Home Business Why debt financing is so important for the African business market

Why debt financing is so important for the African business market

Small and medium-sized enterprises (SMEs) are the beating heart of Africa’s economies. According to the World Economic Forum, as engines of growth, SMEs are responsible for around 80% of the continent’s employment, ultimately helping to reduce poverty and income inequality, enabling the establishment of a new middle class and driving demand for new goods and services.

That’s why creating an enabling environment for SMEs to access finance will enhance their ability to not only contribute to Africa’s labour force but also facilitate the continent’s development and economic growth while driving the innovation needed to help solve the socio-economic issues it continues to contend with.

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However, despite Africa’s booming startup ecosystem, which (according to key findings from Startup Genome’s 2021 Global Startup Ecosystem Report for Africa) boasts a value of $6.6 billion, the continent’s SMEs still find it challenging to secure equity funding.

In addition to this, rising geopolitical tensions, global economic volatility and record inflation highs have created a more competitive fundraising environment, with investors becoming more risk-averse. This could spell even greater trouble in access to financing as Africa has long been perceived as a high-risk environment for investors as a result of a fundamental misunderstanding of the continent as a homogenous entity rife with political instability, weak infrastructure, and other challenges.

It is clear that SMEs have a significant role to play in helping to realise Africa’s economic potential. But, in order to turn this potential into reality, there needs to be a shift away from traditional equity funding towards a more debt-focused approach.

Removing the negative perception of debt

There is a lot of power in debt. Debt is how the world creates wealth and, at moderate levels, it can improve welfare and enhance growth. As such, debt financing offers SMEs the ability to receive funding without having to dilute equity. Essentially, the lender gains no control over the business and once the debt is repaid the relationship with the lender ends, unlike traditional equity funding where the business sells a portion of its equity in return for capital.

Additionally, it is a lot easier for SMEs to forecast their expenses as a loan payment is consistent while interest on said debt financing can often be tax-deductible.

Filling the funding gap by embracing venture debt

Over the last couple of years, Africa’s SME ecosystem experienced significant growth in spite of global economic uncertainty, attracting record amounts of funding against the global trend of a funding decline.

According to the African Private Equity and Venture Capital Association (AVCA), funding for African startups was on track to hit record levels as venture capital deals reached $3.5 billion in the first half of 2022 alone – more than double the amount raised in the same period in 2021.

This year, however, according to the African Private Capital Association’s (AVCA) Venture Capital Activity Report, Africa’s startup investment landscape faced significant headwinds as venture capital decreased by a whopping $1.4 billion (43%) in the first six months of 2023.

In this challenging financing landscape, venture debt (a type of loan aimed at early-stage, high-growth companies with venture capital backing) could prove to be particularly important for Africa’s SME ecosystem and the continent’s growth as a whole.

Unlike with other types of lending, SMEs will not need to showcase any positive earnings or cash flow in order to receive venture debt funding. As such, access to finance is exponentially improved in comparison to traditional equity.

Able to be used as performance insurance, funding for acquisitions or capital expenses, or to bridge the gap between venture capital rounds and carrying strong and stable interest rates, venture debt is extremely attractive for both SMEs, fund investors and development finance institutions alike.

The International Finance Corporation (IFC) mentions that with around 51% of all Africa’s startups and SMEs in need of more funding than they can currently access, Africa’s potential for growth is becoming stuck in a state of stagnation.

Improving access to funding will help to equip SMEs with the tools and resources needed to innovate, create and discover in ways that entire communities stand to benefit. Venture debt offers the continent a well of potential to empower SMEs to bring their groundbreaking ideas to life and drive Africa’s growth, development and competitiveness.

By Nathaniel Nyika, Chief Investment Officer at Norsad Capital.

Disclaimer! Opinions expressed in articles do not necessarily represent those of the Corporation.

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