Post on 24-Feb-2023
CHALLENGES FACED BY SMEs IN ACCESSING PRIVATE EQUITY FINANCING
BY
MARGARET KARIUKI
A RESEARCH PROJECT SUBMITTED IN PARTIAL FULFILLMENT FOR THE
AWARD OF THE DEGREE OF MASTERS OF BUSINESS ADMINISTRATION
(MBA), SCHOOL OF BUSINESS, UNIVERSITY OF NAIROBI.
AUGUST 2014
DECLARATION
I, undersigned, declare that this research project is my
original work and has not been submitted to any other
institution, college or University.
Signed: ……………………………………. Date: …………………………
Margaret Kariuki
D61/79474/2012
This project has been presented for examination with my
approval as the University Supervisor.
iii
Signature: ……………………………………. Date: …………………………
J. Kagwe
Lecturer
Department Of Business Administration
School Of Business
University Of Nairobi
ACKNOWLEDGEMENTS
I wish to acknowledge our Heavenly Father for enabling me and
giving me the knowledge and strength to undertake this
project, my husband for the support and encouragement, my
parents for always reminding me that I can make it and my
supervisor Mr. J.Kagwe for his guidance and taking me through
the process.
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DEDICATION
I dedicate this report to my husband Isaiah. You are a gift
from God, thank you for believing in me.
vi
TABLE OF CONTENTSTABLE OF CONTENTS.................................................ii
CHAPTER ONE........................................................3
1.0 INTRODUCTION..................................................3
1.1 Background of the Problem...................................3
1.2 Statement of the Problem....................................51.3 Purpose of the Study........................................6
1.4 Research Questions..........................................61.5 Justification of the Study..................................6
1.6 Scope of the Study..........................................71.6 Definition of Terms.........................................7
1.8 Chapter Summary.............................................8CHAPTER TWO.......................................................10
2.0 Introduction...............................................102.1 Organizational Factors that Hinder Access to Equity........10
2.2 External Factors that Affect Access to Equity/ Venture Capital by SMEs.................................................15
2.3 Strategies for Enhancing Access to Equity/ Venture Capital bySMEs 18
2.4 Chapter Summary............................................22REFERENCES........................................................23
CHAPTER ONE
1.0INTRODUCTION
1.1 Background of the Problem
According to Rok (2009) Small and Medium Enterprises (SMEs)
refers to those businesses both in the formal and informal
sector and which are employing between 1-50 workers.
Furthermore, these enterprises are seen to cut across all
sectors of employment and offer one of the most productive
sources of employment creation, income generation and above
all contributes to poverty reduction (Rok, 2009). It is noted
that the SME sector contributes approximately 80% of the total
persons in employment (Rok, 2009). In Kenya alone the sector’s
contribution to the Gross Domestic Product (GDP) has upsurge
from 13.8 per cent in 1993 to close to 40 per cent as of 2008
(Rok, 2009).
Notwithstanding, the significant contribution made by SMEs to
the economic growth continue to face numerous drawbacks like
inadequate infrastructural facilities, inability to attract
skilled manpower, high rate of enterprise mortality, lack of a
facilitative operating environment, restricted market access,
and arduous regulatory requirements. Nonetheless, one of the
key areas of distress is access to funding (Stella, 2011). It
is important therefore for SMEs to acquire adequate financing
2
in order to meet needs at every stage of their life cycle,
that is, from creation all through to operation, development,
expansion, and beyond. Financing is important given the nature
of their operations which involves developing new products,
and investing in new staff or production facilities (Stella,
2011).
Stella (2011) opined that many small businesses commence as an
idea either from one or two people, who devote their own money
from savings, help from family and friends in exchange for
business ownership. The success of their business only further
trigger their thirst to explore new investments so as to
expand or innovate further. Access to funding and the high
cost of finance through the traditional channels have been
major stumbling block to SMEs thus the need to discover other
available options (Stella, 2011).
Some studies outline the fact that the essential motives
behind SMEs‘ lack of access to funds can be traced back to
their irregular characteristics, in addition to the fact that
SMEs undergo financing gaps attributed to market imperfections
witnessed on the supply side. In most cased, SMEs experience
financing gaps because of a combination of reasons emanating
from both the supply and demand sides. This financing gap for
SMEs is widely seen in capital market financing and most
nations, including developed ones, experience problems in SME
3
financing through capital markets (CMA, 2010). Consequently,
the main challenges seen as facing SMEs in Kenya include
overlap and inconsistencies both in legal and sectoral
policies, lack of clear boundaries in the institutional
mandates, lack of a suitable legal framework, outdated council
bylaws, unavailability of land and worksites, exclusion of
local authorities in policy development, lack of access to
credit, lack of a central coordination mechanism and
above all lack of a devolved coordination and
implementation mechanism (CMA, 2010).
