1. Private equity can play an important role in financing small and medium enterprises in developing economies, which currently face a financing gap. 2. However, private equity has had limited success in some regions like Africa due to challenges such as a lack of local presence, low familiarity with private equity models, short-term business horizons, and difficulties finding well-managed companies. 3. For private equity to be more effective, firms may need to take a more local approach, have longer investment horizons, and find ways to build trust to overcome issues like a lack of transparency.

1. Financing opportunities
Pontus Engström, PhD, MSc
Session 3

2. Financing of a firm is usually done through either
DEBT or EQUITY
2

3. Difference between Debt and Equity
3
ASSETS
EQUITY
DEBT
Business sales

4. DEBT FUNDED 2017 2018 2019 2020 2021 2022 2023 2024 2025
Sales 100 110 121 133 146 161 177 195 214
Opera4onal costs 40 44 48 53 59 64 71 78 86
Interest expense 100 100 100 100 100 100 100 100 100
Profit -40 -34 -27 -20 -12 -3 6 17 29
Debt 1000
Interest 10%
EQUITY FUNDED 2017 2018 2019 2020 2021 2022 2023 2024 2025
Sales 100 110 121 133 146 161 177 195 214
Opera4onal costs 40 44 48 53 59 64 71 78 86
Profit 60 66 73 80 88 97 106 117 129
Investor return 6% 7% 7% 8% 9% 10% 11% 12% 13%
Equity 1000
Required return: 10%
4
Illustrative example

5. Pecking-order (Myers and Majluf, 1984)
Capital structure emerges as a result of the
various financing options available to the firm,
where internal is preferred if available.
Trade-off choice (Myers and Majluf, 1984)
The firm weighs the costs and benefits of
additional and different forms of financing, for
instance tax benefits.
Theories of financing
5
CapitalStructureDebtvsEquity(%)
Size

6. Size – Larger firms have less earnings volatility and are better clients than
small firms, but on the other hand larger firms can accumulate more
resources and use relatively less debt
Asset Structure – Firms with more tangible assets tend to use more debt
and more external financing than firms with less
Intention to grow – contradictory and inconclusive results
Firm profitability – Pecking order suggests that the better the financial
performance the less likely to use debt. Trade-off theory predicts a positive
relationship primarily for tax purposes. Contradictory results, possibly a
curvilinear (concave) relationship.
Entrepreneur characteristics – Better education and human capital
(financial literacy) seem to be important, but research shows that overall
firm characteristics are more important than entrepreneur characteristics in
the financing decision
Factors affecting financing decision – firm
characteristics most important

7. Fred Wilson: Union Square Ventures:
“The amount of money that start-ups raise in their
Seed and Series A rounds is inversely correlated with
success.”
Let’s Face an Uncomfortable Fact
7

8. Talk with your neighbor
• 1 minute
• 2 top reasons, please
Why Might This Be So?
8

9. My take on it:
• Too much money makes you sloppy, stupid
• Plan A rarely works. But your funder wants you to
(flawlessly) implement it anyway!
Question: Might it be wiser to wait and seek to fund
customer traction, instead of a plan?
Why Might This Be So?
9

10. • Fact: the vast majority of fast-growing businesses
never raise venture capital (nor write business
plans, either)
• Nor should they, at the outset, I argue: why?
• Raising capital too early – whether from angels or
VCs – is a dangerous practice, on both sides of the
table
Let’s Be Candid…
10

11. • Distraction: takes the entrepreneur’s eye off the ball,
now, and later, too
• Higher risk = lower stake for the founder
• And the baggage that comes with it in the
shareholders’ agreement
• Is this good news for the investor in such a deal?
The Killer Drawbacks of Raising
Capital Too Early
11

12. Let’s Consider Some Evidence:
US Venture Fund Returns
12
Returns from inception to 12/31/11.
Source: Josh Lerner analysis of Thomson/Reuters data.

13. So, Is There an Alternative?
The Customer-Funded Business
13
Your
Customer
Pay-in Advance
Models
Matchmaker
Models
Subscription
Models
Scarcity-Based
Models
Service-to-Product
Models

14. Is anything new here?
14
Type Category-
defining
examples
Today´s
examples
Matchmaker
models
Real estate
brokers, eBay,
Expedia.com
Airbnb
Pay-in advance
models
Consultants,
architects
VIA
Subscription
models
Wall Street
Journal,
Showtime, Viasat
TutorVista,
Netflix, Spotify
Scarcity-based
models
Zara Vente Privée
Service-to-
product models
Microsoft Go Viral

