SMEs need to tap financing prudently

Small businesses are one of the most important sectors of the UAE economy. In Dubai, for example, there are around 72,000 SMEs, making up 95 per cent of all businesses. They are responsible for around 40 per cent of the emirate’s GDP (gross domestic product) and employ over half of the total workforce. One of the biggest challenges faced by many small businesses is access to capital. Historically, small businesses have relied on local banks, but when lending dried up post the credit crunch, this meant they were amongst the hardest hit.

Unfortunately, other forms of finance slowed alongside bank lending. Private equity and venture capital also started to leave the region, and international banks became increasingly chary of smaller clients. But we are now starting to see initiatives to address this problem. Last year, the Dubai Financial Services Authority (DFSA) cut the necessary market capitalisation for initial public offerings (IPOs) from $50 million (Dh183.6 million) to $10 million, allowing smaller companies to take part. Now, Nasdaq Dubai plans to design a new market for small companies to list on, further helping provide access to capital. At the same time, banks are announcing that they will increase their SME lending this year, thanks to improving economic growth.

This will undoubtedly improve the climate for small businesses, but prudent companies will want to ensure they access the right type of finance for their needs. Moreover, increased bank lending may be beneficial in the shorter term, but experience in some overseas markets — especially Europe — shows that if interest rates are squeezed, lending will contract again. So, for SMEs looking for capital, it is worth considering all of the financing options.

In it for the long run

Long-term investment, such as business expansion, acquisition, or property, requires long-term financing; loans that mature in three to four years are of little help if a profit cannot be turned around in that timeframe. This is where equity and debt finance are key. Major investments such as overseas expansion or significant product development may require equity financing. This is where schemes such as that proposed by Nasdaq Dubai will be able to provide a solid benefit to businesses. However, issuing equity finance to the public via listing on an exchange has significant ramifications for the way that a business is structured and run, and makes certain demands in terms of corporate governance and reporting. Some companies may, therefore, prefer to issue equity finance privately to investors.

Historically, SMEs have often been reluctant to issue private equity finance as they are concerned about “losing control”. But, there are some activities that banks will not lend to, and this is where investors and business angels can present a solution. Increasingly, there are networks of business angels who are looking to provide seed capital to start-ups or early-stage ventures in the region. When dealing with equity investors, it is important to remember that their priorities will differ from that of the business owners. The level of risk they are undertaking means, justifiably, that they will be expecting high returns — often over 50 per cent. They will also be looking to exit the relationship with the business after a set time period, usually between three and seven years. On the other hand, they can bring corollary benefits; business and management expertise, often in a relevant sector, and a wider range of business and service contacts that could prove invaluable.

Raising capital quickly

Businesses looking for working capital, on the other hand, will usually be looking for shorter-term financing. In addition to the traditional routes of bank overdrafts or obtaining credit from suppliers, there are mechanisms such as factoring (where companies pledge or sell their receivables in return for immediate cash) and invoice discounting (drawing money against sales invoices). In addition to raising short-term working capital, this can also reduce administration overheads. However, both of these mechanisms are comparatively expensive compared to bank loans or overdrafts, and can also pose an element of reputational risk, as financing debts can be taken as a sign that a company is in distress.

Changing the face of SME finance

Finally, technology has revolutionised finance through the growth of online peer-to-peer (P2P) lending portals and crowdfunding, allowing both businesses and investors to diversify their risks quickly and cheaply across a wide group of counterparties. In the past, this ability to diversify has not been available to individuals, and in some overseas markets — where low interest rates make conventional lending unattractive — the growth of P2P is showing signs of changing the traditional closed lender-borrower relationship. It is likely that the completion represented by online P2P finance has the potential to alter SME financing in the longer term.

While access to finance is still a significant challenge for many small companies in the UAE, the situation is improving, and it is gratifying that providers and regulators are recognising the importance of the SME sector to the region.

— The writer is regional director, ICAEW Middle East.