Kenya is not alone when it comes to challenges that SMEs face
like financing. Ghana one of the fastest growing Africa’s
economies is also faced with the challenge of proper book
keeping practices that inhibits financiers who are even
willing to assist its SMEs to acquire funding not to do so a
situation attributed to their unwillingness to give
information to their financiers (Ackah & Vuvoh, 2011). This
has been complicated further by some small business heads who
tend to be restrictive when it comes to providing external
financiers with elaborate information about the core of the
business, given that they believe in one way or the other,
information about their business may filter through to
competitors (Ackah & Vuvoh, 2011).
According to CMA (2010), an approach of moving away from bank
intermediation towards funding in the capital markets has long
4
mentioned as a long-term strategy of many nations. It is
viewed that when companies are in the growth phase, they tend
to get leveraged up to a certain point upon which banks are
reluctant to provide further credit. CMA (2010) noted that
equity capital is of essence in order to bring strength to the
leveraged balance sheet. This scenario requires the promoter
to self-provide for the injection in the essential levels of
equity or do without the capital, which would kill the
impetus of growth. Having the option of equity financing via
the equity market, not only allows the firm to raise long-term
capital but also to get further credit due to additional
equity cushion now being available. The approach if successful
would solve the chronic lack of long-term credit
available to SMEs. Some of the challenges anticipated in
adopting this approach include overcoming having an
adequately developed capital market in terms of depth
and liquidity, high credit risk associated with SMEs;
SMEs have high growth potential hence are also more
vulnerable to sudden changes in the economic and
competitive environment, the existence of severe
information asymmetry in this segment of enterprises;
SMEs’ corporate information is often nonexistent, or comes
with very high access costs in many economies. Finally,
SMEs’ financing is inherently associated with a higher
unit cost when compared with that of large
corporations. This relatively smaller size of funding,
5
as well as higher information and monitoring costs,
leads to higher implementation costs per deal when
processing finance in capital markets (CMA, 2010).
1.2 Statement of the Problem
Several studies have recognized the role played by the SMEs in
the economies of various nations. For instance, Petrakis and
Kostis (2012) explored the role of interpersonal trust and
knowledge in the number of Small and Medium Enterprises
(SMEs). They concluded that knowledge positively affects the
number of SMEs, which in turn, positively affects
interpersonal trust. They noted that the empirical results
indicate that interpersonal trust does not affect the number
of SMEs. Therefore, although knowledge development can
reinforce SMEs, trust becomes widespread in a society when the
number of SMEs is greater Small and medium-sized enterprises
(SMEs) are increasingly being recognized as productive drivers
of economic growth and development for African countries.
SMEs not only contribute significantly to the economy but can
also serve as an impetus for economic diversification through
their development of new and unsaturated sectors of the
economy. In addition, innovative and technology-based SMEs can
provide an interesting platform for expanding outside of
domestic borders, and entering intra-regional and
international markets (Petrakis & Kostis, 2012). Odhiambo
(2013) explored the effect of changes in interest rates on the
6
demand for credit and loan repayments by small and medium
enterprises in Kenya. Therefore this study seeks to fill the
study gap by establishing the challenges faced by SMEs in
accessing equity financing in Kenya.
1.3 Purpose of the Study
Purpose to determine factors that affect access to equity/
venture capital by SMEs in the ICT industry in Kenya.
1.4 Research Questions
The following research questions will form the base of the
study:
1.4.1 What are the organizational based factors that
affect access to equity/ venture capital by SME’s in the
ICT industry in Kenya?
1.4.2 What are the external factors that affect access to
equity/ venture capital by SME’s in the ICT industry in
Kenya?
1.4.3 What strategies can be adopted by SMEs in the ICT
industry in Kenya to enhance access to equity/ venture
capital?
1.5 Justification of the Study
This study will be of significance to the following
stakeholders:
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1.5.1 The Private Equity Owners
These will gather the information in terms of structuring the
policies that align to the expectations of the SME owners.
1.5.2 Venture Capitalists
To understand the legal, regulatory and institutional
framework of SME financing in the ICT industry. Venture
capitalists also experience major losses when their picks
fail, but these investors are typically wealthy enough that
they can afford to take the risks associated with funding
young, unproven companies that appear to have a great idea and
a great management team.
