African Entrepreneurs Need to Choose the Correct Funding Model When Seeking Investment 

Estimated read time 4 min read

If you ask most entrepreneurs what their biggest obstacle is, they most likely will say getting funding and investments. This is especially true in many of the largest entrepreneurship markets in Africa. 

For example, almost half of South African entrepreneurs stated in a survey conducted earlier this year by the Entrepreneurs’ Organization (EO) South Africa that they don’t receive enough funding from the public or private sectors. Conversely, according to a different East Africa Com survey, 59% of East African business owners cite a major obstacle to their operations as being difficult to get funding. In a similar vein, a 2021EFInA report discovered that 70% of Nigerian scale-ups and startups experienced difficulties obtaining funding after COVID-19. 

As important as improving access to that funding is, it’s almost as critical that entrepreneurs identify the funding models best suited to their business needs. The wrong funding model can, after all, mean that entrepreneurs end up over-diluting their equity in the business or taking on too much debt. But what do those funding models look like? And what advantages does each model offer?  

Debt vs equity  

One of the first distinctions that all entrepreneurs should understand is the difference between debt and equity-based financing.  

Debt-based financing simply involves borrowing money, usually at interest, from lenders. For some businesses, that may mean borrowing from traditional financial institutions such as banks. Others may instead go to private lenders. Regardless of how well or badly the business performs, the money lent must be paid back. That said, it does ensure that entrepreneurs retain a greater degree of control over their businesses.  

Equity financing, on the other hand, involves selling ownership shares (equity) in the company to investors, such as shareholders or venture capitalists. While it doesn’t create an obligation to repay any money, it does mean that entrepreneurs end up with a reduced stake in the business. And because they’re part owners, they may not have a full say in how the business is run. 

Choosing whether to take one approach or the other (or a combination of the two), largely depends on a company’s financial situation, risk tolerance, and its desire to maintain control or share ownership with external investors.  

Beyond the basics  

Beyond those basics, most organization’s that offer funding will provide a range of funding models. These include, but are not limited to:  

Senior debt finance  

Senior debt is a company’s highest priority debt that must be repaid first during bankruptcy. This kind of financing is typically secured against some type of collateral (the company’s physical assets, for example) although its can also be unsecured. In the event of bankruptcy or if the loan goes into default, the collateral of a secured senior debt facility may be sold to cover the debt. Unsecured senior debt holders can file claims against the company’s general assets. 

Untrenched finance 

Untrenched finance combines the various forms of debt held by a business into one loan. Under this form of financing, the borrower pays a blended interest rate and has a predictable repayment schedule that can be tailored to the borrower’s needs. Unitranche financing can enable medium-sized companies to access financing that would be impossible to get from a bank. 

Second lien finance 

Second lien debt is secured debt that ranks equally for payment with senior debt and shares the same security package. Second-lien loans are not debt subordinated to first-lien loans, only on the capital pledged to secure the loan. This means that in the event of bankruptcy, the second lien ranks behind senior debt in the receipt of proceeds from shared collateral. 

Mezzanine finance 

Mezzanine finance is a hybrid form of financing that includes aspects of debt and equity-based funding. In addition to being used for expansion or re-capitalization, mezzanine finance can be utilised to acquire other businesses, for management buyouts, and to minimise dilution of equity. Companies will usually consider mezzanine financing to finance business goals when they have reached their senior debt borrowing ceiling or want to preserve future senior debt capacity. 

Choosing the right model  

Knowing what these various models entail and what they’re used for should go some way to helping entrepreneurs figure out which one is best for them. That said, it’s worth breaking it down a little further. When deciding on a model to pursue, entrepreneurs should consider their capital needs, risk tolerance, how much (if any) ownership and control they’re willing to give up, the cost of the capital, and the negotiated terms offered by the lender or investor. 

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