Small and Medium Enterprises (SMEs) are key to driving job creation and economic growth in South Africa. Yet despite the significant contributions SMEs are expected to make to the country’s growth and employment, South Africa reports one of the lowest creation rates of successful SMEs. The lack of access to funding remains one of the most significant obstacles to SME growth.
Here we will explore 5 ways to lift the barriers to SME funding in South Africa, supported by the industry knowledge of investor and Vumela Fund Trustee Mike Sage, and the first-hand experiences of Murendeni Mafumo, founder of Kusini Water.
Listen to the Lifting the Barriers to SME Funding podcast where Mike Sage and Murendeni Mafumo unpack the complexities of capital raising for South Africa’s SMEs.
- Explore alternate funding mechanisms
- Enable SME lending
- Embolden venture capital investment in South Africa
- Encourage corporate-backed funding
- Engage public-private sector partnerships
1. Explore Alternate Funding Mechanisms
Traditional bank finance is a common source of SME funding as many small businesses depend on traditional debt to fulfill their funding needs. However, bank finance can pose challenges to SMEs.The obstacle on the supply side is the shortage of formal SME banking products that can sufficiently cater to the various stages of the SME life cycle due to the perceived riskiness of SMEs combined with the shortage of obtainable financial data and credit information. As Mike Sage explains, “in the more regulated banking environment you need quite a lot of track record, you need a balance sheet, you need equity, you need cash flows to prove affordability and all these kinds of things”.
This in turn presents challenges on the demand side, as SMEs may be reluctant to seek or cannot access credit due to the reams of financial documentation and collateral requirements that banks need for SMEs to obtain a loan, not to mention the high interest rates on these loans.
For SMEs to contribute to innovation, employment and overall economic growth, we need to broaden the range of funding mechanisms available to them. This requires that we develop new and innovative ways to fund high-potential SMEs. By diversifying SME funding in South Africa, we can address the capital gaps that exist in the SME funding ecosystem and provide funding solutions for every stage of the SME life cycle.
Understanding the need for innovative funding mechanisms for SME growth, FNB Business Banking imagined a means to provide SMEs with access to funding unrestricted by the prudential regulations of traditional banking. The objective was to create an innovative and sustainable model for a financially and operationally independent investment business to invest in SMEs in South Africa. What would stem from this is the SME fund named the Vumela Fund.
Pioneered by FNB Business Banking and Edge Growth, the Vumela Fund would present a blueprint for many enterprise and supplier development (ESD) and SME development funds to come. Founded in 2009 to create jobs and alleviate poverty, the Vumela fund invests in high-growth SMEs with good economic and impact returns. Vumela has launched its fourth fund and has raised R588m and made 21 investments. In addition to funding SMEs, Vumela offers non-financial growth support to address further constraints to SME growth.
2. Enable SME Lending
In developing markets such as South Africa, SMEs provide an exceptional number of customers and prospects for financial services. According to the World Bank, the global developing markets’ SME banking revenue reached US$367 billion by 2015, and SMEs in developing markets are estimated to spend between US$8.0 to US$10.0 trillion annually on business-to-business transactions. The SME banking market holds enormous potential but brings with it a plethora of obstacles.Comprised of various businesses in various sectors and at various stages of their life cycle, the SME segment is large and heterogeneous. SME funding needs can range from seed or startup capital to working capital or growth capital. Additionally, of the estimated 2.6 million SMEs in South Africa, only 37% are considered formal with the majority considered informal according to data from the Organization for Economic Co-operation and Development (OECD).These complexities make the SME market challenging to service, and one-dimensional funding mechanisms cannot cater to the multidimensional needs of the segment. Instead, innovative funding mechanisms are needed to bridge the funding gaps for the complex SME market. Fintechs and fintech-enabled SME lenders are doing just that.
The demand for SME financial services without the hassle has given rise to the digital SME lender (DSL). DSLs, empowered by digitisation and unencumbered by legacy systems, are engineering solutions that present a whole new way to provide SME funding to meet the complex and specific needs of the SME market.