1.5.3 Entrepreneurs and SME owners
The owners of these firms will benefit since the study will
help them manage their organizations in a more investor
friendly approach keeping in mind the essence of compliance
with the relevant authorities and need to present financials
in accordance with the International Financial Reporting
Standards (IFRs).
They will also be informed the basis upon which the
entrepreneur will improve the business flow with a view of
attracting financing and the options involved in the financing
process.
1.5.4 Scholars and Researchers
8
This study will contribute to the body of knowledge to those
academicians and researchers who seek to explore the topic
further.
1.6 Scope of the Study
This study is limited to Information and Communication
Technology firms operating in Nairobi, Kenya whose members
will constitute the target population of the study which is
approximated at 100 of which only 80 will be sampled for the
purpose of this survey. This research will be conducted
between September and December 2014.
The Communications Authority of Kenya is the regulatory
authority for the communications sector in Kenya. This is due
to their similarity in location and operational framework as
guided by the Competition Authority of Kenya and also the
unique opportunities and challenges such firms face.
Established in 1999 by the Kenya Information and
Communications Act, 1998, the Authority is responsible for
facilitating the development of the Information and
Communications sectors including; broadcasting, multimedia,
telecommunications, electronic commerce, postal and courier
services.
1.6 Definition of Terms
1.6.1 Small and Medium Enterprises
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According to Snyder (2008) Small and medium enterprises (SMEs)
are companies whose personnel numbers fall below certain
limits. Small enterprises outnumber large companies by a wide
margin and also employ many more people. SMEs are also said to
be responsible for driving innovation and competition in many
economic sectors.
1.6.2 Financing
This is the act of providing funds for business activities,
making purchases or investing. Financial institutions and
banks are in the business of financing as they provide capital
to businesses, consumers and investors to help them achieve
their goals (Gove, P. et al. 1961).
1.6.3 Private Equity
Private equity (PE) refers to equity securities in private
companies that are not publicly traded. Private equity (PE)
investments are investments in privately-held companies, which
trade directly between investors instead of via organized
exchanges (Myers, 1991).
1.6.4 Information and Communications Technology
According to Stevenson (1997) ICT is a more specific term that
stresses the role of unified communications and the
integration of telecommunications (telephone lines and
wireless signals), computers as well as necessary enterprise
software, middleware, storage, and audio-visual systems, which
10
enable users to access, store, transmit, and manipulate
information.
1.6.5 Venture Capitalist
An investor who either provides capital to startup ventures or
supports small companies that wish to expand but do not have
access to public funding. Venture capitalists are willing to
invest in such companies because they can earn a massive
return on their investments if these companies are a success
(UNCTAD, 2000).
1.8 Chapter Summary
The chapter reviews the literature on the background of the
problem, statement of the problem, purpose of the study,
research questions, justification of the study, scope of the
study and definition of terms. Chapter two will highlight a
detailed and critical analysis of existing literature and
other studies that have been carried out in relation to the
challenges that affect access to equity/ venture capital by
SMEs in the ICT industry.
Chapter three discusses the research methodology which
involves the research design to be used in the study, the
population of the study, sampling method, data collection
methods and finally data analysis and presentation.
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CHAPTER TWO
2.0 Introduction
Chapter two presents the review of other scholars’ findings on
the subject of equity access. This section is organized in
line with the research questions. The first part deals with
the organizational factors that hinder access to equity by the
12
SMEs. The second part looks at the external factors hindering
access to equity by the SMEs. The last section deals with the
strategies that can be adopted by the SMEs to increase their
access to equity. The section then present a summary of the
review.
2.1 Organizational Factors that Hinder Access to Equity
2.1.1 High Risk
Literature acknowledges that many managerial decisions are
subject to significant uncertainty such as uncertainty of
environmental changes; technological changes; lack of definite
ideas on future costs of operations; market dynamics;
uncertain stakeholder demands among many more, lead decision
makers to view business ventures with caution (Wall,
2011).Thus the fluctuations around the expected value (mean)
of a performance measure are used as proxy for risk i.e., risk
is equated with variance and consequently has both a potential
"downside" and "upside." (Wagner & Bode, 2008).
