A bakery with six staff has a chance to win a supply contract worth three times its current sales. To deliver, it needs ₦120m for ovens and a bigger depot. The owners cannot put in that much. The bank wants property as security and the bakery rents its premises. A new investor would want a slice of the business.
Small firms are the backbone of the economy, yet they face the hardest time raising long-term capital.
This topic covers what a small and medium-sized enterprise (SME) is, why finance is harder for SMEs than for large firms, equity, debt and leasing for SMEs, venture capital and business angels, the exit route, supply chain finance, crowdfunding, government assistance in Nigeria, and a summary of sources and their features. The previous topic covered debt, convertibles and preference shares.
The next covers Islamic finance. The May 2014 Pathfinder paper tested SME finance in its multiple-choice and short-answer sections.
In 30 seconds
SMEs are usually private and owned by a few people, often a family. Their problem is the financing gap: owners will not dilute control, outside investors see high risk, retained profit is slow, and banks want security, information and reliable management and charge a risk premium. The maturity gap is the shortage of security for short and medium-term loans. Leasing is easier because the lessor keeps the asset.
Venture capital is equity, preference shares and loans from specialist investors who want high returns and an exit route (listing, trade sale or refinancing) within about five years. Business angels are rich individuals buying shares, but there are few of them. Other sources: supply chain finance, crowdfunding and government schemes. Private equity funds take large stakes (about 30%) in mature firms and appoint directors.
Key terms in plain English
| Term | What it means |
|---|---|
| SME | A small or medium-sized enterprise, usually private and owner-managed |
| Maturity gap | The shortage of security for short and medium-term bank loans to SMEs |
| Venture capital | Equity, preference share and loan finance from specialist investors to growing private companies |
| Business angel | A wealthy individual who invests directly in a small firm |
| Exit route | The way an investor plans to sell its stake and take its profit |
| Supply chain finance | Selling approved invoices to a bank at a discount for early cash |
| Crowdfunding | Raising money from many people through an internet platform |
| Securitisation | Turning assets or future cash flows into marketable securities |
Syllabus check
This topic is in syllabus area C (financing decisions). It covers:
- the long-term sources of finance, including equity, debt and venture capital;
- the financing problems of small and medium-sized enterprises;
- the choice of source of finance.
CAMA 2020 and small companies
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 394 | Defines a small company by turnover, net assets and other conditions | Which companies get small-company treatment |
| s. 271 | A small company may have a minimum of one director | Governance of an SME |
| s. 305 | Directors must act in good faith in the best interests of the company | Duties apply to every size of company |
What an SME is
There is no universal definition. SMEs are normally private companies owned by a few individuals, often a family, and definitions vary by industry. ICAN quotes a Central Bank of Nigeria communiqué of April 2010 that treats an enterprise with assets (excluding land) of ₦5m to ₦500m and 11 to 300 employees as an SME. The definition was later revised by the National Policy on Micro, Small and Medium Enterprises.
ICAN also quotes a National Bureau of Statistics count of over 17 million SMEs in Nigeria in 2014, and says SMEs provide about two-thirds of employment in the EU. SMEs are a large part of any economy, so their access to long-term capital matters.
The financing problem
Equity
Owners are reluctant to issue shares to outsiders because it dilutes control, and outsiders see SME shares as high risk. Existing owners may lack the wealth to put in more. Retained earnings are then the only source, which builds capital slowly and may be too late for an opportunity.
Short-term finance helps only up to a point: new firms struggle to get trade credit with no track record, banks want personal guarantees (such as a mortgage on the family home) for overdrafts, and too much short-term borrowing raises the risk of overtrading.
Debt
Bank finance is the main external source, but:
- SMEs may publish little information and have limited or no audit, so the bank needs financial information and a credible business plan;
- management may lack experience, and the bank may think forecasts are too optimistic;
- there may be few assets to offer as security. Long-term loans can be secured on property, but short and medium-term loans often lack security. This is the maturity gap;
- the high risk of SME projects means the bank adds a risk premium to the interest rate.