Agile, innovative and disruptive, DSLs can reach parts of the SME market that would otherwise go underserviced, making them essential players in the SME funding ecosystem. With faster, easier and better-tailored funding solutions, DSLs are influencing changes in SME customer expectations. DSLs offer a quick, simple and technology-enabled application process that differs from the paper-intensive documentation requirements of traditional lenders.
In summary, DSLs are helping to lift the barriers to SME funding by introducing innovative, quick and easy tech-enabled funding solutions that can serve a greater portion of the SME market. An example is ProfitShare Partners, an SME funding solutions company that uses fintech to provide access to funding for SMEs.
ProfitShare Partners (PSP) makes capital easily accessible to SMEs by offering a myriad of short-term funding solutions . Their alternative offering services SMEs who would otherwise not be able to acquire funding through traditional lending channels thereby filling the gap in the SME funding ecosystem. Unlike traditional lending, PSP’s model doesn’t require financials, security or a track record and SMEs can access funding through an easy online application. This removes the red tape for early-stage SMEs who require quick cash flow to seize potential growth opportunities.
3. Embolden Venture Capital Investment in South Africa
Venture capital refers to equity investments made into early-stage businesses with high-growth potential. These investments are typically high-risk and are made by investors in exchange for an equity stake. Venture capital in South Africa plays a key role in funding SMEs who are otherwise considered too early-stage and thus too high-risk for traditional funders. Additionally, venture capital offers an alternative funding instrument to debt funding and, by exchanging equity, entrepreneurs often get invaluable business support from investors that extends beyond capital.Data from the Southern African Venture Capital and Private Equity Association’s (SAVCA) 2022 Venture Capital Industry Survey suggests that South Africa’s venture capital industry is reporting healthy growth, despite economic challenges such as the Covid-19 pandemic. According to SAVCA, the number of venture capital deals grew 11.4% from 2020 to 2021 with early-stage funders investing R1.31bn in 129 entities through 186 investment rounds in 2021.
To continue this growth and further embolden venture capital in South Africa requires an SME development ecosystem that readies SMEs for venture capital investment. According to Disrupt Africa’s Startup Ecosystem Report, South Africa’s universities are leading a host of initiatives to provide support to early-stage startups. The South African government also invests in nurturing innovative entrepreneurship with various initiatives that support startups with grant funding, enabling startups to develop their ideas and test their innovations to ready them for potential venture capital investment.
Murendeni Mafumo’s entrepreneurial journey is a great example of how this type of early-stage support can bolster SME investment-readiness.
On Edge Growth’s The Cutting Edge podcast Murendeni, the founder of the social enterprise Kusini Water, shares that much of the capital he raised in the initial stages was acquired from grant funding supplied by government initiatives established to support innovative business ideas. The grant funding helped him to develop his product, a genius water filtration system that makes use of nanotechnology and macadamia nut shells, and to test product-market fit. This readied his business for an equity investment made by the Vumela Fund.
Offsetting the high-risk associated with early-stage businesses by incentivising investments in these businesses presents another opportunity to embolden venture capital in South Africa. Just last year, South Africa’s National Treasury decided against the renewal of the Section 12J of its 2009 Income Tax Act, a policy that sought to incentivise investments in startups by providing investors with tax breaks, on the basis that their objectives were not sufficiently achieved.
However, other regions such as the UK are successfully demonstrating how tax incentives can successfully encourage investment in high-risk, early-stage businesses. South African policymakers must consider how to better policies such as the Section12J, or to create innovative, improved policies that will encourage venture capital investment in early-stage businesses.
4. Encourage Corporate-Backed Funding
Corporate venturing is burgeoning and it is easy to comprehend why. Investing in small businesses yields not only financial returns for corporates but also allows them to tap into innovations and technologies that will boost their competitive advantage and maintain their relevance in the market. “As technology continues to evolve, if companies don’t take those opportunities to do the same, I’m afraid that they just won’t last,” says Mike Sage. “You have to continually evolve and position yourself in the marketplace”.To keep up with the rapid pace of change, Mike advises that corporates identify opportunities in the market to progress their product or offering by investing in innovation labs or innovative ideas, products, services or technologies that small businesses can contribute to their value chain. Corporates that actively invest in SMEs with new ideas and new solutions can drive innovation in a big way. In South Africa, corporate investors are making their mark on the venture capital landscape, with 43.8% of venture funds raised by fund managers being sourced from corporate investors.