Risks can therefore be seen as the distribution of possible
outcomes, their likelihood, and their subjective value (Wagner
& Bode, 2008). Compared to other established business,
Bhatnagar (2013) posits that SME units are prone to various
business risks due to which they fall sick or sometimes closed
due to heavy losses or many of them becomes non performing
account in the accounts of the banks. Ebiringa (2011) explain
that the failure rates of SME start-ups are known to be high13
in developing Countries. He posits that about 50% of new
entrepreneurial ventures disappear within the first five years
after their establishment. Hence, the issues of adverse
selection before a financial contract is written and ex-post
risk-shifting incentives cannot be ignored.
According to a report by The Task Group of the Policy Board
for Financial Services and Regulationin South Africa, the high
degree of risk involved in financing relatively small and
fragile firms stands out as on of the main limiting factor
when it comes to access to equity funds in United Kingdom and
South Africa (Falkena, et al., 2001). Similarly findings by
Haque (2003) on a review of access to finance for SMEs
Bangaladesh seems to support this argument. The review
indicated that it is the highlevel of risk associated with
SMEs that impedes the access of competitive funding to this
sector. Thus slowed growth of SMEs and contribution as most
enterprises in the sector seek informal funding or are forced
to selfund their activities, which impedes their growth and
subsequent development to a certain extent.
The reason behind this is that risk matters when investing.
According to Damodaran (2013) the expected return on any
investment canbe written as the sum of the riskfree rate and a
risk premium to compensate for the risk.He argues that it
remains un resolved on how to measure therisk in an
investment, and how to convert the risk measure into an
14
expected return thatcompensates for risk and a central number
in this debate is the premium that investorsdemand for
investing in the ‘average risk’ equity investment, i.e., the
equity riskpremium. In the case of SMEs, the riss may be too
high to attarct equity owners or the premuim may be too high
due to the high risk.
2.1.2 Information Asymmetry
According to Deakins, North, Baldock, and Whittam (2008),
informational asymmetries considered under a basic theoretical
analysis of conditions ofimperfect information suggests that
there will be insufficient equity/ credit available for all
sound or‘bankable’ propositions due to lack of ‘perfect’
information.Lean and Tucker (2001) explain that in a perfect
markets setting, with perfect and costless information
available to both parties, and no uncertainties regarding
present and future trading conditions, the equity seeker-
equity owner relationship doesnot suffer from the market
failure of information asymmetry.
‘However, information in the real worldis neither perfect nor
costless, and additionally the small business finance market
is characterisedby risk and uncertainty regarding future
conditions. Information is distributed asymmetricallybetween
the bank and the firm. From the bank’s perspective, it has
incomplete informationregarding the underlying quality of the
project and the management of the small firm, giving rise
15
tothe problem of adverse selection’ (Lean & Tucker, 2001, pg.
45). They continue that the management of thesmall firm may
fail to perform to their full capabilities, giving rise to the
problem of moral hazard, thus thelatter arises because it is
too costly for banks to effectively monitor small firm
projects, therebyresulting in equilibrium credit rationing and
a shortfall in debt provision.
In a study to identify the critical determinants of start-up
capital structure for SMEs in Naigeria, Ebiringa (2011) noted
that information asymmetries between entrepreneurs and outside
financiers are high, as no historical statistics are available
on proposed start-ups. Also, in most countries these start-ups
are subject to less stringent rules regarding information
disclosure than are large listed firms and moreover, start-up
SMEs do not have a reputation at stake that can reduce
asymmetric information and moral hazard concerns.
These findings are support by Hongbo Duan and Yang (2009)who
indicated that the information asymmetry and incomplete
information cause the credit rationing in credit market. He
noted that compared with large enterprises, SMEs suffer more
from the credit rationing due to lack of credible history.
2.1.3 High Cost of Transaction
Transaction cost of equity is the cost of weighted average
cost of capital or the cost of acquiring equity. According to
Pollin and Heintz ( 2011), overall transaction cost of equity
16
my be explicit or implicit. The explicit cost are clearly
defined and understood by all parties to a transaction before
that transaction occurs and includes brokerage commissions,
market fees, clearing and settlement costs, and any taxes. On
the other hand implicit costs refer to costs that are not
explicitly included in the trade price nd includes the bid-ask
spread which is compensation provided to the entity or person
supplying liquidity in a trade.
Falkena, et al. (2001)agree with the multi faceted source of
transaction cost and explain that the problem of equity
transaction cost to SMEs arises from anumber of factors.
Firstly, the transaction and administration costs of
operating a venture capitalfund are largely fixed,
irrespective of the amount of the equityrequired. Secondly,
the fixed costs for small amounts of equity constitute a high
proportion ofthe total costs, including the actual cost of the
finance. Thirdly, to be successful, the fixed costs and the
finance costs both have to bepaid from the returns earned on
the investment.
