revenue-based or royalty-based sme risk finance nazeem martin managing director: business/partners...

1

REVENUE-BASED OR ROYALTY-BASEDSME RISK FINANCE

Nazeem MartinManaging Director: BUSINESS/PARTNERS

28 October 2015

2

AGENDA

1. The SME environment– Economic significance of SMEs– Factors that promote/impede SME formation & growth

2. Sources of SME finance3. Demystifying SME Risk Finance4. Royalty-based or Revenue-based SME finance

Challenges Benefits to SME/entrepreneur and financier

5. BUSINESS/PARTNERS?– Some milestones: Investing in SMEs

6. Questions / comments

3

SME ENVIRONMENT

01

4

THE SME ENVIRONMENT

THE ECONOMIC SIGNIFICANCE OF SMES• Starting and growing a business is not for the faint-hearted,

BUT– If successful, it could be financially rewarding– It’s one of the noblest of human endeavours

• Economic contribution– Account for more than 35% of most countries’ GDP– Entrepreneurial SMEs are innovative … bringing new

technologies, products and services– Create wealth and jobs, and contribute taxes for development &

social welfare programmes– Constitute > 90% of formalised businesses in most developing

countries

• Employment contribution– More than 50% of people in formal jobs are employed by SMEs– Annually, more than 60% of new jobs are created by SMEs

5

The Entrepreneur

Integrity

Doing skills

Business Skills

Entrepreneurial Talent

somedeals

somedeals

Sensible financialinstitutions/financial productsfor RISK FINANCE

Tax Regime

Physical infrastructure:- Transport- Telecommunication- Energy- Information

FACTORS THAT PROMOTE OR IMPEDE SME GROWTH

INFRASTRUCTURE

GOVERNANCE

Socio-politicalstability,security

Absence ofcorruption

Legal rights enforceable:- rule of law- property rights- bankruptcy proceedings

Bureaucratic environment:- labour- fiscal predictability- exchange rate- inflation

SUCCESS OF SME’S DETERMINED BY “DRIVERS”

Big AgricultureBig Manufacturing Big Mining Major Tourism

Nodes of Transport Seats of Learning Seats of Bureaucracy

HUMAN CAPITALEducation system:- Basic-Tertiary

Training:-Including Mentorship

Stimulation of entrepreneurship:-Technology centres

Health

© Copyright Business Partners

FACTORS THAT PROMOTE OR IMPEDE SME GROWTH

• Finance is not the only challenge• Other (more difficult to solve) challenges include

…– Entrepreneur

• Business & management skills• Technical/industry knowledge and skills• Entrepreneurship• Integrity

– Business viability … based on a plausible business plan– Market size and access– Regulatory environment– Infrastructure

7

SOURCES OF SME FINANCE

02

SOURCES OF FUNDING

• “OWN” FUNDS– Savings– Retrenchment packages– Equity in Mortgages

• “OUTSIDE” FINANCE– Family– Friends– Seller– Investors– Banks & other lenders– Development finance

institutions

FINANCING OPTIONS:LOAN FINANCE VS. RISK FINANCE• Traditional Loan Financing:

– Up to 50% owner’s contribution– 1x collateral/security cover

• Risk Finance:– Limited/low own contribution– Less than 1x collateral cover– Viability based– Higher risk … higher returns to

investor

10

03

DEMYSTIFYING

SME RISK FINANCE

HOW DO WE SOLVE THIS PROBLEM?

A competent person with good “doing” skills, business skills and much

entrepreneurship approaches a financier with a business plan to set up or buy a

viable pizza store — (requiring $100 000), but with little own contribution (say $10 000) and no further

security/collateral.

DEAL STRUCTURE 1

LOAN FINANCE

• Loan finance @ prime + … like a bank• But, banks usually require …– up to 50% own contribution ($50 000 in example)– security/collateral which covers their exposure at

least one times.• CONCLUSION: Our entrepreneur’s funding

requirement will probably not be solved by a traditional bank or lender

DEAL STRUCTURE 2

EQUITY FINANCE

• The financier/investor …– acknowledges $10 000 equity from

entrepreneur– invests $90 000 as equity– split shareholding as follows:• 10 - 20% for entrepreneur• 80 - 90% for investor

• Deal not tenable … entrepreneur will not act as owner

DEAL STRUCTURE 3

REVENUE-/ROYALTY-BASED FINANCE

• The financier/investor …– acknowledges $10 000 equity from entrepreneur– injects a $90 000 term loan at prime +, with LESS

THAN 100% collateral cover– obtains no shareholding (100% shareholding for

entrepreneur)– charges a royalty fee based on % of revenue (or

number of widgets sold, etc.)– obtains a return (IRR) commensurate with the risk

… and shares in the upside like an equity investor

15

DEMYSTIFYING

SME RISK FINANCE

Various permutations of loan (interest-bearing debt), equity (shares) and

revenue- or royalty-based finance are possible.