Corporate venturing also drives sustainability. As corporates are incentivised to become as equally purpose-driven as they are profit-driven, investing in SMEs will aid corporates to meet their social impact objectives and drive shared and sustainable value creation. “Impact has an influence to bear in a corporate’s ability to transition forward”, says Mike. “It is incumbent on corporates to be good social citizens and to find their way into clean water, renewable energy and various other things”. The rapid growth of impact investing and the adoption of Environmental, Social and Governance (ESG) factors and the UN Sustainability Goals as tools for impact measurement, indicates the importance of a corporate’s ability to drive social impact.
The South African context brings unique methods for corporates to invest in SMEs. What it requires is that corporates re-envision their Enterprise and Supplier Development (ESD) funds as an opportunity to invest in disruptive SMEs that can contribute innovative products and services to their supply chain.
CCBSA SME Fund
The Coca-Cola Beverages South Africa (CCBSA) SME Fund supports the growth and development of CCBSA’s majority black-owned suppliers by providing the funding they need to scale. Managed by Edge Growth, the SME fund is on track to achieve supply chain transformation for CCBSA, as well as socio-economic impact. In addition to the provision of capital, Edge Growth provides the SME beneficiaries with post-investment business support to drive the sustainability of these businesses as they grow. To ensure that the fund is achieving meaningful impact, Edge Growth tracks and measures impact data with the use of the GrowthTracker.
5. Engage Public-Private Sector Partnerships
The National Development Plan envisions that the SME sector will employ 90% of the country’s workforce and contribute to 60% to 80% GDP growth by 2030. With a lack of access to funding remaining one of the most significant obstacles to SME growth, the government has employed various initiatives that aim to lift the barriers to funding for SMEs.Government funding, provided to SMEs through grants, direct loans and guarantees facilitated by development finance institutions (DFIs) such as Small Enterprise Finance Agency (Sefa), the National Empowerment Fund (NEF), the Small Enterprise Development Agency (Seda) and various others, plays a critical role in funding SMEs.
The government established the Department of Small Business Development (DSBD) in 2014 to accelerate the development of entrepreneurship in the country. An example of a recent DSBD initiative is the Township and Rural Entrepreneurship Programme (TREP) launched in 2021 to develop entrepreneurship ideas originating in townships and rural areas into sustainable business ventures. The government can further their SME development intiatives through public sector and private sector partnerships.
Joint SME development initiatives present a significant opportunity to stimulate entrepreneurship in South Africa by making funding more accessible to SMEs. A study conducted by Mastercard called the MEA SME Confidence Index revealed that 88% of Middle-East and African SMEs believe in the importance of government support and implementation of effective policies, and 63% believe that public-private sector partnerships will benefit small businesses and the markets in which they operate.
With that level of confidence in private-public partnerships, we could do more to engage the potential of joint initiatives between the government and the private sector. Mike Sage encourages the public sector and private sector to implement some of the government programmes that have been so successful in various other countries to bridge the funding gap in South Africa. The recently launched Abadali Equity Equivalent Investment Programme (EEIP) demonstrates the potential that exists for public-private sector initiatives to unlock capital for SMEs.
Abadali Equity Equivalent Investment Programme (EEIP) is a joint initiative by J.P. Morgan and the South African Department of Trade, Industry and Competition (the dtic). The Abadali EEIP aims to create a positive economic and social impact in South Africa by addressing the critical funding gap for majority black-owned enterprises that were historically challenged to access capital for growth. The SME fund, managed by Edge Growth, aims to support over 500 early-stage businesses and stimulate the creation of at least 1 000 permanent jobs.
To conclude, access to funding is a major obstacle in the way of sustainable growth for South Africa’s SMEs. However, there are various ways that we can come together to lift the barriers to SME funding in South Africa. What it requires is big-picture thinking, agile innovation and collaboration between government, private-sector and other key players in the SME development ecosystem.