Raising business funding in South Africa is something most entrepreneurs encounter at some stage during their business journey. It’s important to understand the nuances of the gaining the right type of business funding for the unique needs that every business may have.
All organisations are faced with the challenges of strategic development: some from a desire to grasp new opportunities and others to overcome problems and survive an internal or external set back in its profitability.
Strategic developments always require resources to be applied to the problem. These resources consist of human resources and assets. Deciding to take on new resources or allocate them from other parts of the business require strategic decisions. One of the characteristics of a strategic decision is the matching of the resources and activities of the organisation to the environment it operates in, or plans to operate in. The strategic decisions taken by a business therefore have an impact on the demand for resources. The matching of resources to opportunities leads to the evaluation of risks associated with the opportunity.
According to a prominent business plan consulting team, business has to consider three factors: money (resources), time and risk. These factors influence each other and issues impacting on one factor lead to changes in the other. Since the future is uncertain, the difficulty in financing is that it contains an element of risk when evaluating monetary flows or values over time. Hence money (resources), time and risk interact with each other in each financial decision made related to business funding in South Africa.
One of the most critical strategic decisions faced by the management of the business is the capital structure of the business. The capital structure of the business is primarily concerned with the mix of internal and external sources of capital. These sources of finance falling into each of the internal and external categories of finance are discussed in more detail later in this book. This section concentrates on the mix between these two categories of sources of finance.
Raising Business Funding in South Africa
– the normal Cycle
The external sources of business finance are also known as debt. General characteristics of debt are that the business is committed to make fixed payments in the future, part of the fixed payments are tax deductible and a failure to make the payments can lead to either default or loss of control of the business.
Internal sources of finance are normally referred to as capital or equity. The characteristics of equity are that the business is normally not committed to repay the amount and these payments are normally not tax deductible. The owners of equity are considered to be the owners of the business.
The general ratio used to describe the finance structure mix between capital and debt is the business’ leverage ratio. The leverage of a business is calculated by dividing the long term debts of the company by its equity.
We will now look at the factors that impacts on the this strategic decision.
What will the money be used for?
The business is continually faced with strategic decisions necessary to capitalise on a certain opportunity. If the company which to expand its activities and grow the business it would be essential to evaluate the risks attached the opportunity. These risks tied in with the requirement for cash resources will give an indication on the period over which finance are needed. For short term solutions debt will probably be the preferred option while long term cash requirements could be funded by either debt or equity. It is important to note that equity tend to be a more expensive way to finance a business due to the fact that the business will give away after tax profits in the way of dividends which are not limited like interest on most types of debt.
What will the money be spend on?
The business faces the question of how it will determine the level and composition of its monetary investments. The business has the choice to invest in either physical assets and/or financial assets (securities) with a view to receiving future income from them. There are two categories of factors impacting on the returns the business makes from its investments in these assets. Those factors that are under the manager’s control (i.e. operational decisions) and those factors that are not under the control of the manager (i.e. market conditions in which the business operates).
The management of the business has to be aware of the factors under their control as well as the factors out of their control to ensure that successful investment decisions are made.
For instance the management of a service- based business will be involved with various investment issues, of which investment in the business’s human resource “-assets” is of primary importance.
Investment decisions related to human resources are complex and there are various laws and regulations governing the rights of both the business and the employees. Due to the limited resources, the business needs to make the best investment decision possible to ensure its survival and growth. It is therefore common for businesses to look to advisors for assistance in making investment decisions.
From whom will the money come from?
Another decision in financing relates to the sourcing of finance. This decision being the financing decision is more applicable to the subject of this book. Different sources of finance have different prices attached to them and the business is faced with a great variety of options to choose from. See chapter 3 in this book for a discussion on the sources of finance available.
The decision of the mixture in funding a business lies with the management of the business, but for this reason we need to have a look at the difference between the owners of the business and the management of the business.
Who makes the decision the owners or the management?
The owners of the business are the shareholders and they are entitled to the profits generated by the business. The management of the business is usually the person or group of people that run the company on a daily basis. The makers of financing decisions or management of the business has a major impact on the capital structure of the business and you should understand how these decision makers influence the capital structure of the business.