Therefore, on average, in order to provide the same return to
investors,activities that require small amounts of equity need
to be capable ofdelivering higher rates of return than the
equity provided in large amounts tolarger firms with a similar
risk profile. This, in turn, impacts on the venture capital
17
market, particularly for SMEs that want to raise smaller
amounts of money (Falkena, et al., 2001).
2.1.4 Managerial Competencies
Fatoki and Odeyemi (2010) defines managerial competencies as
sets of knowledge, skills, behaviors and attitudes that
contribute to personal effectiveness. They indicate that SMEs’
lack of managerial experience, skills and personal qualities
as well as other factors such as adverse economic conditions,
poorly thought out business plans and resource starvation are
found as the main reasons why new firms fail. This mirrors
differently from the high growth firms characterized by
education, training and experience of managers.
While studying the situation in South Africa, Herrington and
Wood (2003) indicated that lack of education and training
reduced management capacity in SMEs leading to high failure
rates. They suggested that the managerial competency affect
access to finance by new SMEs. The general assumption is that
managerial competencies as measured by the education of the
founder, managerial experience, entrepreneurial experience,
start-up experience and functional area experience positively
impact on new venture performance (Fatoki & Odeyemi, Which New
Small and Medium Enterprises in South Africa Have Access to
Bank Credit?, 2010).
Further Badulescu (2010) allude lack of technical, managerial
and marketing skills among SMEs to generate adequate cash
18
flows.He posits that SMEs are characterized by
unsatisfactorytechnical endowment, difficulties in assuring
qualified technical staffand experimented management (human
capital) in order to adapt to themultiple and rapid changes of
present-day economy. This makes would be capital owners
hesitant in advancing finances as it is diffucult to compute
the real profitability of thecompany, cahsflow management
capacity and the business reliability.
A report by the Capital Authority in Kenya indicated that by
their very nature of being small start-ups, SMEs face a number
of constraints, which include the difficulty in employing
competent people with techniques in financial management
because of the salaries such people would demand, thus the
inability to raise own finance and access financial services
from formal sources (Capital Markets Authority [CMA], 2010).
Furthermore the smaller the enterprise, the less likelihood
its management will understand the need for financial
management and the poorer the understanding of financial
management and equity sourcing (CMA, 2010).
2.1.4 Networking
According to Fatoki and Odeyemi (2010), networking in a small
firm context is an activity in which entrepreneurially
oriented SME owners build and manage personal relationships
with particular individuals in their surroundings. Thus
networking can be used to reduce information asymmetry in
19
creditor/debtor relationships as social obligations between
connected parties, and information transfer through social
relationships, influence venture finance decisions.
Ngoc, Le and Nguyen (2009) explain that networks and
relationships increase a firm's legitimacy, which in turn
positively influences the firm's access to external financing.
They also indicate that networks also help a firm learn
appropriate behaviour and therefore obtain needed support from
key stakeholders and the public. Hence networking substitutes
for the lack of effective market institutions, and can be an
effective way for SMEs to access external financing, including
bank loans in emerging economies (Fatoki & Odeyemi, Which New
Small and Medium Enterprises in South Africa Have Access to
Bank Credit?, 2010).
Additionally, networking could be expected to provide to the
banks information on legitimacy, which in turn should give the
SMEs advantages in accessing capital (Ngoc, Le, & Nguyen,
2009).In Kenya most SMES are located in the rural and small
per-urban centres with limited opportunities for them to
effectively network with peers in the know as well as equity
owners predorminatly in the urban centres (CMA, 2010).
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2.2 External Factors that Affect Access to Equity/ Venture
Capital by SMEs
2.2.1 Limited Access to Stock Markets
Accordimg to Kira (2013) most SMEs in East Africa cannot
raise funds from stock markets since stock market require more
relevant and transparentinformation to attract investors. He
indicates that mostly small firms have low analyst coverage
which affect their bond rating.
Although in Kenya, the Capital Markets Authority have
estabished a division at the Nairobi Securities Exchange
specifically for the SMEs to trade in the stock market, access
to this market is again hampered by the distribution of the
SMEs in the Country. CMA (2010) report indicates that most of
the SMEs in Kenya are predorminatly located in the rural and
small per-urban centres far from the City where the stock
market is situated. The report posits that the size and the
distance from major cities/urban centres are negatively
related to the level of awareness of financial instrumentsi.e.
the smaller the size of the enterprise and the farther away
from the city/urban centrethe enterprise is, the less aware
the firm is of the financial instruments available. This makes
themvulnerable to shocks to revenue or costs and, therefore,
and makes them unlikely to expand beyond acertain limit.
