SME Funding in Kenya: How to raise capital for a small business in Kenya

Accessing capital remains a persistent challenge for many SMEs looking to expand operations, invest in technology, or simply sustain their businesses.

Accessing capital remains a persistent challenge for many SMEs looking to expand operations, invest in technology, or simply sustain their businesses. The options available for raising capital will typically vary depending on the size and structure of a business. In this article, we will explore the various options for SME funding in Kenya, including equity, debt, and alternative financing, and analyse the advantages and disadvantages associated with them.

Equity Financing

Equity financing involves the raising of capital through the sale of shares or through capital injection from angel investors, venture capital firms or incubators. Equity financing offers an important alternative for growth-oriented SMEs to raise capital, especially for businesses that depend on more hard-to-value intangible assets e.g. goodwill, trademarks, or with little-to-no credit history. These include, the following:

Issuance or sale of Shares & IPO;
Venture Capital;
Business Incubators;
Angel Investors.

1. Issuance or Sale of Shares & IPO

SMEs can raise capital by selling their shares. This will mean businesses will sell a slice of ownership in their company to investors in exchange for capital that can be invested into the business. However, this type of capital raising can lead to a loss of control, as investors become owners with voting rights. To mitigate this risk, it is crucial for businesses to carefully structure shares, granting investors limited rights such as dividends without voting power, to preserve control.

Businesses can choose to issue shares privately by seeking out investors directly or through an initial public offering (IPO). An IPO is a vehicle that companies can take to ‘go public’. In an IPO, a company issues shares for sale to the general public for the first time. This will only be applicable for Public Limited Companies. This is a complex and lengthy process that involves several stages, and engagement with underwriters, regulators and other key stakeholders. In return for their investment, shareholders may receive dividends, which are a portion of the company's profits.

2. Venture Capital (VC)

This is financing provided by firms into promising businesses in exchange for an equity stake. Venture capital financing provides funding at every stage of a business's early development. VCs offer different types of funding dependent on the needs of the business, for example:

Seed funding - where investors supply capital to support the initial research and development of a promising idea;
early-stage funding - where Investors supply capital to support a newly existing/start up company; or
growth stage investment - funding for companies who have been in operation looking to expand .

To secure VC funding, applicants must prepare a compelling pitch that demonstrates their business' potential for high growth and scalability.

3. Business Incubators/ Accelerators

Business incubators and accelerators are institutions that assist entrepreneurs in developing their businesses. They provide funding, workspaces, and mentorship to early-stage ventures, helping them refine their business models and attract further investment. Their aim is to accelerate growth and scale.

4. Angel Investors

Angel investors are high-net-worth individuals who provide funding to entrepreneurs, small startups, SMES in exchange for equity stake in the company. Angel investors themselves tend to be successful entrepreneurs and view this as a means of fostering young and promising businesses.

Advantages & Disadvantages with Equity Financing

Equity financing through the modes explored above have several advantages and disadvantages. Let’s explore these below:

Advantages

Growth-focused: Investors in equity financing typically invest for the long-term, focusing on the growth and profitability of the business instead of immediate returns. This enables SMEs to allocate resources according to their strategic needs.
Mentorship: Venture Capitalists, Angel Investors and Incubators all offer some form of mentorship from experienced business leaders.
No Credit, No Problem: Creditworthiness is generally not a factor for investment. Therefore, newly established, younger businesses need not worry about their credit history being an obstacle as is the case when borrowing.
No Repayments: There are also no requirements for repayments as the process involves selling a stake of the business rather than borrowing against it.

Disadvantages

Loss of Control: Selling a stake in your business will require you relinquish control and dilute your own ownership depending on the extent and terms of investment. Businesses should carefully structure shares, granting investors limited rights such as dividends without voting power, to preserve control.
Sharing Profit: Equity investors reap their returns by taking a share of your profit in the form of dividends.
Accessibility: Unfortunately, not all SMEs will be able to engage in these forms of capital raising because they may be too small or suffer from low visibility. Equity investors are keen to connect with viable businesses that are scalable, have strong chances of survival in the long term, and with a unique offering. There is also bias towards tech-focused businesses and start-ups.
Complexity: SMEs may be overwhelmed with certain complex aspects of equity financing, particularly the IPO process. As the process requires engagement with regulators and negotiation with specialist financial middlemen, such as investment banks, SMEs may struggle with navigating this process or preparing the necessary documentation without support.

Debt Financing

SMEs can secure capital through debt financing, which involves raising funds through borrowing or through the sale of debt securities such as bonds. However, raising funds through the issuance of debt securities is generally a method reserved for larger corporate entities and not a viable route to raising capital for small businesses. In Kenya, SMEs have various borrowing options, including:

Bank Loans & Credit Facilities;
convertible loans; and
MFIs & SACCOs.

a. Bank Loans & Credit Facilities

Raising capital through bank financing is a traditional yet reliable option for SMEs. Banks offer various loan products tailored for SMEs, including working capital loans, asset financing, and trade finance facilities.