Leasing
SMEs make wide use of leasing, operating or finance. The lessor owns the asset and can take it back if payment is missed, so that is a form of security. A lessor may be more willing to deal with an SME than a bank is to lend.
Venture capital and business angels
Venture capital is capital from outside investors to an SME in the form of equity, preference shares or debt, often a mixture. Specialist institutions supply it, sometimes with a bank adding a loan. Investors require large returns because of high risk: successful investments must cover the losses on failures.
To obtain it, the company needs a clear strategy and convincing business plan, and experienced, committed management. The investor may require a seat on the board or appoint an independent director. It invests only if there is an exit route, usually expected within about five years (ICAN’s summary says three to seven):
- a stock market listing, after which the investor sells its shares;
- a trade sale to a larger company;
- refinancing by another venture capital organisation.
The main problem is finding an investor who will look at the company. It is worst for seed finance for very small start-ups, because the potential return is small compared with the time spent. Venture capitalists prefer established medium-sized firms, including management buyouts. Some very large institutions invest globally; ICAN notes a 2008 announcement of a $15bn fund by Warburg Pincus for venture and growth capital.
Business angels are wealthy individuals who buy new shares directly but do not take part in management. The problems: there are few of them, they are hard to find and the total finance is too little for the demand.
Other sources
- Supply chain finance. A supplier sells invoices, once approved by a large buyer, to a bank at a discount. The bank prices on the buyer’s credit risk, not the supplier’s, so the supplier gets more cash than through factoring. The buyer can delay payment, so it is a win-win.
- Crowdfunding. Money from many people through an internet platform. It has initiators, platforms and investors, some wanting a return and others supporting a cause. ICAN notes a video game project that raised $75m on a $500,000 target.
- Government assistance. ICAN describes Central Bank of Nigeria schemes, including the Small and Medium Enterprises Equity Investment Scheme (banks set aside 10% of profit after tax for SME equity and cheap loans), a credit guarantee scheme for loans up to ₦100m and an agricultural credit guarantee scheme.
A summary of sources
| Source | Main features | When suitable |
|---|---|---|
| Equity | Owners’ capital; highest cost; issue costs; dilutes control | Long-term finance; when gearing is already high |
| Overdraft | Flexible; interest only on the balance; repayable on demand | Day-to-day working capital |
| Bank loan | Fixed term and schedule; interest tax-deductible; may be secured | Short loans for small projects, long loans for major ones |
| Hybrids | Debt with equity option; lower interest | Long-term investment; when the share price is low |
| Leases | Lessor owns the asset; rentals; shown on the statement of financial position | Big or short-term assets |
| Venture capital | Needs a plan and exit; typical life 3 to 7 years | Growth firms and management buyouts |
| Business angels | Equity from individuals; limited supply | Small firms needing equity |
| Private equity funds | Large stake (about 30%), directors appointed | Mature firms, or private firms that cannot raise equity publicly |
Factors for choosing: the amount, cost, duration, flexibility, repayment and effect on the financial statements. Securitisation turns assets or future cash flows into securities through a special purpose vehicle, letting a company borrow at the rate suited to the asset’s rating rather than its own.
The rules in more depth
Why banks ask for security from SMEs
They have little information on the firm and cannot rely on audited accounts, so they look for assets that can be sold if the loan fails.
Why venture capital needs an exit
The investor is not a long-term owner. It must realise its stake to repay its own funders and take a profit.
Why the returns required are high
Some investments fail completely. The winners must pay for the losers.
Why supply chain finance is cheaper than factoring
The bank prices on the large buyer’s credit risk, not on the small supplier’s.
Effect on analysis
Match the source to the firm’s size, security, stage of growth, owners’ control wishes and the time needed.
