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.

iv

v

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:

7

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

9

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.

11

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).

20

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.

22

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

REFERENCES

Ackah, J., & Vuvor, S. (2011). The Challenges faced by Small & Medium

Enterprises (SMEs) in Obtaining Credit in Ghana. Blekinge: Unpublished.

Ahiawodzi, A. K., & Adade, T. C. (2012). Access to Credit and

Growth of Small and Medium Scale Enterprises in the Ho

Municipality of Ghana. British Journal of Economics, Finance and

Management Sciences , 6 (2), 34-51.

Akhavein, J., Frame, W. S., & White, L. J. (2001). The

diffusion of finacial innovation:an examination of adoption

of small business credit scoring by large banking

organizations. Working paper series, The Wharton Financial Institutions

Center , 1-19.

Ammann, M., Oesch, D., & Schmid, M. M. (2009). Corporate

Governance and Firm Value: International Evidence. St.

Gallen, Switzerland: Swiss Institute of Banking and

Finance, University of St. Gallen.

Badulescu, D. (2010). SMEs Financing: the Extent of Need and

the Responses of Different Credit Structures. Theoretical

and Applied Economics , 17 (7), 25-36.

Bannock Consulting . (2001). Innovative Instruments for Raising Equity for

SMEs in Europe. Brussels, Luxembourg: DG Enterprise of the

European Commision.

34

Beck, T., Demirgüç-Kunt, A., Laeven, L., & Maksimovic., V.

(2006b). The Determinants of Financing Obstacles. Journal of

International Money and Finance, 25 (6), 932–952.

Bhatnagar, V. (2013). Various Risks Involved in SME Units and

Measures to Fight Them: A Case Study on SME Units with

Special Reference to Moradabad- India. International Journal of

Application or Innovation in Engineering & Management , 2 (11), 162-

167.

Calomiris, C. W. (2009). Financial Innovation, regulation and

reforms. Cato Journal , 29 (1).

Capital Markets Authority [CMA]. (2010). Capital Raising

Opportunities for SMEs: The development of micro caps securities

market in Kenya. Nairobi: Capital Markets Authority.

Damodaran, A. (2013). Equity Risk Premiums (ERP): Determinants, Estimation

and Implications-The 2013 Edition. New York.

Deakins, D., North, D., Baldock, R., & Whittam, G. (2008).

SMEs’ Access to Finance: Is there still a debt finance

gap? Institute for Small Business & Entrepreneurship , 1-19.

Ebiringa, O. T. (2011). Synthesis of literature on small and

medium enterprises start up financing. International Journal of

Economic Research , 2 (1), 85-95.

Falkena, H., Abedian, I., von Blottnitz, M., Coovadia, C.,

Davel, G., Madungandaba, J., et al. (2001). SMEs access to

35

finance in South Africa – a supply side regulatory review. Policy Board for

Financial Services and Regulation, South Africa, Pretoria.

Fatoki, O., & Asah, F. (2011). The Impact of Firm and

Entrepreneurial Characteristics on Access to Debt Finance

by SMEs in King Williams’ Town, South Africa. International

Journal of Business and Management , 6 (8).

Fatoki, O., & Odeyemi, A. (2010). Which New Small and Medium

Enterprises in South Africa Have Access to Bank

Credit? International Journal of Business and Management , 5 (10),

128-136.

Haque, A. E. (2003). Economic Policy Paperon Access to Finance for SMEs:

Problems and Remedies. Dhaka: The Dhaka Chamber of Commerce

and Industry (DCCI) & The Center for International Private

Enterprise (CIPE).

Herrington, M., & Wood, E. (2003). Global Entrepreneurship

Monitor, South African Report.

Hongbo Duan, X. H., & Yang, H. (2009). An Analysis of Causes

for SMEs Financing Difficulty. International Journal of Business

Mnagement , 4 (6), 73-75.

Karadeniz, E., Kandır, S. Y., Iskenderoğlu, Ö., & Onal, Y. B.

