Equity Finance for SMEs in SA

My first article on this blogsite was about the new Venture Capital Tax Incentive SARS was about to launch in July this year - now that the incentive is effective, here is a brief overview together with how it could benefit SME owners planning to expand their businesses.

Access to equity finance by SMEs is one of the main challenges to the growth of this sector of the SA economy – potential growth opportunities often do not easily outweigh the risks and SME owners often lack the expertise and network to reach potential investors. In addition, the typical characteristics of SME companies and entities in SA would be as follows:

· They are forced to grow organically
· Are undercapitalised – often attractive businesses in terms of product, future potential and sustainability, but unable to grow / expand (this in turn can lead to missed opportunities and cashflow pressure)
· Succession planning is not a priority – often, the owner ‘is the business’ and little value remains upon his exit (which results in making the business less attractive for buyers / investors)
· Are generally owner managed – business owners sell their business at retirement
· Do not have middle management
· Generally lack solid financial systems and controls
· Are sceptical towards relinquishing a share in their business (fear of loss of control, future direction of business, reduced profit share)
· Given the current economic climate, access to funding from financial institutions has become even more difficult

Venture Capital Tax Incentive

There was a very exciting development on the SME front earlier this year.

To assist SMEs in raising equity finance, SARS has legislated a tax incentive (Revenue Laws Amendment Act 60 of 2008) for investors in SMEs – the incentive came into effect on 1 July 2009 & will run until 30 June 2021. Very broadly, this development entails the following :

· A Venture Capital Company (VCC) fund would be established & approved by SARS (subject to certain conditions)
· Investors would invest in the VCC which would in turn invest in small businesses
· The minimum size VCC fund must be R 30m
· Investors can be individuals & listed entities & would be allowed tax deductions against their taxable income subject to certain criteria
· Individuals would be allowed a R 750 000 deduction per tax year with a life time limit of R 2.25m eg. if an individual invested say R 1.5m into a VCC, they would be allowed to deduct R 750 000 from their taxable income over 2 years
· Listed companies (& their 70% held / controlled subsidiaries) would be allowed a 100% deduction provided they do not own more than 40% of the VCC.
· The VCC must invest not less than 80% of the fund (R24m in this instance) in SMEs where the book value of the assets after the investment does not exceed R 10m
· The VCC can only invest in qualifying companies viz. SA registered & owned, privately owned (cannot be listed). Non qualifying companies include those involved in financial / professional services, property developments, casinos, liquor, tobacco or arms. Importantly, VCCs may invest in companies involved as hotel-keepers ie. hotels, bed & breakfast / guest house establishments, lodges.
· The VCC would normally invest in certain preferred industry sectors and would have strict investment criteria – these would of course vary from fund to fund.

Please note that the VCC Tax Incentive also applies to investments in junior mining companies – although the investment criteria are similar, the VCC fund sizes & target company asset requirements are different.

What would VCCs focus on ?

A recent survey conducted by the South African Venture Capital Association (SAVCA) on it’s members highlighted the following as the key considerations (in descending order) for investing in a particular business :

· Management – the entrepreneur must be honest with integrity together with a great desire for success, excellent management skills, hardworking & reliable combined with good leadership ability ie. Does the entrepreneur and his team have the capacity to grow the business to it’s full potential ?
· Product / Service – a solid market acceptance for the product / service with a competitive advantage
· Financial – the business can provide a high internal rate of return, solid potential for earnings growth and could be worth substantially more in 4-5 years time
· Market – strong market need for the product / service and potential for market growth

Investor readiness

As an SME owner with plans to expand your business over the next 2-3 years, it is vital that you are constantly ready for an approach by an investor / VCC that is looking to secure investment opportunities with solid potential. So what is required and what can you expect should such an approach be made ? – here are some thoughts & suggestions :

The process of raising venture capital can be time consuming (3-6 months) – make sure you prepare thoroughly to save time
Ensure your disclosure document is clear, balanced & up to date & covers at least the following : background, current position, products, markets, management, strategy, financials & the employment of funds received
In an uncertain world, investors like facts & figures (rather than guesses & speculation)
VCC teams back teams rather than individuals – show that you have a spread of skills
Be prepared to answer very detailed questions about your projections (sales & cost drivers)
Be prepared to devote sufficient time & effort to the process

What to look for in a VCC

By acquiring a share in your business, the VCC would of course have a vested interest in the future of the company. At the same time, it would essential that as the owner of the business, you are clear about your expectations regarding the involvement of the VCC team in your operation ie. what would they bring to the table ? A suitable VCC team should be able to offer :

· Mentoring & advice to the SME owner – together with acting as a ‘sounding board’
· Access to new networks
· Strategic & succession planning input
· Various business development services eg. business planning
· Specific expertise relating to various facets of the business

At the same time, a very important consideration would be to ascertain as soon as possible whether you could see yourself working closely with the new investor on a regular basis.

The advantages & disadvantages of equity finance

1) Advantages

· Funding is committed to a business when you dispose of a portion of the shareholding – the investor will only realise his investment if the business does well
· Right investor can bring skills, expertise & experience
· An adequately capitalised business improves it’s ability to borrow (the banks are placing increased emphasis on the strength of a company’s balance sheet)


2) Disadvantages

· Raising equity finance can be demanding, expensive & time consuming – however, even if you are not successful in raising equity finance, it could be a worthwhile exercise
· You will lose total control of your business – however, a reduced share may be worth a lot more in time
· Business owners would have to invest additional management time in providing information to investors
· There would be various legal & regulatory issues to comply with

Going forward

The advent of the global recession late last year impacted heavily on potential investors appetite for risk. Although a recovery is expected to be slow, there will no doubt be opportunities for investors to take advantage of the growth in certain SMEs - as such, one could possibly see the formation of various VCCs during the course of 2010 across SA.

Capital can make the difference between an average company & a great company – there are many solid SMEs that lack the capital to grow / expand. Although they can be high risk, they have the potential to generate high returns provided they receive the right support / input from the incoming investors.

SA needs a strong, healthy & vibrant SME sector – they are substantial contributors to GDP & have the ability to reduce unemployment.