Worked examples
Example 1: supply chain finance against factoring. A supplier has an approved invoice of ₦10m due in 90 days. A bank discounts it at 12% a year on the buyer’s credit. A factor would charge 20% a year.
- Bank discount.
10m × 12% × 90 ÷ 365 = ₦295,890, so cash received = ₦9,704,110. - Factor discount.
10m × 20% × 90 ÷ 365 = ₦493,151, so cash = ₦9,506,849. - The supplier gets about ₦197,000 more cash.
Example 2: a venture capital return. An investor puts in ₦200m for 30% of a company. After five years the company is sold, with the whole company worth ₦2bn.
- Proceeds = 30% × 2,000 = ₦600m.
- Multiple = 600 ÷ 200 = 3.0 times.
- Annual return.
31/5 − 1 = 24.6%, before any failures elsewhere in its portfolio.
Example 3: dilution. The two owners of a firm hold 100% of the shares. A venture capital fund buys new shares for 30% of the enlarged company.
- The owners together now hold 70%.
- The fund may also ask for a seat on the board.
- That is the price for the finance, so the owners must weigh control against growth.
Example 4: choosing. A start-up needs ₦50m. It has few assets, no track record and owners who want to keep control.
- A bank loan needs security and records it lacks, and its overdraft would need personal guarantees.
- Leasing equipment may work, since the lessor holds the asset.
- Venture capital is unlikely for a seed-stage firm; a business angel or crowdfunding is more realistic, but each has limits.
How to score full marks
- Describe the firm’s situation: size, security, growth and control wishes.
- Explain each problem (equity, bank debt, maturity gap, risk premium).
- Evaluate several sources against the facts.
- Include the exit route for venture capital.
- Recommend a mix, not a single source.
- Note limits and the effect on control.
Common mistakes in the exam
- Ignoring the owners’ wish to keep control.
- Forgetting the exit route.
- Suggesting a stock market listing for a very small firm.
- Confusing business angels and venture capital funds.
- Not explaining the maturity gap.
- Giving a list of sources without matching them to the case.
Quick revision
- SMEs: private, few owners; high risk; limited equity and security.
- Maturity gap; risk premium; leasing as partial security.
- Venture capital: needs plan, management and exit route in about 5 years.
- Business angels: few. Seed capital is hard to find.
- Supply chain finance prices on the buyer’s credit.
- Private equity: about 30% stake, appoints directors.
- CAMA 2020: ss. 271, 305, 394.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. SMEs are usually:
- Private and owned by a few people
- Listed and widely held
- Government owned
- Banks
Show the answer
A. Often family firms.
Question 2. The maturity gap refers to a lack of:
- Security for short and medium-term loans
- Interest
- Customers
- Equity
Show the answer
A. Long-term loans can use property.
Question 3. Venture capital investors require:
- An exit route
- No return
- Only debt
- No plan
Show the answer
A. To take their profit.
Question 4. Which is NOT an exit route?
- Stock market listing
- Trade sale
- Refinancing by another venture capitalist
- Paying a dividend each year only
Show the answer
D. Exit means selling the stake.
Question 5. A business angel is:
- A wealthy individual who invests in a small firm
- A bank
- A stock exchange
- A regulator
Show the answer
A. They do not manage the firm.
Question 6. Leasing helps SMEs because:
- The lessor keeps the asset and can take it back
- It needs no rentals
- It is free
- It gives equity
Show the answer
A. A form of security.
Question 7. Supply chain finance is cheaper than factoring because the bank prices on:
- The buyer’s credit risk
- The supplier’s credit risk
- Zero risk
- The seller’s tax
Show the answer
A. The buyer is usually large.
Question 8. Crowdfunding raises money:
- From many people through a platform
- From one bank
- From the government only
- From shares only
Show the answer
A. Over the internet.
Question 9. A private equity fund typically takes a stake of about:
- 30%
- 1%
- 100%
- 5%
Show the answer
A. And appoints directors.
Question 10. Which section of CAMA 2020 sets the director’s duty of care and skill?
