By Job Lakal
There is a growing financing gap required to meet the global Sustainable Development Goals (SDGs). Estimates by the Organization for Cooperation and Development (OECD)—an organization of the top 35 economies in the world, indicate that developing countries have an annual US$ 2.5 trillion SDG investment gap.
This financing gap has pushed the development community to rethink the conventional approach of relying on aid and government revenues.
As a result, focus is increasingly shifting to the private sector’s role in development. Indeed, in Uganda, the second National Development Plan (NDPII) estimated at least 42% of its total financing to originate from the private sector. However, to meet the above expectation, Uganda’s domestic private sector needs to be fully integrated in the development process and they themselves need to be adequately financed before they can ably invest in the interventions required to meet SDGs.
Sources of financing
Enterprises can be financed either through debt, equity, or a combination of both. The choice of capital mix is determined by several factors, including cost and business size. According to the 2013 World Bank enterprise survey data, 49% of firms in Uganda used retained earnings to finance working capital while about 28% of enterprises borrowed some working capital from commercial banks.
Local financial institutions (LFIs) are a major source of finance to Uganda’s private sector, but due to high economic risks, debt financing has been very costly. The high cost is manifested in the high interest rate which averaged 21% during January 2017-June 2018. High interest rates according to a Bank of Uganda report subdue growth in private sector credit (PSC).
LFIs tag the high cost of capital to high operational costs, inflation, high risk of default and high level of non-performing loans in sectors like agriculture among others. As a result, the private sector also finds it expensive to borrow from LFIs.
This partly explains the huge reliance on retained earnings as working capital mentioned above. However, retained earnings are not significant enough to spur considerable growth/expansion, and according to the Capital Market Authority, they are quite unpredictable and have little scope for risk-sharing.
Specifically, with retained earnings, growth can be piece-meal (until a certain threshold) and may not provide the impetus, compared to firms that have external options to get them to the threshold needed to take off.
Equity financing—an option rarely used by Ugandan entrepreneurs
Because financial institutions are expensive and retained earnings may not provide the much needed big-push, equity financing may come in handy.
A publication by Uganda Securities Exchange (USE) highlights the fact that equity financing exposes enterprises to factors affecting cost of capital that they can control, contrary to debt financing, which may put enterprises at risks beyond their control, especially high interest rate regime and taxes. The publication adds that ‘By optimizing what is in the firm’s control, the firm can significantly lower its capital cost’.
Equity financiers acquire a stake in the business by buying shares. They become part owners of the enterprise and hence are able to exercise some level of control. The add-on with equity investors is that they often come with experienced investment managers who provide managerial support for the business.
They are known to help improve corporate governance by putting in place internal control systems and external oversight. Equity investors can only recover their investment through selling their shares (mostly at a higher value later). This means they seek growth opportunities and have the incentive to help the business grow.
In the African context where exposure to equity markets has been low, venture capitalists are an option, given that they fund small companies looking to expand but lacking access to equities markets. However, equity finance come with its fair share of demands that may be challenging for Uganda’s SMEs, yet, on a brighter side, these demands provide an opportunity for SMEs to develop.
They require ownership stake in the enterprise, which can be done through buying or selling company shares. It therefore requires companies to not only be legally registered but limited by shares so as to provide an entry point for investors. However, about 50% of Uganda’s enterprises are informal, and by 2013, only about 8% of Ugandan companies were limited by shares, of which 2.6% had traded shares. This means only 8% of firms could raise equity, but just 2.6% were actually doing it.
The rest of the other firms (92%) cannot raise equity because potential funders do not have a legally safe way to put a stake in their entity and later cash out.
Equity financiers look for a pipeline of bankable projects (growth opportunity). This requires the conduct of proper due diligence to establish credit worthiness and bankability of their potential investment. It also requires SMEs to have credible and easily verifiable corporate information, especially on credit history, which is lacking among most SMEs in Uganda. Oteh’s blog post notes information asymmetry as a key barrier to SMEs’ access to capital in developing countries.
They often require enterprises to have strong corporate governance system, example having a strong board in place so as to tighten internal control and accountability. About 72% of enterprises in Uganda are sole proprietorship, meaning they are more likely to have loose internal control systems and owners are only accountable to themselves.
They require a supportive regulatory environment with good incentives for equity investment. Currently in Uganda, venture capitalists reportedly get double taxation (due to capital gains tax) when cashing out of an investment. This can be a disincentive to invest. A venture capital firm in Uganda has had to domicile two of its East African funds in Mauritius partly because of that.
To set the groundwork for boosting equity financing, we ought to increase discussions and knowledge sharing about equity as an alternative financing form for SMEs.
This will necessitate cultivating a community of practices focused on bringing the wider business community to appreciate the reforms and benefits that come with equity. Three key reform areas that Uganda’s SMEs will have to take to attract equity are:
1) Consider having your company/enterprise as limited by shares, this will give liberty to both the business and equity investors to safely transact
2) Improve corporate governance. Most SMEs in Uganda are family-run businesses with founders shy of accountability or losing control of their inheritance.
While accountability is something founders will have to work with if they want equity, control can be negotiated, example venture capitalists do not invest to stay in your business, they invest to grow and get out at the right time;
3) Keep credible corporate information. Information is key in every business, it is what potential investors use to assess the state of your business, without which they cannot invest in you. SMEs therefore need to migrate to digital ways of transacting business and keeping records so as to ease due diligence processes by potential financiers.
Government also needs to put in place a supportive regulatory framework for equity investments. Example to attract more venture capitalists the like of Pearl Capital to Uganda, we will have to institutionalize tax benefit for equity investments, review our tax regimes and minimize on issues like double taxation to prevent venture capitalists from domiciling in friendlier climates like Mauritius.
For Uganda’s private sector to be a formidable game changer in financing development, its own financing options need to be broad to permit the mixing and optimization of working capital in ways that widen investment options for development. In the end, the choice of equity or debt or a ratio of both is a case by case, but having both options is a plus for business and development.
The Writer works with the Economic Policy Research Centre. Source: www.http://eprcug.org/blog/630-why-do-ugandan-firms-avoid-equity-financing