(2011). Firm Size and Capital Structure Decisions: Evidence

From Turkish Lodging Companies. International Journal of Economics

and Financial Issues , 1 (1), 1-11.

36

Kira, A. R. (2013). Determinants of Financing Constraints in

East African Countries’ SMEs. International Journal of Business and

Management , 8 (8), 49-68.

Kira, A. R., & He, Z. (2012). The Impact of Firm

Characteristics in Access of Financing by Small and Medium-

sized Enterprises in Tanzania. International Journal of Business

and Management , 7 (24), 108-119.

Krafft, J., Qu, Y., Quatraro, F., & Ravix, J.-L. (2013).

Corporate governance,value and performance of firms: New

empirical results on convergence from a large

international database.

Lean, J., & Tucker, J. (2001). Information Asymmetry, Small

Firm Finance and the Role of Government. Journal of Finance and

Management in Public Services , 1, 43- 60.

Mason, C. M., & Harrison, R. T. (2002). Barriers to investment

in the informal venture capital sector. Entrepreneurship & Regional

Development , 14, 271- 287.

Ngoc, T., Le, T., & Nguyen, T. (2009). The impact of

networking on bank financing: The case of small and

medium enterprises in Vietnam. Entrepreneurship Theory and

Practice , 33, 867-887.

Obeng, F. A., & Mwebi, J. (2012). An inquiry into the venture

capitalists' investment creteria in developing countries. A

South African Study. 57th ICSB Conference, 10-13 June 2012 (pp. 1-

37

59). Wellington, New Zealand: University of the

Witwatersrand (Wits) Business School.

Odhiambo, L.A (2013). The effect of changes in interest rates on the demand

for credit and loan repayments by small and medium enterprises in Kenya.

Nairobi, KE: University of Nairobi

Pattani, A. (2011). Going public-UK Copmanies use of Capital

Markets. Quarterly Bulletin-Research and analysis , 319-330.

Petrakis, P.E. & Kostis, P.C. (2012). Τhe Role of Knowledge

and Trust in SMEs, Journal of the Knowledge Economy,

10.1007/s13132-012-0115-6.

Pollin, R., & Heintz, J. (2011). Transaction Costs, Trading

Elasticities and the Revenue Potential of Financial

Transaction Taxes for the United States. Research Brief , December

2011, 1-16.

Republic of Kenya (2009). Sessional Paper No. 2 of 2009 on Development of

SMEs for Wealth and Employment creation and Poverty Reduction. Nairobi,

KE: Government Printers

Snyder, D. (2008). The Potential for Credit Scoring for SME Lending in Kenya.

Nairobi, KE: Financial Sector Deepening Kenya

Stella, K. (2011). Consultative Forum on the Proposed Market for SMEs.

Nairobi, KE: Capital Markets Authority.

Teece, D. J. (2010). Business Models, Business Strategy and

Innovation. Long Range Planning , 14, 172-194.

38

Todeva, E., & Knoke, D. (2005). Strategic Alliance and Models

of Cooperations. Management Decision , 43 (1), 1-22.

Tufano, P. (2002). Financial Innovation. In G. Constantinides,

M. Harris, & R. Stulz (Eds.), The Handbook of the Economics of

Finance.

UNCTAD (2000). Issues concerning SMEs access to finance in Development

Strategies and Support Services for SMEs: Proceedings of Four

Intergovernmental Expert Meetings, Vienna, UA

Wagner, S. M., & Bode, C. (2008). An empirical examination of

supply chain performance along several dimensions of risks.

Journal of Business Logistics , 29 (1), 307-325.

Wall, K. D. (2011). The Kaplan and Garrick Definition of Risk and its

Application to Managerial Decision Problems. DRMI, Naval

Postgraduate School.

Zamir, Z., Sahar, A., & Zafar, F. (2014). Strategic Alliances;

A Comparative Analysis of Successful Alliances in Large

and Medium Scale Enterprises around the World.

Educational Research International , 3 (1), 25-39.

39