allow Africans to trade mineral products like gold, agri-products like coffee and local currencies. The exchange is built by T.E Markets to allow people to buy and sell stocks, bonds, forex, cryptocurrency and get venture capital from all over the world from a one-stop trading platform,” he said.

He added, “We have our own coin (XTEMCoin), that will be used as the main medium of exchange on the platform. There has been a lot of crystallisation and massive adoption of crypto assets all over the world and Africa is one of those. We know that crypto is here to stay. And with ACEX we hope to put Africa on the map and help businesses get VC funding from across the globe”

According to Nvula, T.E Markets’ first goal is to leverage disruptive technology to solve the problem of access to finance not currently offered by other players in the African market.

“I have realized there is no one-stop-shop for trading agricultural commodities, especially those of African origin, Stocks, Indices, Forex and Cryptocurrencies. ACEX will bridge this gap, with Africa’s first Consolidated Exchange that will be synthetically indexed to almost all tradable instruments including African commodities”, said Nvula

Research from developed countries such as the United States of America recognizes VC as a viable financing model with the proficiency to escalate access to finance for SMEs’ growth.

Given this, for the VC market to flourish in Uganda and developing economies at large, Nvula says it is incumbent upon both the public and private sector structures to increase VC investment into the early-stage entrepreneur ventures with growth potential.

What is Venture Capital

Venture capital is a high-risk equity capital consisting of seed, start-up and expansion financing in start-up firms already demonstrating business potential but not listed on public securities markets or underprivileged to access traditional funding sources.

Venture capital financing is a momentous financial innovative asset in the 21st century, several scholars have recognized it as a precursor for SMEs’ growth, global technological development and employment generation.

Altogether, entrepreneurs repeatedly face the problem of lack of access to finance, consequently compelled to accept patient capital from fund managers specializing in financing high-risk firms.

Windward side of venture capital

Given the high-risk nature of the early-stage firms, some VC-funded companies do not blossom to their expectations, nonetheless, there is inadequate evidence that exposes failed VC-backed companies since venture capital usually comes with expertise and consultancy.

However, it is undeniable that VC is viewed as a real-world answer to rejuvenate the growth of SMEs to avert emergent youth unemployment, poverty eradication and economic development.

Unlike the debt-funding model, VC provides patient capital to start-up firms showing growth potential and without collaterals to offer in exchange for lucrative equity shares that attract ROE disclosed that VC-backed firms outperformed the non-VC-backed firms across every level of investment both before and after receiving VC.

There is little or no empirical research done to provide empirical data to benchmark future research, but available research affirms increasing total productivity from sales revenue after VC financing. 

However, profits were lower compared to the significant market expansion of the VC-backed firms, implying that even though funded companies increased their market shares, they did not translate into profitability growth.

Such drawbacks in the available literature necessitate more research in the field of VC finance to provide a clear understanding of its impact on SME performance, specifically in Uganda.

Most of the VC deals are concentrated in Nairobi, Kenya, enhanced by the manifestation of Silicon Savannah and the East African Private Equity & Venture Capital Association (EAVCA) headquartered in Nairobi.

Current literature suggests that the growth of the VC industry in developed and transitional economies is attributable to the private equity investors’ efforts to add value to the portfolio companies, with a greater focus on SME growth.

In isolation, VC tickets in Uganda range from US$250000 to US$1000000 according to Ernst and Young 2016, explaining why Uganda’s VC market is grappling.

VC Stimulates growth

According to Organization for Economic Co-operation and Development (OECD) 2018, VC financing stimulates the growth of start-up firms and is a sustainable solution to their equity gap.

The VC4Africa 2015 report shows an increasing number of African businesses successfully growing their operations over time.

The research shows that 49% of the ventures start generating revenue in their first year of operation with 44% of the ventures successful in securing external capital investment.

The top investment categories are related to the Technology sectors, followed by Agriculture, Health, Finance and Energy.