Microequity

This is something I've been thinking about for a long time now (several years) and I finally decided to get it on paper, at least in very rough draft form. If you aren't interested in development, skip this post - nothing about georgian life here :-)

The concept of microfinance has been proven to be a solid driver of both entrepreneurial growth and development across the globe. However, as innovative as microfinance products have been, the co-development of microequity has either completely stalled or simply hasn’t happened.

I believe this has happened for a variety of reasons.
1) Structured debt products are easier to understand, and in a limited rule-of-law society offer less risk to the lender. The default/no default matrix is a simple binary – either the recipient pays the loan, or they don’t. There’s not a lot of gray area. Most developing countries have experience with debt products and have a legal framework for lenders.
2) Investment vehicles are not understood, or there is a lack of legal structures encouraging co-investment.
3) The cash flow from microequity does not have the stability that cash flows from microfinance has. Microfinance has a relatively steady stream of incoming cash to operate the firm; microequity would have an extremely irregular cash flow situation. Planning for operational sustainability is therefore much more complicated.
4) The level of trust between the entrepreneur and the firm has not reached a necessary level to support full and open cooperation. By this, I mean that there is a potential for fraud from the part of the entrepreneur – keeping two sets of books, failing to disclose cash receipts, etc. which destroys the equity relationship. The debt model operates on the fear of retribution (ie, failure to service the loan results in personal harm – my home is repossessed, etc) while the failure of an equity investment does not. Finding sufficiently high levels of human capital is a critical component.
5) Difficulty in obtaining a payout, either in the form of an equity buy-back from the entrepreneur, a dividend stream, or business sale.

There are, however, substantial advantages to a microequity framework that are separate from a microfinance framework.
1) Businesses that have delayed or unstable cash flows are able to finance operations through stable equity investments, rather than debt. This encourages entrepreneurs to create businesses that may have unstable or delayed cash flows, but have long-term profitability and sustainability. The emphasis on current cash flows for debt service is valuable, but many business models cannot generate the necessary current cash. An equity model offers more flexibility in creating businesses for the long run.
2) It aligns the needs of the firm and the needs of the entrepreneur together. Rather than a lender/debtor model, we create a partnership model. Aligned interests offer a greater chance of success and cooperation than the arm’s length model from lenders.
3) Higher risk investments may be made more easily, and it encourages entrepreneurs to take risks that they might not be able to afford otherwise. Debt financing supports risk-aversive models; equity finance models allow for a greater measure of risk, and, consequently, a greater potential reward. Here I do not mean investments that encourage poor choices or bad management. Rather, I mean risk in a purely economic sense – the potential for the enterprise to fail.


The steps to an equity investment from a model microequity firm.
1) Scan the environment and find will entrepreneurs with either currently running businesses or business plans.
2) Build trust with the entrepreneur and community, before any investment is made. This is done through free trainings and seminars on the basics of investments and the concept of cooperative financial action.
3) Begin to build a portfolio of possible investments to be made. The selection criteria would be critical, and will be developed at a later time.
4) Audit the enterprise and create accounting controls and ensure transparency as a prerequisite to the creation of a term sheet.
5) Create and explain the term sheet to the entrepreneur, and clearly lay the groundwork roles and responsibilities in the enterprise. The standard investment would be as a limited partner or whatever local legal structure offers limited liability. Clearly define the liquidity mechanism – buy out, dividends, business sale – and delineate responsibilities and roles.
6) Make the actual investment into the enterprise.
7) Monitor the enterprise with frequent audits and business education; maintain the connection to the entrepreneur with frequent meetings.
8) Achieve growth and the liquidity event or begin a stable stream of dividends based on current cash flow.
9) Roll the portfolio.

Potential difficulties
1) Equity investments are often much more costly to the entrepreneur than debt instruments. By this, I mean that the relative share of cash flows returned to equity investors of the life of the firm may far exceed the cost of debt service, had debt been utilized for the amount of the initial equity investment. I highly doubt that most entrepreneurs in the developing world think this way, but it is possible that sophisticated entrepreneurs will realize the costs involved in selling part of their equity.
2) Fraud is high on the list of possible concerns.
3) Fair valuations of businesses are extremely difficult; the relative sophistication of the entrepreneur involved will have a definite impact on the valuation process.
4) Governmental/currency instability is a definite risk not found in developed countries.

Microequity would be the process of investing in small business through equity-side purchases and investment, rather than structured debt or loan products. The substantial downside of structured equity are the long payoff timeframes and the associated risk of business failure.

In the case of microequity, these concerns may be alleviated by the usage of best practices risk management and cooperation with the entrepreneurs to align their interests and the interests of the microequity firm.

The techniques of venture capitalism can be applied to the developing world as easily as they are applied in the developed. Entrepreneurs, when given the chance and the education, could readily see the value in having an institutional partner for their business. Guidance, education, and

Microequity is best suited to working with small to medium sized enterprise, or startup enterprises run by seasoned entrepreneurs. Small enterprise I define as enterprises that employ 3 – 10 people; medium sized enterprise employ 10 – 50. The employee levels are arbitrary but establish a critical point: there must be enough cashflow from the enterprise to generate returns to scale.

Microequity would run on the same principles of microfinance: using investment officers that speak the local language, live in the community, and personally know the entrepreneurs involved. It is not efficient or effective for the day-to-day operations to be run by foreigners [outsiders] of the community. The face of the institution needs to be one that is recognizable to the community (same principle as microfinance – you are less likely to cheat your neighbor than a foreigner).

Microequity would work best in transitional economies. These are countries that have had substantial improvement in basic conditions, but are still definitely not ‘developed’ in the traditional sense of the word. A relatively strong rule of law, stable currency, and high-quality entrepreneurs are required. As an aside, if the court system is used to enforce a term sheet or contract, the system has failed. The prescreening of entrepreneurs needs to be focused on the qualities of the person and their ability carry their side of the deal to fulfillment without using the legal system.

The initial funding of the microequity enterprise would be grant money, probably from USAID or similar organization. In general, like most MFIs, a MEI would be a for-profit institution. The eventual goal of the organization is sustainability through the rolling of investment funds. Eventually, private investors could be solicited to invest in the future of the developing world.

If you have any comments, or know of any similar systems being developed/utilized, I would love to hear about it. Any suggestions/feedback would be appreciated. Heck, if you just want to swear at me for using the developing world, do that too….