Financing Small Businesses in Tanzania: Opportunities and Challenges for Entrepreneurs and Investors
Small to Medium Sized Enterprises (SMEs) in Tanzania
Small businesses are a big deal in Tanzania today: Tanzania’s small-to-medium enterprises (SME) sector is estimated to consist of more than three million businesses, contributing to 27% of the country’s overall Gross Domestic Product (GDP). This large number of small businesses underlies Tanzania’s need for investment capital and presents opportunities for both entrepreneurs and financial services providers.
For this rather obvious reason and others we will examine later in this post, Tanzania now has a huge need for financing for SME capital investment, raising challenges that can be met for great rewards for entrepreneurs and investors alike. But before getting into small business financing in Tanzania, what exactly is meant by SMEs according to the government, entrepreneurs and investors?
According to the Government of Tanzania, two-thirds of enterprises are categorised as micro (66%) with less than four employees; just under a third (31%) are categorised as small businesses with 5 to 49 employees, and the remaining 3% as medium with up to 99 employees. As we will see, banks and other large financial institutions tend to favor larger businesses for lending and investment. While there are some smaller financial services companies that focus on SMEs, the need for small business capital is far from being met, which is currently making Tanzania’s small businesses struggle needlessly.
Tanzania’s estimated three million SMEs are mostly urban, and split by sector across trade (55%), services (30%), manufacturing (14%) and other (1%). Rural SMEs have a similar split, with slightly more (4%) manufacturing than urban SMEs, which is surprising because rural areas typically have much lower electricity access rates, and electricity is usually a prerequisite for machinery for manufacturing purposes.
Trade and service sector small businesses, which make up the majority of both urban and rural small businesses, are generally more difficult to finance via traditional methods such as bank loans. This situation poses an immediate threat to the growth of small businesses in these sectors, but one that can be remedied with innovative investment methods such as angel investing, to which we will soon turn.
The Government’s “Tanzania Development Vision 2025” highlighted the SME sector as one important contributor to the country’s long-term development, noting that SMEs comprise enterprises with different characteristics that must be taken into consideration to foster small business growth. Common differentiating characters are size, sector, location, business life cycle, and ownership profile (gender, education, etc). Based on these characteristics, SMEs have different needs for financial services and products.
Financing in Focus: Challenges Faced by Small Businesses in Tanzania
It is important to keep in mind that some key challenges remain for the development of small businesses in Tanzania. These challenges include unfavorable legal and regulatory frameworks, undeveloped infrastructure, poor business development services, limited access to financing, and ineffective and poorly coordinated institutional support framework.
Among these challenges, access to finance is the most critical. To address this major problem for small businesses, the Government of Tanzania is currently working with the World Bank on a new US$150 million financial intermediary lending operation designed to increase access to finance for SMEs. However this lending operation is not the only, and is certainly not the best, solution to the financing problem facing small businesses in Tanzania.
Tanzanian SMEs employ around 5.2 million people, and most employees (80%) are the entrepreneurs themselves or relatives or friends of the entrepreneurs. Most businesses are informal, with only 3.9% registered with the Business Registrations and Licensing Agency (BRELA). Registration processes require certification and registration with tax authorities, among other regulatory bodies, which provide additional documentation to secure financing in the form of loans or investments.
It is more challenging for informal businesses to secure financing from formal lenders and investors, so many turn to informal sources, or simply don’t get financing at all, which severely limits their growth potential. Yet there are many options for small businesses to receive funding in Tanzania. What are these financing institutions and why are they failing to finance small businesses? What can be done differently now and in the future?
Solutions or Problems? Current Funding Sources for Small Businesses in Tanzania
Tanzania has sixty-seven banking institutions offering various commercial and consumer financial products, but these are usually only offered as larger loan amounts to certain customers and in certain sectors — those that are familiar to the banks and consequently lower risk. This reduces the banks’ ability to reach more niche areas with typically lower socioeconomic profiles, where there is more uncertainty and higher risks with smaller loan sizes and higher transaction costs.
Bank loans for small businesses are generally offered at a very high interest rate, require considerable collateral and documentation, take a long time to secure, have rigid repayment schedules and often are of very short terms. Despite these shortcomings, many small businesses in Tanzania see bank loans as the only possible source of funding, and give up seeking funding if they are unsuccessful with banks.
In the face of this unfavorable bank loan situation, groups of people have begun to self-organise and form semi-formal and formal variations of Village Community Banks (VICOBAs) and Savings and Credit Co-Operative Societies (SACCOs), as well as other types of lending institutions, or microlenders. It must be stressed that these microlenders do exactly that, offer loans to small businesses, not investments, and do so on terms that are only slightly more favorable to small businesses than large banks.
For microlenders such as VICOBAs and SACCOs, overhead is usually minimal, which allows these groups to charge lower interest rates than banks, at around 5%. The loan amounts are limited by the number and amount of member deposits, and it can take months before an individual member can access a loan. More recently, SACCOs have been capitalising funds from commercial banks and government funds at low interest rates for lending. This has opened up more financing options for rural and poorer customers.
