Big Challenges for Small Business

Article reposted from the Guardian's Global Development Professionals Network and DAI Partner Zone.

Linda Jones and Katie Turner on building up the financial ecosystem around small businesses to enable them to thrive.

Small and medium-sized enterprises, or SMEs, are vital to development. A subset of SMEs known as small and growing businesses, or SGBs, is particularly important. Yet, too often, such businesses fail to attract the investment capital or support services necessary to their continued growth. Business incubators, accelerators, and other initiatives are helpful responses to this problem, but ultimately small businesses need to function within a dynamic financial ecosystem. And for that to happen, a whole range of stakeholders must play their parts.

SMEs drive economic growth in developing economies. In Asia alone, SMEs contribute to more than 60% of gross domestic product and more than two-thirds of employment. In Africa, that employment number jumps to 90%. Despite their critical importance, roughly half of SMEs in developing countries find themselves impeded by lack of financing. The Consultative Group to Assist the Poor reports that only 32% of SMEs had received a loan from a financial institution, compared to 56% of large firms.

Development actors have responded to this challenge. Development finance institutions – such as the International Finance Corporation and Britain's CDC – play a significant role in early stage SME financing while laying the foundation for other forms of investment. Private equity funds – such as Sarona Asset Management, Small Enterprise Assistance Fund, and Business Partners Inc. – place capital in local funds and SMEs to support growth and nurture local equity markets. Other stakeholders are testing and scaling new investment models in emerging economies, adapting well-known strategies for business upgrading and new approaches for de-risking investment. At the same time, nonfinancial returns — environmental, social, and governance benefits — have become increasingly important to impact and commercial investors alike, offering opportunities to progressive companies but putting additional pressures on SMEs to perform across the board.

But these initiatives have largely failed to reach SGBs – businesses with up to 250 employees that require from $20,000 to $2 million in investment. Such businesses have the potential to deliver on development objectives by offering increased employment opportunities for unskilled and skilled workers, appropriate products and services for local markets, and greater economic inclusion for women, youth, and other disadvantaged groups. They constitute the new missing middle, since few SME investors (including most impact investors) are willing to move downmarket to work with them.

To address this shortfall, business incubators and accelerator programmes operate to promote business performance and investment readiness. In addition to providing training, advice, and market linkages, accelerators match SGB managers with mentors and forge ties to impact investors. Research by the Aspen Institute for Development Enterprise and Village Capital indicates that most accelerators work with enterprises at the prototype or pre-revenue stage, a crucial entry point in the investment ecosystem. The Agora Partnerships Accelerator programme, for example, targets enterprises with potential for high impact in Latin America, focusing on firms that are too large for microfinance but too small for traditional sources of capital. To date, they have raised $13.1 million for participating businesses, which have experienced 80% annual revenue increases.

Because investor segments such as development finance institutions are placing an increasing premium on environmental, social, and governance factors, small and growing businesses must be willing and able to upgrade their capacities in these areas. Yet these businesses too often perceive such upgrades as adding unnecessary costs with long payback periods. Encouragingly, through donor grants and incentives, more consulting firms in developing economies are offering environmental, social, and governance coaching to emerging businesses, leading to initiatives such as worker health and safety programmes, environmental management practices, and employee incentive programmes.

Linda Jones is the research and development director and Katie Turner a senior programme manager at Mennonite Economic Development Associates, Canada.