The business is not necessarily a single person (operating as a sole proprietor), or Close Corporations and partnerships where a group of individuals are both the owners and managers of the business. Where there is a separation between the owners and the management (i.e. directors and management board) of the business, an “agency” relationship exists.
In smaller businesses it is typical that the owner and manager is the same person or closely connected (i.e. owner managed businesses). The management of the business in this case attempts to promote the welfare of the business’s owners in the decision-making process.
Under the agency relationship the management of the business has a conflict of interest with the owners of the business. This potential conflict between the management’s interests (i.e. the manager’s prestige, salary and performance related bonus structures) and the interest of the owners of the business (i.e. the growth in the share investment value and returns on the share investment) forms the basis for this discussion.
When we look at larger businesses the management of the business has a conflict with the owners in the sense that the benefits that the management consume reduce the profit available to the owners of the business. Benefits consumed by the management could be in many forms: salary, bonuses, benefits and corporate comforts i.e. prestigious offices, corporate vehicles or planes and corporate entertainment. The other side of the coin is that if the manager is deprived from the cost of these benefits there is little return to them by way of excess profits that flow back to the management.
One way of reducing the conflict between the manager and the owner is to give the management a part of the ownership. This will put some of the benefit of reduced management costs back in the hands of the management.
Where the management of the company already have a stake in the equity (ownership) of the business taking on debt instead of increasing the share investment in the business will ensure that the management’s share of ownership will remain constant. Debt also creates an obligation for repayment which curbs the spending on corporate comforts. There is also an argument that additional debt increases the risk of bankruptcy which the management would normally want to avoid because the impact of bankruptcy on the management is often more traumatic than the impact on the owners.
Difference sources for raising business funding in South Africa
What is the risk associated the business?
The business’s value depends on the value of its income producing assets. This value of the business is of importance to funders because it is directly related to the risk of their funds not being repaid. It is for this reason that some funders like to substitute debt for equity. It is then up to the owners of the business to increase the shareholder’s expected return from profits generated by the business. For more profit to be made the owners of the business need to ensure that the benefit of new debt in the form of additional profits should be more than the cost of the debt.
It is this relationship between risk and cost of the loan that determines the whether your business will qualify for finance. Unlike start-up businesses, existing businesses have a track record and assets that the lender can rely on when calculating their risk of providing finance.
One of the key risk indicators for any business is its credit score. It is important to understand what the credit score is and how it works.
Credit scoring works on the assumptions that performance of the lender in relation to future loans with a given set of characteristics will be like the performance of past loans with similar characteristics.
The credit-scoring model is based on a formula, which differ from credit agency to credit agency. The formula puts weights on different characteristics of a borrower, a lender, and a loan. The result of the formula produces is an estimate of the probability or risk that an outcome will occur i.e the loan will be repaid..
A simple scoring model might state that the base risk for loans to manufacturers is 0.15 (15 percent), that traders are two percentage points (0.03) less risky, and that each R100 disbursed increases risk by half a percentage point (0.005). Thus, a trader with a R500 loan would have a predicted risk of 14.5 percent (0.15 – 0.03 + 5 X 0.005), and a manufacturer with a R1,000 loan would have a predicted risk of 24 percent (0.15 + 0.00 + 10 X 0.005). The weights in the formula are derived from statistics gathered by the credit agency. This simple model also demonstrates why higher amounts of borrowings often carry higher interest but this is not always the case. A mortgage is very often at quite a low rate even though it is for a large amount. The reason for this lies in fact that the asset against which the lending is secured is typically of a very low risk nature.
The main factors listed in order of their importance that impacts on credit scores are:
- The businesses’ repayment of existing debt history
- How much is owed by the business
- What is the period of the credit history record
- How much new credit did the business take on recently
- What types of credit does the business utilise.
The firm has two main categories of sources of finance available to fund its investments and trading activity: external sources and internal sources. Although there are a great variety of external sources of finance, the internal sources of finance are limited.
