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First Regional SME Finance Conference Amman
February 24 26, 2008

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Risk Capital Finance for SMEs Tom
Gibson smethink.org
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Principal Points

• Private equity is only appropriate for large
  investments and favors ICT, natural resources,
  and financial services.
• The SME financing gap has caused an SME growth
  gap which can only be closed by new sources of
  risk capital.
• Both risk and reward need to be adjusted in SME
  risk capital strategies through
• specialized, innovative, entrepreneurial
  investment intermediaries, and
• public-private partnerships to draw investment to
  SME risk capital.

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Why private equity and venture capital cant fit
most SMEs.

• The issues
• exits
• information
• alignment

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SME Risk Capital Major Obstacles to PE / VC

• Information deficits
• asymmetry
• poor record-keeping
• absence of credit bureaus
• absence of collateral registries
• absence of comparable data
• Exit realities
• illiquidity / low turnover of stock exchanges
• low potential for mergers and acquisitions
• difficulty of financing MBOs (buy-backs)
• lack of motivation to sell (family/life-style
  businesses)

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SME Risk Capital Major Obstacles to PE / VC

• Misalignments of interests
• Funds want high SMEs dont want to
• dividends. pay high taxes.
• Funds want high SMEs want
  a low
• capital gains.
  buy-back price.

180
180
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Incentives to cook the books

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The WorldCom Method of accounting Cook a
soufflé!
hide expenses profits up
The SME Method of accounting Cook
a crêpe!
hide income profits down
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Risk Capital Financing for SMEs Fourth Door
Funds
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Why SMEs?

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Where do large firms come from? How does a
country best diversify its economy? Which group
of businesses, by size and degree of development,
has the greatest incentive to define and insist
on policy reforms and accountable, transparent
government?
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SMEs Who are they?

• Typically
• fruit processors
• spare parts suppliers
• furniture manufacturers
• commercial printers
• computer skills trainers
• wholesale bakers
• door and window manufacturers
• internet service providers
• poultry processors
• fast food franchisors (local)
• tour organizers
• industrial cleaners

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SMEs Who are they?

• Typically
• 10 to 150 employees
• formally registered, generally compliant
• 250,000 to 2.5 million annual turnover
• owner-managed/family-managed
• most often life-style business
• financing growth through cashflows
• financed at birth by family, friends,
  secured loan of 25-50K
• often lack training and financial discipline
• require 100 K to 1M for expansion

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Financing SMEs Current Market Options
SMEs looking for 100,000 to 1,000,000
Leasing Commercial
Private Equity
Companies Banks
Venture Capital
?

• high interest
• high fees
• short-term
• high collateral

• need high liquidity
• high base cost
• high fees
• working capital?

• want 3rd-party
• exit potential
• require high
• returns
• do few deals

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SME Risk Capital Adjusting Risk Adjustment
Risk adjusted returns on SME risk capital

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market return on fully secured corporate
financing (opportunity cost)

10 adjustment for size and SME sector
perceptions 5 adjustment for less than 100
collateral 10 adjustment
for political/market vulnerability
5 adjustment for difficulties in exiting
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40 management fee and fund expenses
5 Investors required IRR (hurdle
rate) 45
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Is 45 IRR realistic?
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Fourth Door Funds Adjusting Risk Adjustment

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Reduced risk at the investee level.
Improved returns at the investor level.
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Fourth Door Funds

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Reducing risk at the investee level.

• royalty-based (sales-based) finance
• investment in expansions (not-start-ups)
• minimal exposures in equity
• more investment staff at lower cost
• grant-based technical assistance (TA
  Facilities)

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Fourth Door Funds

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Reduced risk at the investee level.
Improved returns at the investor level.
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Fourth Door Funds

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Improving returns at the investor level.

• aligning instruments and returns
• for diverse investors with
• diverse objectives
• providing government incentives
• to invest

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Fourth Door Funds
Aligning instruments and returns for diverse
investors with diverse objectives

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Investor objectives (examples)
IRR
45 /- 0

• - high risk/high financial yield only
• - moderate risk/modest yield, plus market
  knowledge
• - low risk/low yield, plus govt./public relations
• - lowest risk/lowest yield, plus developmental
  objectives
• philanthropy

• Instruments (examples)
• - pure common equity shares
• equity shares with capped yield and preferences
• low-interest debt with equity kicker
• low interest debt (leveraged fund)
• grants for capital for technical assistance

Risk
high low
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Fourth Door Funds
Providing government incentives to invest

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• tax incentives (Trinidad and Tobago, U.S.
  CDFIs)
• loss insurance (U.S-OPIC)
• non-voting equity (Israel-Yozma Program)
• co-investment ((France, Germany)
• leveraged funds (Australia-IIFs, U.S.-SBICs

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Fourth Door Funds
Providing legal and regulatory incentives to
invest

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• Funds able to operate as private companies with
  tax neutrality (particular need for limited
  partnerships), not regulated as banks or NBFIs.
• No restrictions on minority shareholder rights
  (to much or too little power).
• No restrictions on, or lack of provision for,
  separate classes of shares with rights agreed by
  investee and investors.
• No restrictions on rights to dismiss management
  for cause.
• No restrictions on rights to sell minority shares
  as agreed between investor and investee.

