The System is Broken for Hard-Working Entrepreneurs in Developing Countries

Aug 15, 2018 7:05:02 PM / by Hannah Barkan | 6 minute read

When first starting a business, entrepreneurs almost always need some upfront capital to finance start-up costs such as buying inventory, purchasing a building, or hiring your first employees.

Once your business is successful, you then need working capital to finance your everyday business workings. Things such as rent, utilities, and fulfilling orders.

But later, when you want to grow your business by doing something such as moving to a bigger facility or hiring more employees, who will fund those growth costs?

The people who might loan you money will only do so if they trust that you can pay them back and that your business will be even more successful. And, seeing as how most entrepreneurs in developing countries use their entire life savings to fund their start-up costs, finding outside funding is usually their only option.

A Global Problem for Entrepreneurs

Around the world, this is a problem faced by SME’s; small and medium-sized businesses, defined by the European Union by their headcount and revenue (<250 people and revenue <€50 million).

As a rule, most companies are SME’s (in Europe 99% of companies are defined as small or medium-sized). They are the backbone of economies everywhere, but in developing countries, SME's access to credit is more restricted than in the growth-backed economies of Europe and North America.

"These entrepreneurs took a risk, and in doing so, are propelling the economy forward whilst lifting themselves and their communities out of poverty."

These SME’s are mostly unable to access finance; banks won’t lend to them (at least not at favorable, market rates) because they are unable to provide security, they operate in unfamiliar sectors, business owners may exhibit poor financial skills, and it often isn’t worth the due diligence for the lender.

Other difficulties in accessing finance include an unsupportive government and lending environment, a lack of visibility, an unwillingness of lenders to take risks, and volatile country politics.

In developing countries, between 52% and 64% of smaller enterprises are underserved, with women and men unable to raise financing to run or grow their business. Research by the World Bank suggests that the existing credit gap for SMEs in developing countries, that is the money needed by enterprises to fulfill their growth needs, stands between $2.1 – $2.6 trillion.

SME’s aren’t looking for free money or grants, they are trying to grow and build a business against all odds, in a system that is often stacked against them. If you are very small, you can access the growing number of microfinance institutions, and if you are a larger business you have the capabilities to access fair credit from traditional finance organizations. 

The Real Problem Is Not Access, It's Cost

There are plenty of people lining up waiting to lend out micro-loans to businesses starting up. Money lenders are easy to find in the developing world and range from the very informal (agreements with mafias) to large corporations (who are not necessarily offering a better service than the mafia).

"These SME's aren't looking for free money, they are trying to grow and build a business against all odds..."

However, money lenders in developing countries are incredibly expensive and relentless; they don’t offer payment holidays or flexible interest rates, and if your business doesn’t grow you can find yourself in a lifetime of mounting debt.

Small organizations don’t generally have the collateral to back up their loans. They may not have a building, a lease, or a strong balance sheet to provide lenders with confidence, or recourse, should they be unable to pay back any money they borrowed.

This makes the investments higher risk and more unattractive to potential lenders. The capital that is needed is often patient long-term capital, and investors who want to see a return quickly will be uninterested. Volatility in the markets and regions of investments also plays a role; you would expect investors to understand that certain circumstances, such as a civil war, political unrest, or an environmental disaster might warrant a payment holiday (repayments are temporarily frozen until business returns to normal). In the UK, social investors play this role, but in developing regions so far, most impact investors have been more interested in microfinance.

Due Diligence and Evaluating Risk

On the supply-side, due diligence is costly, deterring many investors

The cost of due diligence may explain part of the reason for the gap in access to credit. Due diligence is necessary for any investment, big or small, but it is always expensive.

"Start-ups are building innovative solutions that allow companies globally to access finance from lenders located internationally."

For smaller investments, the due diligence costs can often outweigh the return on investment. Due diligence is hard to outsource, and whether you are looking to lend $3 million or $3,000 you want to be sure that the company is financially robust, has a good management, and will be able to pay back the loans. This almost always involves spending time with each individual borrower and understanding their business and the political environment.

It also means that investors tend to focus on certain regions and countries, making it more difficult for organizations operating in countries with few investors.

Entrepreneurs Need to Up-Skill, but the Help Isn’t Always There

It is not all about the lenders, and entrepreneurs have a role to play in matching their business skills to their desire for growth. Entrepreneurs are not always equipped with the right finance skills needed to raise and repay funding, though there are potentially limited opportunities to expand their knowledge. In Europe and the US there are ‘investment-ready’ programs, and while they have had limited degrees of success, there is a wider sector of intermediaries that work with social enterprises to help them approach and access funding, that does not yet exist in many developing countries.

Other options for financing

There is an increasing number of options for finance that have emerged in response to the monstrous credit gap. Friends and family loans are often used in the developing world, but these are resources largely unavailable to entrepreneurs in poorer economies. Crowdfunding, (capital provided in small amounts invested by many people), has filled a gap, making it easier for an entrepreneur to find the startup or growth capital needed to kick-start their business. Amounts are usually small, raised for a specific purpose, and done through a platform (like Lendahand). This type of funding is hugely important in lifting people out of poverty, but there are still few alternatives that meet the demand for mid-sized businesses.

What Does the Future Bring for Impact Investors?

As companies in the developing world are increasingly able to access resources developed online, start-ups are building innovative solutions that allow companies globally to access finance from lenders located internationally. Harnessing the widespread use of mobile phones for making regular payments, companies are using the data available to form risk profiles that they can then lend again, charging much lower interest than a traditional money lender and cutting their due diligence costs.

Companies like Tala Kenya and Lenddo offer credit scores through mobile phones as well as access to financial services. These initiatives are valuable and needed, but I would argue that more needs to be done on a larger scale to help bridge the funding gap.

Governments need to step in to regulate money lenders that are profiting from the vulnerable and provide encouragement, possibly in the form of 1st loss capital, for banks who are as yet reluctant to lend to SME’s.

Companies of all sizes rely on working capital loans to finance their growth. Whether you are a one-man enterprise, or a large corporation you are likely to take out loans with a bank, money lender or friends and family. Mid-sized businesses are often punished for attempting to grow, and most lenders refuse to take a risk on companies that haven’t yet proven their worth.

How to Close the Developing Country Funding Gap

The gap for micro-businesses has started to close, and it is now those small and medium-sized companies that are being squeezed out. More must be done, on the part of governments, banks, and lenders to provide access to credit needed by businesses; businesses run by entrepreneurs that took a risk, and in doing so, are propelling the economy forward whilst lifting themselves and their communities out of poverty.

Topics: impact investing, crowdfunding, fighting poverty, social impact

Hannah Barkan

Written by Hannah Barkan

I am an investment analyst located in Zurich, Switzerland. I'm passionate about impact investing and want to use my knowledge to show the world the incredible impact their investments can have.

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