On the other hand, Haque (2003) cited an example of Bangladesh
where the capital market is not well developed and21
coordinated, hence the entrepreneurs do not feel confident to
raise fundsthrough shares and bonds or through venture
capital. The situation was no different in China if not worse.
A study by Hongbo Duan and Yang (2009) reported that the
security market in China was crowded by state-owned
enterprises and SMEs could not occupy any position in the
market. They noted that just a few SMEs could enter the
market by reforming into stock enterprises. The capital
market, compared with the fund market, is imperfect as it
lacks a multi-levelcapital market that can offer financing
services for SMEs and the domestic main board market is only
for state-ownedlarge and medium enterprises’ financing.
2.2.2 Legal Framework
Lack of institutional and legal structures that facilitate the
management of SMEs’ access to finance has been identified as
another major cause of lack of finance among the SMEs
(Ahiawodzi & Adade, 2012). In highlighting the importance of
the legal system and financial institutions for firms’
finances, Beck, Demirgüç-Kunt, Laeven, and Maksimovic (2006b)
posit that the legal system help provide an alternative way of
accomplishing some of the key functions that the firm
accomplishes internally e.g. the mobilization of resources for
investment, the monitoring of performance, and resolution of
conflicts among different parties.
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In China, for example the private financing is regulated
strictly . As a result, SMEs face demanding politicalbarriers
in direct financing. Thus some enterprises have to develop by
their own assets leading to retarded growth of SMEs in the
country (Haque, 2003).
The other legal based factors that affect SMEs access to
equity is the firm’s legal status. Kira and He (2012) point
out that firm with limited liability (incorporated) possess
development attributes than firm with unlimited liability due
to the separation of owner’s affairs and business affairs,
which increases the commitment of managers to the firm goals.
Secondly, publication of their financial statements as one of
legal requirement makes corporation’s openness for users to
know the firm’s status including their debt ratio and firm’s
assets.
In financing business, lenders observe incorporation as a good
indicator for firm’s trustworthiness and commitment to
operational laws (Kira & He, 2012). Thus the form of business
organization has an effect on equity – debt decisions on SMEs
operations. Fatoki and Asah (2011) demostrated the
association between debt financing and legal formation of
business organization. Kira and He (2012,pg. 112) explain
that ‘the owners of limited firm have limitations to answer
against losses generated by the corporation whereby the owners
of unlimited forms of organization are liable up to their
23
personal assets to cover for business losses. Therefore,
limited companies prefer to use the equity to finance their
projects than debt financing while unlimited form of business
organizations (sole proprietorship and partnership) the only
option available to finance their projects is debt financing’.
2.2.3 Firm Size
The firm’s size has a crucial weight on the capital structure
of the firm (Kira & He,2012). For exmple in debt financing,
real assets tend to influence the accessibility to long debt
as with more real assets, the firm tends to have greater
access to long-term debt (Fatoki & Asah, 2011). The larger
firms tend to be more diversified and fail less often, so size
can be an inverse proxy for the probability of insolvency.
Thus firm size affects SMEs access to debt finance from
commercial banks whereby small enterprises are less favoured
to large firms.
A study by Karadeniz, Kandır, Iskenderoğlu and Onal (2011)
indicates that firm size is a significant factor for
capitalstructure decisions of Turkish lodging companies. The
study shows that firm size seems to affect lodging companies
inusing incentives, issuing common stock, using personal debt
and determining target debt ratio which tends to support the
pecking order theory. The lodging companies studied prefered
internal sources as the primary financing source follwed by
debt and issuing common stock are the following financing
24
alternatives. Although the study did not explain why observed
pecking order.
On the other hand, Pattani (2011) reported that the size of a
company appears to be a critical factor associated with the
use of public bonds. The study indicated that 90 percent of
bond issues recorded in the United Kingdom are larger than 60
million Sterling pounds and 90 percent of the issuers employ
more than 2,500 staff. The study suggests that investors
prefer large issue sizes as these are more likely to be traded
in the liquid secondary markets
2.2.4 Stringent Conditions Set by Financiers
As part of venture capital investment process, entrepreneur
and the venture capitalist enter into negotiation on the terms
and conditions of the investment following the investor’s
decision to invest. Ahwireng–Obeng and Mwebi (2012) explain
that the object of deal structuring is to reconcile varying
needs and concerns of the two parties in respect to the
venture capital deal. They indicate that the contract terms
specify among other things, control rights, the division of
any returns, the mix of financial instruments to use and the
circumstances in which debt can be converted into equity.