15. Vinay Gupta 2006:
A Pay-in-Advance Model
15

16. Brian Chesky & Joe Gebbia 2007:
A Matchmaker Model
16

17. Krishnan Ganesh 2005:
A Subscription Model
17

18. Krishnan Ganesh 2005:
A Subscription Model
18

19. Jacques-Antoine Granjon 2001:
A Scarcity Model
19

20. Balder Olrik, Claus Moseholm 2003:
A Service-to-Product Model
20

21. 1. Negative working capital – love thy float!
2. They required essentially no external capital to get
started
3. When they did raise capital to grow once the
concept was proven, there was an eager queue of
angels or VCs lined up at their doors
These Examples Share
Three Attributes in Common
21

22. First, what NOT to do
Prepare
• Pages of prose
• Reams of spreadsheets
• All in support of the perfect Plan A (that probably
won’t get you where you’d like to go!)
OK, “So What?” As an Entrepreneur,
What Should You Do?
22

23. Mark Suster, Upfront Ventures
“I say ring the freaking cash register. I have said so
for years!”
In other words, get some customers, now!
OK, “So What?” As an Entrepreneur,
What Should You Do?
23

24. • Not necessarily. It’s the timing that concerns me.
• And it concerns Venture Capitalist´s too!
• If you’ve got a venture that’s firing on all cylinders,
perhaps yours, that’s when to add fuel!
So, Is Venture Capital – from Angels
or VCs – Bad for You?
24

25. Consider the rejection rates
• YCombinator 97.1%
• Angel List 98.9%
• Andreessen Horowitz 99.3%
• And it’s even worse in Europe!
Is pursuing customer funding a better way to spend
your precious time? And it’s cheaper, too!
But Can You Get Funded by a
Good Angel or VC?
25

26. “The customer is not just king.
He can be your VC, too!”
Bernie Auyang, Angel Investor, Shanghai
And it is hard work, “there are no shortcuts to success”
Olav Nils Sunde, Investor and Businessman, Oslo
In a Nutshell…
26

27. On the growth of small and
medium enterprises in
developing economies. The
role of private equity.
Financing
opportunities in
developing countries
27

28. • According to the World Bank, all low and middle income
countries with a GDP per capita less than USD 4,036
dollars.
• Higher income countries start at USD 12,476.
• Sweden has a GDP per capita of USD 55186, or 14 times
higher than a developing country.
Source: World Economic Outlook, April 2015.
What is a developing economy?
28

29. The world is divided – with Africa still behind
29
Source: www.gapminder.org

30. • Microenterprise up to 10 employees, total assets of up to
$10,000 and total annual sales of up to $100,000
• Small enterprise up to 50 employees, total assets and
total sales of up to $3 million;
• Medium enterprise – up to 300 employees, total assets
and total sales of up to $15 million
• Typically defined as FORMAL enterprises
Defining small and medium enterprises
30

31. According to the World Bank
• Create 4 out of 5 jobs
• 600 million jobs are needed over the
next 15 years (mainly in Asia and Sub-
Saharan Africa)
• More than 50% of SMEs lack access
to finance (70% including micro)
• 365-445 million micro, small and
medium enterprises (MSMEs) in
emerging markets: 25-30 million are
formal SMEs; 55-70 million are formal
micro enterprises; and 285-345 million
are informal.
Small and medium enterprises
7%
16%
77%
Formal
SMEs
Formal
Micro
Informal
MSMEs
31
“improving SMEs’ access to finance and finding solutions to unlock sources of capital is
crucial to enable this potentially dynamic sector to grow and provide the needed jobs.”
(http://www.worldbank.org/en/topic/financialsector/brief/smes-finance)

32. Higher income per capita has
more MSMEs per 1,000 people
32
Source: MSME Indicators, World Development Indicators
Note Statistically significant at the 5% level
Regional distribution –
more MSMEs in
MSMES are key to economic growth

33. • Private equity is a source of investment capital from high net worth
individuals and institutions for the purpose of investing and acquiring
equity ownership in companies.
• Partners at private-equity firms raise funds and manage these monies to
yield favorable returns for their shareholder clients, typically with an
investment horizon between four and seven years.
• These funds can be used in purchasing shares of private companies, or
in public companies that eventually become delisted from public stock
exchanges under go-private deals.
• The minimum amount of capital required for investors can vary
depending on the firm and fund raised. Some funds have a $250,000
minimum investment requirement; others can require millions of dollars.
• Typically a management fee of 2% and 20% upon gross profit from sale
of assets
What is Private Equity?
33
Private Equity often attracts top talent, consultants, and lawyers and often
require large transactions in order to be economically viable