16

GETTING A FAIR DEAL

COST OF RISK FINANCE

• Secure funds: Good collateral– Financier’s expected return (IRR) = prime +

• Less Secure funds: Equipment as collateral– Financier’s expected return (IRR) = prime + 2%

to 8%

• Funds @ risk: Unsecured– Financier’s expected return (IRR) = 25% to

35%

17

CHALLENGES OF

REVENUE-/ROYALTY-BASED FINANCE

• Moral hazard: SME may under-report sales or revenue on which royalty is based– Need for a monitoring/tracking system – often costly & time consuming– Contracting as the less expensive option:

• “the higher of budgeted or actual revenue”• “payable for the period of the loan or until the loan has been repaid in full,

whichever period is the longer”

• A royalty, in the wrong hands, may be a very dangerous deal structuring instrument which could destroy businesses.– Because royalties strip cash out of a business, one must be mindful of

factors such as seasonality.– The rule is to structure royalties as payable when the cash is there.

• Even with cash royalties – risk financiers must remain patient capital investors

18

BENEFITS OF

REVENUE-/ROYALTY-BASED FINANCE

• For the SME– An opportunity – to start/grow a business– Affordable finance (albeit more expensive than loan finance)– Retain 100% ownership – especially important for family-owned

businesses– Access to a risk sharing financier/investor with business acumen

and expertise– No single, large “exit” required

• For the Financier– A financing opportunity with a return (IRR) which is

commensurate with the risk– Regular payments (periodic contractual “exits”), rather than rely

on a large, undetermined exit only– Lower likelihood of entrepreneur managing the business to

reduce the exit of an equity investor – Deal structure could “guarantee” a minimum return plus upside.

19

04

BUSINESS/PARTNERS?

20

WHO IS BUSINESS/PARTNERS? • A specialist risk finance company providing …

– Funding (customised financial solutions), – business premises, and– technical assistance, sector knowledge & added-value

services

… only for SMEs (formal small and medium enterprises)… to have a positive development impact and make profits

• Established in 1981 … a sustainable track record of success in South Africa

• Expanded SME finance & TA business model into East Africa (Kenya, Rwanda and soon Uganda, etc.) and Southern Africa (Malawi, Namibia and Zambia)

SOME OF OUR MILESTONES

21

$1,6 billionSME finance

596 388Job opportunities facilitated

70 506SME finance transactions

INVESTMENTS APPROVED(US$ MILLION: $1 = ZAR10)

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 -

20,000,000

40,000,000

60,000,000

80,000,000

100,000,000

120,000,000

140,000,000

75,051,123

90,047,169

104,931,029 98,741,167

76,499,733

100,934,853 93,521,245

89,173,097

108,255,495

117,702,177

INVESTMENTS APPROVED PER “PRODUCT”(US$ MILLION: $1 = ZAR10)

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 -

20,000,000

40,000,000

60,000,000

80,000,000

100,000,000

120,000,000

TF TFR TFRS TFS PFS PFEP PFR EI WOP

LEGENDDISBURSEMENTS BY PRODUCT TYPE

• TF Term Finance• TFR Term Finance with a Royalty• TFRS Term Finance with a Royalty and

Shareholding• TFS Term Finance with Shareholding• PFS Property Finance with Shareholding• PFEP Property Finance with Equity Participation• PFR Property Finance with a Royalty• EI Equity Investments

FY2011 FY2012 FY2013 FY2014 FY2015

TF 10186.18348 3029.49147 2367.20902 2654.32007 2026.1046

TFR 60605.59822 53003.92783 59068.05232 37479.25574 31497.84998

TFRS 9219.76349 13538.11945 1470.08709 1666.40657 1487.07381

TFS 0 4195.76149 9559.41954 718.15186 2092.5643

PFS 3324.24548 12509.2214 2174.76383 18595.12676 9790.30565

PFEP 0 1039.19375 0 0 0

PFR 0 0 0 0 0

EI 1508.36756 1106.82059 2491.43613 0 3116.10574

5,000

15,000

25,000

35,000

45,000

55,000

65,000

75,000

85,000

95,000

Bad debts written off per product type

FY2011 FY2012 FY2013 FY2014 FY2015

TF 0.120057570167492 0.0342615311404915 0.0306907728961518 0.0434328004522619 0.0405139858968794

TFR 0.714316689378981 0.59943912762227 0.765815001486913 0.613275337082732 0.62983098200939

TFRS 0.108667039456112 0.153107115736447 0.0190596219579945 0.0272675118743868 0.0297355266682474

TFS 0 0.0474512684294536 0.123937502621199 0.0117511624850129 0.0418429140028177

PFS 0.0391806053516196 0.141470963950066 0.0281957284909701 0.304273188105606 0.19576694363669

PFEP 0 0.011752589297315 0 0 0

PFR 0 0 0 0 0

EI 0.0177780956457961 0.0125174038239567 0.0323013725467713 0 0.0623096477859755

5.0%

15.0%

25.0%

35.0%

45.0%

55.0%

65.0%

75.0%

85.0%

95.0%

Bad debts written off per product type

27

BUSINESS/PARTNERS’ HISTORY

NET CREDIT LOSSES

28

THANK YOU / GRACIAS

QUESTIONS / PREGUNTAS?

WWW.BUSINESSPARTNERS.CO.ZATEL: +27 11 713 6600