Types of finance available for SMEs

With employment levels falling, now is as good a time as any to consider the option of starting a business, developing an existing one, taking on a government or private sector contract or embarking on a management buy-out or buy-in. But how does one go about finding finance?

The growing importance of small and medium enterprises to the South African economy means that, despite the tough regulatory environment, they now account for approximately half of all people in formal employment in South Africa and for about a third of the national GDP.

Many existing and potential entrepreneurs also feel it is still difficult to access the funding required to start or develop a business and, as importantly, to acquire the necessary business information and skills that they may need.

Essentially, there are four principal types of financing available to entrepreneurs when they're thinking of starting or expanding a business.

These are:

  • Private loans from family, friends or other interested parties
  • Bank loans in the form of either overdrafts or fixed period personal or business loans
  • Term financing such as hire purchase or leasing
  • Private- or quasi equity investment

Private loans

In the case of private loans, entrepreneurs often find themselves limited by the amount of money a family member has available. These loans are also often unstructured, leaving the entrepreneur open to uncertainty and even abuse, or there is an expectation that they will be paid back within a very limited time period and/or at a rate of interest higher than that available through a financial institution. 

Many small business are started with private loans, but a major inhibitor for this source of funding can be the requirements by the family member or friend providing the funds to be "hands-on" and even "hands-in" involved in the business.

Bank loans and term financing

In the case of overdrafts, bank loans and term financing, the amount available to the entrepreneur is limited by the security he or she is able to offer against the loan. This usually takes the form of property, fixed assets and insurance policies, or in the case of term-financing of moveable assets it will be the underlying asset item that is funded.

Also, when making use of these forms of financing, the financial institution in question has no vested interest in the business' ultimate success or failure and so provides no on-going business support.  The collateral and deposit (or own contribution) requirements often make this an option that is out of reach of many aspiring entrepreneurs.

Quasi- equity investments

Private and quasi equity investments are made on the basis of two main criteria:  Firstly, the potential for success in the market sector as contained in the applicants' business plan and, secondly, the skills and business management abilities of the entrepreneur or entrepreneurs.

Quasi equity investments are not made on the basis of security. The funders usually assess the entrepreneurs, examine the viability of the business and consider the portion of the required investment the entrepreneur may or may not have to contribute to the venture, either in the form of cash or assets. This enables SMEs - run by solid entrepreneurs - with limited security or own contributions, but with a viable business plan, to obtain financing for their ventures.

The funder has a vested interest in the success of the business venture since it will be sharing in the profits of the business, depending on the structure of the funding transaction.  In a certain sense, this type of finance can be similar to the funding provided by a family member or friend, but with the difference that the investor will be an outside, professional and disassociated entity.

Before acquiring finance for a business, an entrepreneur should carefully assess his funding needs, what he or she has to offer in terms of own funds and collateral and then target the best funder based on these facts.

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