‘When negotiating an investment deal, the venture capitalists’
aim is to control corporate decisions, minimize potential
costs and risks and guarantee sufficient downstream protection
and a favourable position for additional investment’25
(Ahwireng–Obeng and Mwebi, 2012, pg. 12). An earlier study by
Mason and Harrison, (2002) looking at the barriers to
investment in the informal venture capital sector from the
venture capiatlists point of view indicated that over 90% of
venture capiatalists in the United Kingdom were constrained on
their ability to invest as they did not see enough deals that
met their investment criteria. The study showed the the
majority of the investment proposalsthat they received were of
poor quality, and they were often unable to negotiate
acceptable investmentterms and conditions with entrepreneurs.
Thisdemonstrates that the equity owners were settig conditions
way beyond the reach of the entreprenuers.
For example in some equity markets, entreprenuers are are
required to show favorable liquidity conditions,
profitability, and risks thatoffer both trust and security to
investors (Haque, 2003). The case in point is Bangladeshwhere
SMEs in most cases are unableto meet all the requirements.
Therefore, in most cases they have been relying on
theirpersonal savings, loans from relatives, friends,
moneylenders, retained earnings, profitsfrom other business
ventures or funds generated through employee stock ownership
(Haque, 2003).
2.3 Strategies for Enhancing Access to Equity/ Venture
Capital by SMEs
2.3.1 Corporate Governance
26
Corporate governance is one of the tools used by investors in
making decisions regarding investments. According to Krafft,
Qu, Quatraro and Ravix (2013), Corporate Governance
acknowledge that an effective corporate governance system can
lower the cost of capital and encourage firms to use resources
more efficiently, thereby promoting growth. This implicitly
and explicitly support the belief that better corporate
governance will result in higher firm value and more
profitable firm performance.
Ahwireng–Obeng and Mwebi (2012) point out that good corporate
governance practices with strong financial controls help
companies to transition from informally run businesses to
professionally managed organizations. They advise that for the
venture capitalists to insist on transparency in management,
accounting and operational information formulation, they must
be physically close to the companies, and educate the
entrepreneur and the venture team on the benefits of good
governance which include, higher company valuations, lower
cost of capital, increased investor confidence, greater access
to external funding and increased exit premium. Good corporate
governance also reduces information asymmetry and the risk of
moral hazard.
Empirically, a study by Ammann, Oesch and Schmid (2009)
indicates a strong and positive relation between firm-level
corporate governance and firm valuation. This can be explained
27
by the fact that good governance increases investor trust and
willingness to pay more and renders managers’ actions costly
and expropriation less likely. Thus good governance means that
‘more of the firm’s profit would come back to (the investors)
as interest or dividends as opposed to being expropriated by
the entrepreneur who controls the firm (Krafft, Qu, Quatraro,
& Ravix, 2013).
The trust arises from the factor that investors perceive well-
governed firms as less risky and better monitored and tend to
apply lower expected rates of return, which leads to a higher
firm valuation (Krafft, Qu, Quatraro, & Ravix, 2013) as
better governed firms may have more efficient operations,
resulting in higher expected future cash-flow streams.
Thus for small-scale entrepreneurs to attract equity, proof of
good corporate governance is a critical tool in building
confidence and trust among investors. Apart from the trust,
the majority of the prior literature on the relation between
corporate governance and firm value, documents that a stronger
corporate governance is associated with a higher firm
valuation (Ammann, Oesch, & Schmid, 2009). This would be
instrumental in deal structuring for the entrepreneur.
2.3.2 Strategic Alliances
Strategic alliances represent new organizational formation
that seeks to achieve organizational objectives better through
collaboration than through competition. The alliances are
28
developed and propagated as formalized inter-organizational
relationships (Todeva & Knoke, 2005).
A strategic alliance is an agreement between two or more
companies working on same horizontal level in the market, that
share resources to carry out a desired project for which both
parties have some common interest (Zamir, Sahar, & Zafar,
2014). The firms remain legally independent after the alliance
is formed but share benefits and managerial control over the
performance of assigned tasks; and make continuing
contributions in one or more strategic areas, such as
technology or products (Todeva & Knoke, 2005). Hence,
strategic alliances create interdependence between autonomous
economic units, bringing new benefits to the partners in the
form of intangible assets, and obligating them to make
continuing contributions to their partnership.