34. The J curve effect
34

35. Interest in Africa has never been higher and it
continues to see strong interest from investors
– Ernst & Young 2015
Current status
35

36. Private Equity (PE) Exits in Africa hit record
levels in 2015, but is still only half of Europe
36
Source: AVCA

37. Between 2001 and 2014, 3100
companies received private-
equity capital
• 50% had revenues less
than USD 2 million
• 30% had revenues
between USD 2m and
USD 125m.
Increasing proportion of total capital raised
Private Equity in India
20%
31%
46%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
37

38. The impact of Private Equity in India
Positive impact
• 6% faster job growth
• 28% higher sales growth
• 39% faster earnings growth
• Improved strategic
capabilities
• 60% faster growth in exports
• More cross-border mergers
• Improved governance
Negative impact
• Minority interest led to little
influence and disputes over
strategy, value creation, and
timing of capital events
• Exit routes restricted - Of $51
billion invested in 2008, only
$16 billion were extracted in
2014 at a multiple of 1.4 (very
low).
38
Source: McKinsey & Co, 2015, Indian Private Equity: Route to Resurgence

39. 50-60% (200-250m) of MSMEs (formal and informal)
in emerging markets are unserverd or under-served
39

40. • Developing countries have a large number
of microenterprises and some large firms,
but far fewer small and medium
enterprises.
• In high-income countries, small and
medium enterprises (SMEs) are
responsible for over 50% of GDP and over
60% of employment, but in low-income
countries they are less than half of that:
30% of employment and 17% of GDP.
• This SME gap is called the 'missing
middle’ – but note that also large
companies in reality are missing to a large
extent
The Missing Middle
40
Source: Center for International Development at Harvard University

41. Evidence of the Missing Middle
41

42. LOCAL PRESENCE IS KEY
“I think that private equity very
well has a place in Africa. I think
the private equity firm must be
local. It must have a strong local
presence, because otherwise it is
difficult to bridge and
communicate about the
challenges that you have locally.
Thus, being in the same market, it
is easier to obtain mutual
confidence between the private
equity firm, and those who receive
money, the management of that
company.”
42
Source: Interview – 14 June 2016
Micael Edler – entrepreneur

43. EQUITY IS NEEDED BUT
AFRICA IS NOT FAMILIAR
WITH PE
“Africa needs much equity. That's
the challenge, and there Private
Equity has a role. It is difficult to
borrow money, and if want you to
speed up a project, yes then you
need to strengthen the balance
sheet with other people's money.
However, knowledge is generally
low in Africa if you take the help of
private equity companies.”
43
Source: Interview – 14 June 2016
Micael Edler – entrepreneur

44. EXTENDED HOLDING PERIOD
& CONSOLIDATE CROSS
BORDER
“I think that you should be
prepared to extend the time
period and I think that as a private
equity player one may be also find
companies in other parts of Africa
to create consolidation and speed
up Pan African solutions faster.”
44
Source: Interview – 14 June 2016
Micael Edler – entrepreneur

45. TRUST IS KEY
“Trust in Africa is generally low.
People deceive and cheat more.
People do not dare to invite
others in to own, or to be
transparent. There is often double
or triple book-keeping. Some
books for the employees, some
for the tax-authorities and some
for investors. This is of course not
ok.
45
Source: Interview – 14 June 2016
Micael Edler – entrepreneur

46. SHORT TERM FOCUS
“It is much more short term. As
we work with 5 and sometimes
10-year horizons, this simply does
not exist. There must be money in
the pocket now. Private Equity
companies often work on the
medium term as well, from 5 to 8
years at least. This perspective on
time is shared by very few in
Africa.”
46
Source: Interview – 14 June 2016
Micael Edler – entrepreneur

47. CREATING A WALLET, NOT
VALUE
“If you are an entrepreneur in
northern Europe, you know that
you have to follow the rules to
create value, whereas
entrepreneurs in Africa often see
this as a way of creating a wallet
where one early can extract
money. It is not value creation,
but a cash flow creation for own
consumption which preferably is
grey or black in order to avoid
taxation.”
47
Source: Interview – 14 June 2016
Micael Edler – entrepreneur

48. FEW WELL MANAGED
COMPANIES
“It is also difficult for PE
companies to find well managed
firms. Again, it is a matter of trust,
and of course they say they are
well managed, but then you see
quite soon that they are not, break
rules and misbehave.”
48
Source: Interview – 14 June 2016
Micael Edler – entrepreneur

49. Thank you for the attention!
Pontus Engström, PhD, MSc.
Stockholm School of Economics
E-mail: pontus.engstrom@hhs.se