Asset Financing: Asset financing are loans taken with the intention of use for purchase of movable assets such vehicles.
Working Capital: Working capital loans cover day-to-day expenses incurred during the course of running the business; these are often short-term solutions not intended to facilitate long-term investment plans.
Line of Credit: Businesses can also seek to open a line of credit. These are a kind of pre-approved unsecured loan which allows the borrowers to borrow on an ongoing basis, rather than applying for loans every time a business requires funds. The advantage with this type of financing is that funding is accessible immediately.
Trade Financing: Trade financing is an option provided to facilitate global trading. If a business imports or exports products, trade financing enables them to carry out international transactions that facilitate the movement of goods and services both domestically and globally.

b. Convertible Loans

SMEs can also consider convertible loans as a flexible financing option. This involves raising capital through debt financing that can be converted into equity at a future date. Convertible loans offer a balance between debt and equity financing, providing immediate capital without diluting ownership. However, it is crucial to have comprehensive legal documentation in place to clearly outline the terms of conversion, valuation methods and investor rights.

c. Micro-Financing Institutions (MFIs) & SACCOs

MFIs are institutions that offer micro-loans, savings accounts, and other financial products tailored to the needs of small businesses and the unbanked. Under the Microfinance Act, 2006, there are two types of MFIs: deposit-taking MFIs who are required to register under with the Central Bank (CBK) and credit-only MFIs. Credit-only MFIs are subject to limited regulation and are not considered ‘banks’ under the law. Their loan products are usually intended for small businesses and micro-entrepreneurs that lack access to traditional banking.

Digital credit lenders have emerged as a popular alternative for SME’s seeking quick access to capital. However, it is important to exercise caution as these platforms often charge significantly higher interest rates compared to Commercial Banks. It is important for businesses to thoroughly compare interest rates, repayment terms, and any hidden fees before committing to a loan from a digital credit lender.

A widely accessible option for most Kenyans are Savings and Credit Co-Operatives, or ‘SACCOs’. These are membership-based financial institutions, formed and owned by their members to promote their joint economic interests. Certain SACCOs function as MFIs and offer micro-loans to their members. SMEs can explore options with local MFIs and SACCOs that understand their unique business environment and offer flexible and often cheaper financing solutions.

Advantages & Disadvantages with Debt Financing

Raising funds through debt financing comes with several advantages and disadvantages that SMEs must consider. Let’s explore these below:

Advantages:

Ownership and Control Retention: Unlike equity financing, debt financing allows business owners to retain full ownership and control over their companies. For limited companies, there is no dilution of equity since debt does not involve issuing new shares, the original owners' equity stake will remain unaffected.
Immediate Access to Funds: Borrowing provides quick access to capital, which can be crucial for funding immediate business needs or opportunities, particularly through lines of credit.
Repayment Predictability: Debt financing typically involves a fixed repayment schedule, making it easier for SMEs to budget and plan for future expenses. These fixed repayments help SMEs build on their credit history. Successful repayment will help boost their creditworthiness, therefore improving their ability to secure future financing on more favourable terms.
Credit-Boost: Consistent repayments helps SMEs build on their credit history. Successful repayment will help boost their creditworthiness, therefore improving their ability to secure future financing on more favourable terms.

Disadvantages

Requirements for securities: Access to debt financing is heavily dependent on the SMEs credit history and financial health, potentially limiting options for young or struggling businesses. Additionally, traditional lenders often require collateral to secure a loan, which could put business assets at risk in case of default.
Risk of Insolvency: High levels of debt increase the risk of insolvency, particularly if the borrower experiences cash flow problems or a downturn in business.

Restrictive Debt Covenants: Loan agreements may come with covenants that restrict certain business activities. Though debt covenants are not intended to hinder growth they may potentially limit the SMEs operational flexibility.

Debt Burden: The cost of borrowing is influenced by interest rates, which can fluctuate and increase the overall expense of the loan if it's not fixed. The repayment of debt may turn burdensome if the business suffers and repayments are missed and accumulate, turning the loan into persistent debt.

Government-backed Funding Initiatives

The Kenyan government has a number of initiatives to support SME development locally. Government-backed programmes offer low-to-no interest loan products aimed at supporting SMEs across different sectors and developmental stages. Majority of the programs are generally targeted at women, the youth and people with disabilities. Some notable government-backed funding initiatives include:

Youth Enterprise Development Fund (YEDF)
Women Enterprise Fund (WEF)
Kenya Youth Employment and Opportunities Project (KYEOP)
Uwezo Fund

Conclusion

While raising capital remains a challenge for SMEs, there are diverse and evolving options available. By exploring the avenues listed above, SMEs can increase their chances of securing the capital necessary to fuel growth. At CM SME Club, our team of lawyers will help you in choosing the best capital raising option by providing legal expertise and guidance throughout the process. Contact us today via email or call +254 745 342 125 to learn more.

Disclaimer: This content is for informational purposes only and should not be construed as legal or financial advice.


Published on Aug. 22, 2024, 1:10 p.m.