2.4. Financing Sources
The common financing sources used in developing economies can be classified into four categories: Family and Friends, Equity Providers, Debt Providers and Institutional Investors.
Family and Friends: This source of financing is a popular primary source for many people and small businesses, especially in developing economies. The close familial/friendship relationships between lender and borrower tends to support a level of trust and risk tolerance that most start-ups are unable to secure from outside lenders. This financing is often ‘informal’ (i.e., without a formal contractual agreement) and the transaction sizes tend to be small. The terms and conditions tend to be flexible but relatively patient, reflecting the fact that this sort of financing usually supports start-up or rapidly growing businesses.
Debt Providers: These include commercial banks, microfinance institutions (MFIs), credit unions, and leasing companies, which bundle short-term funds and then extend them as loans or leases. Financial transactions here tend to be larger (with the exception of MFIs), and low-to-medium risk. Debt is an essential financial instrument because of the lower cost relative to equity. It has greater flexibility and does not require the borrower to cede control.
Equity Providers: These include “public collective investment vehicles” such as mutual (stock) funds and exchange traded funds, and private funds such a private equity funds. Such funds tend to be primarily ‘equity’ focused (taking ownership in business rather than a lending to businesses).
Equity providers are often aligned with commercial investors (or investment banks), which are primarily in the business of structuring and selling (often termed “placing”) equity investments to investors and providing financing advisory services to businesses. While investment funds are not prevalent in USAID presence and other developing countries, equity can benefit start-up and rapidly growing businesses by providing longer-term patient capital, and in some cases advisory services, while having a higher tolerance for risk. See Equity vs. Debt for more information related to the advantages and disadvantages of equity and debt, respectively.
Institutional Investors: These include pension funds and insurance companies with large amounts of cash inflows that typically need to be invested over the long-term. Institutional investors are important because of their size and huge appetite for debt and equity. While institutional capital in developing countries remains relatively small, it is growing rapidly and is generating interest as to how it can be unlocked to support development.