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Fourth Door Funds
Features for SME Risk Capital

• mid- to long-term financing
• cashflow-based financing with less
• than 100 collateral coverage
• returns linked to SMEs performance,
• de-linked from market interest rates
• not dependent upon third-party exits from equity
• (MA and IPOs) or high capital gains from
  MBOs
• streamlined, replicable transaction structures
• operated by people with local business skills as
  opposed
• to imported investment banking skills
• direct hands-on technical and management
  assistance
• diverse investors with diverse motives and
  diverse returns
• government-sponsored incentives to invest

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Fourth Door Funds

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Reduced risk at the investee level.
Improved returns at the investor level.
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Shareholder Loan Funds

• Imposes specific investment methodology,
  combining
• - minority equity participation
• - low-interest loan
• - percentage of sales (royalties)
• All investments must have equity component.
• 75 - 90 of investment must be as
  shareholder loan.
• All loans must include royalty rights in
  addition
• to interest.

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Shareholder Loan Funds

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• Why equity?
• Voting rights and/or participation in
  decisions.
• Reduce debt burden in early phase of
  expansion.
• Establish close partnership.
• Freedom from regulation as a lending
  institution.

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Shareholder Loan Example
Business assumptions pre-investment
equity 100,000 total investment
required 300,000 post-investment
sales (Year 1) 250,000 average
growth p/a 25 Investment
Structure Equity
50,000 for 33 of shares dividends
paid none exit
at pre-determined multiple of purchase
price or sales Shareholder Loan
250,000 interest prime minus /- 2
points royalty 3 of gross sales term
5 years, w/1-year grace on
principal

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Shareholder Loan Terms

• - invest for new shares only
• minimum 26, maximum 49 ownership
• no dividends paid
• tag-along rights
• no less than 3 years, no greater than 6 years
• normally below prime, no greater than
• prime
• no less than 1 of sales, no greater than 5
• based on greater of projected or actual sales
• no less than 25 in pledges of business
• and personal assets pledges, plus pledge of
• shares, but no requirement for 100 coverage

Equity Investment Term of Loan Interest
Rate Royalty Percentage Collateral
Requirement

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Shareholder Loan Funds

• 80 exposure in debt means less risk.
• Less pressure on exits means more easily
  managed by local
• talent (most often local bankers who are
  tinkerers).
• Current income from interest and royalties
  means early
• benchmarks, reduced risk.
• Current income means investments easier to
  monitor by
• management.
• Current income means projections more firm
  and portfolio
• easier to monitor by investors.
• Less pressure on exits means more time on
  Investees.
• Eliminates arguments over earnings .

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Shareholder Loan Targets

• SMEs
• lacking other financing options
• in significant expansion situations
• with high cashflow and sales growth
• low net worth
• independent from groups
• dependent on viability for livlihood
• hiring key positions from outside the family
• managed by entrepreneurs focused on sales
• open to non-financial added value

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Shareholder Loan and TA

• assistance in establishing financial controls
• strategic planning
• cost accounting and pricing
• development of market plans
• identification of appropriate outside experts
• negotiation of terms of sale and purchasing
  agreements
• negotiation of licensing agreements
• identification of lenders and loan
  negotiations
• identification of new business support
  technologies
• board selection and corporate governance
• preparation of product catalogues and trade
  fair
• presentations
• etc.

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Principal Points

• Private equity is only appropriate for large
  investments and favors ICT, natural resources,
  and financial services.
• The SME financing gap has caused an SME growth
  gap which can only be closed by new sources of
  risk capital.
• Both risk and reward need to be adjusted in SME
  risk capital strategies through
• specialized, innovative, entrepreneurial
  investment intermediaries, and
• public-private partnerships to draw investment to
  SME risk capital.

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tgibson_at_smethink.org
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Investment Size and Stage
m 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1
Investment Funds
Strategic Investor
International V.C.
Irish V.C.s
Stage
Idea Seed Early
Development Exit