Entrepreneurs seeking to grow their business must look beyond traditional financing options such as bank lending and explore equity as a possible source of capital. Failure to do so may lead to stagnation or, ultimately, going belly up, warned a startup expert.
Tarek Kettaneh, a senior lecturer of entrepreneurship at Olayan School of Business at American University of Beirut, told Zawya that funding is the major challenge that small and medium enterprises (SMEs) in the region face.
"Financiers [often] consider an SME a risky investment and they prefer more sizeable deals with big companies. The risk is the highest at the SME's start-up phase as it doesn't have a proven track record of success at such an early stage of its development," said Kettaneh, who also lectures on venture capital.
He said some SME owners are reluctant to tap equity financing for fear of losing control of their business by bringing in 'outsiders' as new partners.
"Your financials cannot sustain bank debt, so you need equity; thus you either open up and grow, or stagnate and ultimately fail," Kettaneh advised. "Better own 25% of a USD 50 million company than 90% of a USD 3 million company."
EARLY FINANCING: A RISKY BUSINESS
Equity financing is the first form of funding that a startup can usually secure early in its life cycle. Other financing options are usually more costly and limited at these stages because capital providers view them as high risk.
"The usual sources of [earliest] startup finance are the three F's: Family, Friends and Fools; it is very difficult to convince outsiders of the validity of a new unproven business idea, and it would require too much work to investigate all its aspects before making a decision," Kettaneh said.
"In more advanced economies, [angel investors] are organized as associations and can raise up to USD 1-2 million per company. This concept is in its infancy in the Middle East and North African region, with Dubai and Lebanon leading the way," Kettaneh said.
Early equity financing is used to fund operations with an initial focus on research and product development.
"Subsequent rounds of equity financing are usually negotiated upon the completion of specified technological or financial milestones or key management hires. They are generally applied to grow sales and marketing functions," the startup expert said.
Debt financing typically comes after angel investors or venture capital funding.
During the "Idea" stage, the entrepreneur has a business concept and a few employees and funding is required for market research and product development. By the seed stage, the company is engaged in product development and launches marketing efforts in anticipation of product sales.
After completing the product development process the company, with little or no revenue, needs funding to kick start operations. At the next stage, the business starts realizing revenues but is usually still not profitable and may require financing to cover any negative cash flow.
SMEs find it hard to get debt financing even at later stages of their development as banks favor larger companies that can offer better collateral.
SMEs often have single product lines so cash flow is likely to vary with market changes, and banks do not like unpredictability. Many SMEs do not present complete financial reports and mix personal wealth with that of the business, making it difficult for banks to evaluate the financial health of the business.
FEAR OF LOSING CONTROL
Sometimes entrepreneurs hamper the possible flow of funding because of fear of losing absolute control over their businesses.
"There is no way savvy investors will intervene in the operations of the company. They may provide strategic advice, open doors to banks or large customers, but they recognize that they have no expertise in the company they are investing in," Kettaneh said. "At any rate, if the investment is done properly, the investment contract will specify the limits of intervention of investors."
Another obstacle to equity financing created by some SME owners is their belief that investors undervalue their company.
"Entrepreneurs usually have a grossly exaggerated view of the value of their companies, and feel that investors want to cheat them of their efforts by buying 'on the cheap'," Kettaneh said.
While the availability of an adequate financing may be beneficial, it is undoubtedly not enough to support the sustainable development of SMEs and startups. They rely on the ecosystem of their country for vital services.
"[Compare] an average of 32 days and an annual cost of USD 10,000 to start a company in Lebanon [with] an average of one day and a negligible cost to start a company in Bahrain," Kettaneh said.
Other key resources that vary from one country to another include the availability of a reliable electricity, Internet and telecom services.
There is also a need for incubator centers that can provide startups with a network of professional service providers such as lawyers, accountants, draftsmen, laboratories and engineers.
© Zawya BusinessPulse 2014
