Whilst there are various sources of capital which may be available to small businesses, the most prominent sources of capital will be elaborated on below.
According to Gitman (2003), the capital structure of a business is defined as the mix of debt and equity that a business uses to finance its operations, where the equity capital can be raised either internally or externally. Internal equity is normally funds obtained from the current owner/s of a business, family, friends, or from the retained earnings within an existing business. External equity refers to capital acquired from external channels such as the issue of equity through a public listing on the Johannesburg Stock Exchange (JSE) (Beck, Demirgüç-Kunt & Maksimovic, 2008). A motive for obtaining external equity may be to share the risk with less risk-averse investors (Abdulsaleh & Worthington, 2013). On the contrary, one of the reasons for not opting for external equity is that the owner/s may not want any undesirable changes in the ownership of the business (Abdulsaleh & Worthington, 2013).
As previously identified in the lifecycle stages of a business, the capital structure decisions are influenced by the age of a business. The public listing option is unavailable to a business in the early stage of the business lifecycle, as a business needs to be relatively large, and must be able to meet the minimum size requirements for listing (Fatoki, 2014a). Berger and Udell (2005) state that only in the more advanced stages of a business’s growth cycle, when the business becomes more informationally transparent will the business develop access to securitized debt and publicly listed equity markets.
According to Abdulsaleh and Worthington (2013), equity finance is preferred over debt finance during the early stages of a business lifecycle. As a business progresses through the business lifecycle the capital structure is adapted accordingly. Ideally, as the business grows and develops, it starts to establish a good credit history and the ability to provide collateral. There is a smaller dependency on internal equity and the business begins to rely more on retained earnings or seeks external financing (La Rocca, M., La Rocca, T & Cariola, 2011). For start- up businesses in South Africa, it is common knowledge that the initial source of capital is through internal equity. This is confirmed by a Survey of Employers and the Self Employed (SESE) study by Statistics South Africa (2013) which reports that 73.4% of the surveyed small businesses borrowed money from friends and relatives to start the businesses (Dlova, 2017).
The problem, however, arises where the initial capital through internal equity is not sufficient and/or may not be able to support the growth of the business (Makina, Fanta, Mutsonziwa, Khumalo & Maposa, 2015). Debt finance is normally not an option at the stage of start-up due
to the unique characteristics of a business in its early stages, such as the lack of credit history, lack of collateral, and the high risk of failure (Abdulsaleh & Worthington, 2013). There are a number of alternative finance sources available during the early growth phase in the business lifecycle. The most prominent sources are equity finance in the form of venture capital and capital investment from Business Angels. Finance options are normally through trade credit and debt finance. These options will be further explored.
Venture Capital
Venture capital can be defined as funds which are raised from investors and re-deployed by investing in high-risk informationally opaque businesses which are in the early growth lifecycle stages or at the start-up phase (Prajogo, Laosirihongthong, Sohal & Boon-Itt, 2007). Venture capital organizations are normally public corporations, small business investment corporations and private limited partnerships (Balogun, Agumba & Ansary, 2015).
There are many benefits to obtaining funds from venture capital organizations. Firstly, venture capital does not require repayments by the owner/s during the term of the loan, and the capital increases the businesses’ net asset value which makes the business more feasible for debt financing or future investors. Secondly, venture capitalists normally assist in the strategic planning and decision-making of the business. The venture capitalist organization may also assist businesses with access to new suppliers and customers, as well as strategic partners.
Thirdly, the venture capital organization allows the business to have access to support structures and experts such as taxation, accounting, legal and technical experts (Da Rin, Hellmann & Puri, 2013).
Venture capital organizations normally have vast experience in business practices which will assist in ensuring the feasibility, development, and growth of a business. It is common that one of the members of the venture capital organization will be part of the board of directors of the business receiving the venture capital funding (Da Rin et al., 2013). There is, however, also disadvantages as the receiving business will likely encounter ownership dilution, as previously identified. Secondly, venture capital is more costly than debt financing as the venture capital organization typically takes an ownership stake in the start-up business, often referred to as an “equity position”. Essentially this means that the venture capital firm is a co- owner of the business.Thirdly, it is a time-consuming process to apply for venture capital as it entails a lot of paperwork and the expertise of legal and financial advisors (Kortum & Lerner, 2001).