- Section 308
- Section 400
- Section 405
- Section 409
Show the answer
A. Directors should test the assumptions behind a decision.
Written questions
Question 11 (10 marks). (a) Describe the characteristics of an SME. (3 marks) (b) Explain four reasons why banks hesitate to lend to SMEs. (7 marks)
Question 12 (20 marks). Alade Foods Ltd, a family firm with few assets and rented premises, needs ₦120m for ovens and a depot. The owners want to keep control. (a) Explain the financing problems it faces. (6 marks) (b) Evaluate a bank loan, a lease, venture capital and a business angel as sources. (8 marks) (c) A venture fund offers ₦120m for 40%.
After five years the whole company is sold for ₦1.5bn. Calculate the fund’s proceeds, multiple and annual return. (4 marks) (d) Explain one benefit of supply chain finance for a supplier. (2 marks)
Question 13 (10 marks). (a) State three possible exit routes for a venture capitalist. (3 marks) (b) Explain the features of private equity funds. (4 marks) (c) Explain securitisation. (3 marks)
Model answers
Show the model answer to Question 11
(a) Characteristics (3 marks). Usually private companies; owned by a few individuals, often a family; definitions vary by industry. (1 each)
(b) Reasons (7 marks). Little published or audited information, so the bank needs a credible plan. (2) Management may lack experience and forecasts may be optimistic. (2) Few assets as security, especially for short and medium-term loans (the maturity gap). (2) The high risk of the projects means a risk premium on the rate. (1)
Show the model answer to Question 12
(a) Problems (6 marks). Owners do not want to dilute control, and outsiders see the risk as high. (2) Retained profit is too slow for a large investment. (2) It has few assets, so a bank would need security, personal guarantees and a risk premium, and short-term finance risks overtrading. (2)
(b) Sources (8 marks). Bank loan: a credible plan is needed, security is lacking, a premium applies. (2) Lease: the lessor keeps the asset, which gives it comfort, and suits ovens and vehicles, though the depot is harder. (2) Venture capital: suitable for an established growing firm, but it takes equity, may want a board seat and needs an exit within about five years.
(2) Business angel: equity without management involvement, but angels are few and the sum may be too small. (2)
(c) Return (4 marks).
- Proceeds = 40% × 1,500 = ₦600m. (1)
- Multiple = 600 ÷ 120 = 5 times. (1)
- Annual return.
51/5 − 1 = 38%. (2)
(d) Supply chain finance (2 marks). The supplier sells approved invoices to a bank for early cash at a discount based on the large buyer’s credit risk, so it gets more cash than with factoring. (2)
Show the model answer to Question 13
(a) Exit routes (3 marks). A stock market listing; a trade sale to a larger company; refinancing by another venture capital organisation. (1 each)
(b) Private equity funds (4 marks). Equity in operating companies that are not listed. (1) The fund takes a large stake, about 30%, in a mature business and appoints directors. (1.5) It aims to add value by removing inefficiencies or driving growth, and then to realise the investment. (1.5)
(c) Securitisation (3 marks). Existing assets or future cash flows are transferred to a special purpose vehicle, which issues securities to investors for cash. (2) The company can borrow at a rate that reflects the asset’s rating, not its own. (1)
Pathfinder on SME financing problems, venture capital and business angels
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Multiple-choice 11 asked which is NOT a direct source of finance to SMEs in Nigeria from microfinance banks, the Central Bank of Nigeria, the Bank of Industry, co-operative societies and friends and relatives (ICAN’s key gives the Central Bank). Short-answer 9 asked for the problem small firms face in obtaining bank loans under the 5Cs of lending (collateral or security). Read the sections on the financing problem.
Revise first: The financing problem
Case questions ask you to recommend a mix of sources for a small firm. See the summary of sources and the worked examples.
Revise first: A summary of sources
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: May 2014 multiple-choice 11 and short-answer 9.
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