Todeva and Knoke (2005) outline the following as some of the
strategic motives, intent, choices for engaging in a strategic
alliance. To enhance their productive capacities; to reduce
uncertainties in their internal structures and external
environments; to acquire competitive advantages that enables
them to increase profits; to gain future business
opportunities that will allow them to command highermarket
values for their outputs; to overcoming legal / regulatory
barriers; to create legitimation, bandwagon effect, following
industry trends among others.
29
The current study hypothesises that with strategic alliance,
the SMEs will be in a postion to share competencies for
synegistic purposes. The expectation is that flexibility will
result from reaching out for new skills,knowledge, and markets
through shared investment risks as well as other various
sources of equity funding. The alliance would create the
needed benefits that accrue from networking, information
sharing, and competency sharing.
2.3.3 Financial Innovation
Financial innovation may be viewed as an act of creating and
then popularizing new financial instruments as well as new
financial technologies, institutions and markets. Innovations
in this context are sometimes divided into product or process
innovation, with product innovations exemplified by new
derivative contracts, new corporate securities or new forms of
pooled investment products; and process improvements typified
by new means of distributing securities, processing
transactions, pricing transactions, capital sourcing and
structuring (Tufano, 2002).
It has been generally accepted that innovation plays a crucial
role in improving productivity and financial innovation has
been described as the life blood of efficient and responsive
capital market (Akhavein, Frame, & White, 2001). Financial
innovations come in handy in finding ways around financial
hurdles and barriers. For example, Calomiris (2009) posit that
30
financial innovations often respond to regulation by
sidestepping regulatory restrictions that would otherwise
limit financial activities in which people wish to engage.
Other than side stepping regulations, the role of innovation
is key in helping organizations move funds across time and
space; pooling of funds; managing risk; extracting information
to support decision-making; addressing moral hazard and
asymmetric information problems; and facilitating the sale or
purchase of goods and services through a payment system
(Tufano, 2002).
In the United States of America and number of countries in
Europe, SMEs are encouraged to participate in a number of
financially innovative schemes such as equity guarantee to
attract more funds. For example, a report on innovative
instruments for raising equity for SMEs in Europe by Bannock
Consulting (2001) indicates that public-sector equity
guarantees providing loss-sharing for investors in SMEs have
been used in several European countries to stimulate the
growth of the venture capital industry as a whole, and in
others to encourage investors to extend the size range of
their investments downwards, particularly in high-tech
sectors.
The report further shows that some more generous schemes, for
example among those operating in Germany, provide soft
leverage or co-funding as well as a guarantee. Where the
31
upside of the private investor is enhanced through options to
buy-out the funding at a low return, the costs of the scheme
can increase further, and the departure from market conditions
for the SME investment decision is even greater. Still, in the
private capital markets, there are innovative products like
the Princess bond to attract institutional funding for the
wider (that is extending beyond SME investment) private equity
and venture capital activity. These provide advanced global
risk pooling and cash flow management as well as insurance to
clearly limit the downside risk (Bannock Consulting,
2001).Insurance products have also been develop to cushion the
investors against probable losses.
2.3.4 Business Strategy
Viewing strategy as long term direction, business strategy
implies how the individual businesses should compete in their
particular markets. Business level strategy therefore
typically concerns issues such as innovation, appropriate
scale and response to competitors’ moves (Teece, 2010).
A good business strategy should be in a position to
demonstrate specific organization’s objectives, develop
policies and plans to achieve and attain these objectives, and
allocate resources to implement the policies and plans
(Muogbo, 2013). In this respect management of any business
venture needs to develop a clear business strategy, which
32
defines their company’s direction in the short, medium and
long term.
The business strategy perspective argues that implementing a
robust business strategy, leads to competitive edge over
competitors (Acquaah, 2013). The implementation of a robust
and feasible business strategy will generate superior
performance as well as act as sources of competitive
advantage. Hence, good business strategies will therefore
reflect positively on the key management and their leadership
ability. Such strategies typically tend to growth targets;
performance enhancements; and Succession policies (Baroto,
Abdullah, & Wan, 2012). This will act as an edge on attracting
equity capital.
2.4 Chapter Summary
The chapter reviewed previous literature in regard to equity
access by the small to medium enterprises. The review looked
at the organizational and external barriers to accessing of
equity funds by the SMEs. The chapter also presented
strategies that can be used to mitigate against these
barriers. The following chapter will cover the methodology to
be adopted in this study.
33
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