Many business owners therefore, do not want to waste time and money to apply for venture capital funding due to the tedious process, as it takes on average six to nine months to secure
funding if successful (Cumming et al., 2015). On average only 1 in 100 businesses secure venture capital funding (Shane, 2012). In South Africa, there are 65 venture capital funds controlling a total of R29 billion, with an average investment size of R15.4 million (South African Venture Capital Association, 2008). However, according to Fatoki (2014), new venture capital for small businesses is about R1.1 billion which is only a fraction of the funds. This implies that venture capital is limited for small businesses in South Africa.
Business Angels
Business Angels can be defined as wealthy individuals or small investment groups of people that have vast business experience who invest in businesses by way of an equity contract, typically common stock (Abdulsaleh & Worthington, 2013).
According to Morrissette (2007), in comparison to venture capital organizations, Business Angels on average provide eleven more times the capital to businesses. The downside is that few Business Angels are prepared to provide additional capital during the growth stages of a business. Fatoki (2014) notes that in South Africa access to equity finance in the form of venture capital and from Business Angels is generally not available to small businesses (Fatoki, 2014).
Trade Credit
Trade credit can be defined as the provision of goods and services by a supplier where there is an agreement between the two parties for the recipient to pay at a later stage, normally thirty to sixty days after receiving the goods or service. If payment is not made on the agreed date, interest is charged by the supplier which can make this form of finance expensive for a business (Baños‐Caballero, García‐Teruel & Martínez‐Solano, 2010).
Trade credit is a very common and important source of external financing for small businesses, specifically for emerging businesses during the early stages of the business lifecycle when the business is considered high risk (Abdulsaleh & Worthington, 2013).There is a general belief by some authors that suppliers have an advantage over banks in determining the creditworthiness of their customers and on monitoring and enforcing the payment of credit.
Some of the reasons cited are that suppliers may have an informational advantage over banks and that some suppliers are in the position of reselling goods in the event of default, or withholding future supplies (Berger & Udell, 2006).
Mateut, Bougheas and Mizen (2006) state that trade credit is more readily available than credit from banks during tight monetary policy periods. In South Africa however, this is not necessarily the case as small businesses struggle to obtain trade credit, as suppliers are
concerned that they may not receive payment for the goods or services offered (Dlova, 2017).
A recent study by Enow and Kamala (2018) to investigate the accounts payable management practices of SMMEs in the Cape Metropolis, indicated that 70% of the sampled SMMEs purchase only on a cash basis, 22% purchase on both cash and credit, and 8% purchase only on credit. One of the main conclusions drawn from the study was that SMMEs may be viewed as risky ventures to which suppliers were reluctant to extend credit terms. Fatoki and Odeyemi (2010) state that similar to bank criteria, a feasible business plan, and good credit history with the bank, location of the business, and the competency of the owners are important determinants of whether a business will qualify for trade credit.
Debt Financing
Debt financing is a method of financing in which a business borrows money from a financial institution to finance its operations. Debt finance is normally in the form of bank loans, overdrafts and credit card financing (Blumberg & Letterie, 2008).
The benefits to the business of debt financing are that the business owners maintain full ownership and control of the business, and the interest on debt finance is tax deductible (Abdulsaleh & Worthington, 2013). Small businesses according to Fatoki (2014a) prefer debt financing from commercial banks over equity financing in order to keep full ownership and control of the business.
Debt financing is, however, limited for small business, specifically in the early stages of the business lifecycle as previously identified (Fatoki, 2014a). It would be prudent at this point to look at the challenges faced by small businesses, from a credit access perspective, and also considering other challenges which may impede the development and growth of small businesses.
2.6 Challenges faced by small businesses