Funding in the Small Business Lifecycle
Most small businesses in Tanzania start their businesses using their own savings and seek financing only as their businesses grow. There are numerous factors hampering small businesses’ access to finance. According to the Financial Sector Deepening Trust (FSDT), an intermediary operating in Tanzania, seed capital for small businesses in Tanzania typically comes from entrepreneurs’ own savings or from family and friends. About half (49%) of all respondents to their survey said that they had not previously borrowed from formal or semi-formal financial institutions.
According to the SME 2012 National Baseline, only around 20% of MSMEs reported that they had taken out a loan in the previous twelve months. A majority of those experienced problems: 28.6% reported that “it took a long time” to borrow money; 9.7% said that they could not secure the amount they needed; 6.7% stated that they did not have collateral; and 5% stated that getting a loan had “many conditions”.
Only a small percentage (4.8%) of MSMEs nationwide reported experiencing no problems in securing a loan. This is in contrast to other surveys, where 37% of those who borrowed reported no challenges. While very different methodologies and sampling were used in the surveys, it is speculated that because financial access has increased, more people are able to access the loans that they need with fewer challenges.
These surveys on loans to small businesses highlight that it is difficult or even impossible for early stage small businesses to receive funding from any type of financial institution, and that there is a strong tendency among lenders and investors to limit their financing to small businesses to those that have a proven track record. Venture capitalists and angel investors are, in theory, supposed to be more interested in seeding small businesses, but they too stress that they are more keen on businesses that are growing and poised to grow.
It seems as though startup small businesses in Tanzania are stuck between a rock and hard place when it comes to financing. Are there any ways out?
The Small Business Capital Markets in Tanzania
It appears that for Tanzanian entrepreneurs, the lower the investment required, the higher number of businesses flock to start in certain sectors. A majority of the small businesses in Tanzania are in clothing and tailoring, furniture industry and food processing industries with women being major players in these sectors. The reason entrepreneurs go for these sectors is not growth potential or profitability, but mainly due to the low costs associated with investments as well as the fact that these sectors do not need sourcing of materials from outside the country.
Would small businesses in Tanzania benefit from more effective investments in other sectors as well? Would more of Tanzania’s three million small businesses flourish as a result? The answers are clearly yes and yes.
Tanzania’s small businesses are rarely if ever able to borrow medium and long-term capital investment funds from banks. There are multiple reasons for this: being unable to provide real estate security enough to make them bankable; banks not accepting manufacturing machinery; and interest rates being too high to borrow in the medium to long term. Finance leases are often recommended as a means to solve such difficulties in financing small businesses, but there is an even more potent solution available today: angel investors.
Small business financing is a blip in the radar of most banks in Tanzania. The percentage of SME finance to total loans outstanding is 11% for the CRDB and 8% for the NMB and NBC, the largest banks in Tanzania. Clearly, small business finance is not a main business activity for banks. Microlenders do contribute to the financing landscape of small businesses in Tanzania, but again they provide loans not investments. That’s where angel investors can and are stepping in.
Access to finance is the key to the survival, let alone growth, of small businesses. Angel investors, by requiring equity for their investments instead of collateral for loans, are in a unique position to empower Tanzania’s small businesses and position them for growth. Moreover, the advisory services angel investors often provide along with their financial services provides valuable support to entrepreneurs looking to build their businesses. Small businesses may not qualify for venture capital, but they can for angel investment. The angel investment arena in Tanzania is in its beginnings but, as explained in this post, poised for rapid and long term growth. Small business entrepreneurs and investors are set to gain.
A Glimpse at the Global Picture for Small Business Financing
Tanzania is not the only place in the world suffering from “financingitis.” Indeed, it is a global epidemic which is hurting economies worldwide. To conclude this post on financing small businesses in Tanzania, it may be helpful to put its prospects and problems in a wider context in order to show that so goes Tanzania’s small businesses, so goes the world’s.
Data from the International Council for Small Businesses (ICSB) shows that SMEs globally account for 70% of employment and half of GDP. One dataset from the International Finance Corporation (IFC) shows that across 132 low- and middle-income countries, there are 29.9 million formal SMEs and 285 million informal small businesses.
Yet another study shows that for 31 low- and middle-income countries, more than 744 million jobs are directly attributable to SMEs, with small businesses contributing about 63% of those jobs, underlining the importance of small businesses to jobs in low- and medium-income economies. Clearly, as in Tanzania, small businesses worldwide are a force to be reckoned with, and have needs and requirements of their own to be sustained and grow, notably financing, as we have seen in this post.
One of the keys to stimulating these millions of SMEs is financing. But there is a huge gap in meeting their financing needs. At the global level, the IFC estimates that formal SMEs require US$8.6 trillion in financing, with only about US$3.8 trillion — just 44% of total demand — being met. Approximately 28% of SMEs in middle-income countries and 44% in low-income countries need a loan but refrain from applying.
This post has presented some solutions to the small business financing crisis in Tanzania, and they apply to other countries as well.