Striking the balance between internal and external sources of finance
The firm is constantly faced with the problem of finding the optimum balance between external sources of finance (i.e. banks, creditors and the Government) and internal sources of finance (shares and member loans / capital accounts).
Debt is considered cheaper than equity because creditors has limited risks and they have more certainty about getting their interest and principal back from the business over a set period of time. However, debt too much debt can be risky to the business because, if the business does not generate enough profit to cover the interest and principal payments attached to the debt, the firm could face liquidation.
Debt providers are concerned about the risk attached to their financing instruments and the competence with which the finances in the businesses are managed.
A consistently good track record in managing the business’ debts could in itself be regarded as a reason for debt providers to provide further debt facilities for some firms and not for others.
The risk attached to the business is influenced by the capital structure of the business, particularly the leverage ratio which determines how sensitive the solvency of the business is to change in its profit position. The business’s capital structure is dynamic and the finance decision is constantly influenced by the availability of source of finance.
The pecking order of finance options
Myers developed a model called the Pecking Order Theory that finance decision makers will seek to use the internally generated finance i.e. accumulated profits first before taking on external finance sources. Where internal sources of finance i.e. accumulated profits are low or not available, the business is forced to look at other sources of finance. According to the Pecking Order Theory, the business will consider external sources of finance after it has used up all of its available reserves.
Returning to the assumption of the Pecking Order Theory the question could be asked why businesses don’t use external sources of debt for all their finance decisions once the available reserves has been exhausted.
The impact of too much debt
If debt is the cheaper option due to the tax deductibility of debt costs (finance charges), why issue equity, why don’t just fund the business entirely through debt?
Excessive use of debt is not the answer though because as the proportion of debt increases, the probability of default increases. This has a negative impact on the owner’s investment value and will cause an added premium on the cost of the debt.
There is a point at which the business will not seek further debt because:
1 Finance distress: As the business increases the portion of its debt financing, it also increases the probability of incurring financial distress or even liquidation as a result of an inability to meet creditors’ claims when they fall due. Financial distress can mean disruption of the business’s business and a decrease in net returns (suppliers may become unwilling to give the business favourable terms if it defaults on payments or goes into liquidation). The owners will incur loss of reserves available for distribution due to a lost of revenue and an increase in operating costs due to higher finance costs.
2 Flotation / access costs: The cost of gaining new debt is lower than that of gaining owner finance through an additional issue of share. However, the finance of investments from accumulated profits (increased equity) is free of costs and thus cheaper than debt. One would therefore assume that the company would use its excess reserves before acquiring debt.
3 Tax bias: The business will gain a tax deduction on the debt finance charge at the corporate taxation rate. In cases where the personal taxation rate of the owner is higher than that of the business (if incorporated), it would be more beneficial to gain a tax deduction for the finance cost in the hands of the owner (favouring owner finance or equity), rather than in the hands of the business. The taxation considerations related to finance are complex and it is difficult to draw an assumption of how much these considerations impact on the capital structure decisions of the business.
4 Agency costs and debt policy: It is possible that the business may have to pass up profitable investments or be forced to abide by costly restrictions due to the existence of debt. The provider of debt will limit the amount that they are willing to provide to the business. It is also quite common in the modern market for debt providers to impose constraints on the business’s investment and other policies by stipulating provisions in the finance agreement. The purpose of these restrictions is to encourage the business to adopt policies that protect the debt providers’ interests. The debt providers also assume a preferential right to the owners over the business’s assets in the event of liquidation.
There is also an argument that debt would be limited because the owners of the business view secured debt providers as a threat to the control that they have over the business. It is important for this reason to distinguish between debt providers that seek an interest in the business’s equity (i.e. Venture capital investors) and those that do not (i.e. banks providing bank overdrafts).
If debt finance is limited what is the alternative finance alternatives?
Seeking business funding in South Africa needn’t be a complex issue. Finding support from a corporate advisory service such as Caban Investments, or using external bodes such as the SA Venture Capital Association could support you in funding the funding required.