Where and how you get fund to finance your business operation is very crucial in determining success or failure of your business
In previous articles, we saw that it is critical to have fund enough to sustain your business operations for at least first six months or one year . After those six months you must have evaluated the performance of your business and be able to forecast its future performance.
If your business is promising, the next key thing now is to think of expanding it. Getting an ideal source of fund is key at this stage.
In this article we will discuss informal sources of fund and how to effectively utilize them for your business prosperity.
There are a number of informal sources of finance that an entrepreneur can use to access financing. Informal sources of finance are normally characterized by lack of contract documents. However the borrower in most cases is well known by the lender. In Tanzania the mostly used informal sources of finance includes; relative and friends, money lenders and rotating savings and credit associations. Below is a detailed elaboration on each of the commonly used informal sources in Tanzania.
Relatives and friends.
This is by far the most commonly used informal method of sourcing finance. With this source of financing MSMEs borrow from relatives and friends to finance their businesses. Some of the reasons why MSMEs opt for family and friends financing includes:
- Easy to approach: Entrepreneurs can easily source funds from family members or a friend through a simple agreement struck between them. In most cases, the borrower and lender have a personal relationship and do not need any formal introduction. This makes it easy for the entrepreneurs to approach the relative/friend and seek for funds.
- Few requirements: In comparisons to banks and other formal sources relatives/friends normally have fewer requirements. Many entrepreneurs do not have proper books of accounting, business plans, business licenses, perfected collateral or guarantors which are required by the banks and Microfinance Institutions (MFI). The financing is usually based on a gentleman’s agreement between the parties.
Despite lesser requirements, there are some disadvantages associated with sourcing funds in such fashion including:
- Small loan size: Many of the entrepreneur’s friends and relatives have limited funds and may not be in a position to provide finance to the level that the business require. This leaves the entrepreneur sourcing for funds from other sources and could potentially lead to multiple loans that normally are difficult to service.
- Not reliable: One disadvantage associated with relying on relatives and friends for financing is that at times they do not hold their end of the bargain. This leaves the MSME in a precarious position more-so if the expected funds had been factored to the working capital budget for expenses such as stock purchases, rent payment and salaries. In the situation where relative or friend does not provide the financing as agreed, the MSME has little recourse and there is not much s/he can do.
- Interference: Many times when relatives and friends have financed an MSME, they want to be involved in making decisions for the business. Some of these decisions are detrimental to the business. It is important for the MSME to limit the involvement of relatives/friends to providing finance only.
Another commonly used informal source of financing for MSMEs is through money lenders.
In Tanzania we have currently seen people of the same interest forming saving groups which allow them to collect agreed amount of money from each member every month. These groups are commonly known as Vikoba. After saving for a certain period they start lending to people including businessmen and women.
Money lenders usually demands for collateral that is many times more valuable than the loan borrowed to be deposited in their custody. In the event when the MSME fail to service the loan, the lender sell the collateral and recoups their money. Benefits of sourcing finance from money lenders includes;
Quick processing: In the event that the MSME requires money on short notice then s/he may go to a money lender. Upon satisfying the set requirements almost all the money lenders disburse cash on the spot without any delays.
It is worth pointing out that there are serious challenges of using money lenders as sources of business funds such as:
- High cost of funds: Majority of money lenders charge very high interest rates that are compounded frequently on the borrowed funds. When the borrower fails to service the loan then the outstanding balance balloons to huge amount that are many times equivalent to the initial borrowed funds. Many MSME have difficulties in servicing loans from money lenders and end up losing the collateral that is many times more valuable than the loan borrowed. MSMEs are advised to avoid borrowing money from money lenders unless it is very necessary and they are very sure that they can service the loan in the agreed duration.
- Miscommunication of interest rates, fees and penalties: Many money lenders communicate the interest rates charged on loans very attractively but do not disclose that they compound the interest to the principal. This causes a situation where MSMEs are always behind on their loan repayments leading to further penalties that further raise the outstanding loans. MSMEs should be very careful and make sure that s/he understands all the costs related to the loan and how they are calculated.
Rotating Savings and Credit Associations (ROSCAS):
Many MSMEs are members of Rotating Savings and Credit Associations (ROSCAS) in which they save and extend credit to each other. The members contribute a prescribed amount of money regularly and then the total/part of the money raised is given to one of the members during each meeting until all the members have been covered. Some of the advantages for a MSMEs to raise funds through ROSCAS are:
- Affordable: MSMEs make savings in the ROSCAS by making small contributions. In each meeting -which is done in most cases once every month, a member who is in need of money is given a loan. ROSCAS charges very little interest to members making the funds cheap.
- Few requirements: There are few requirements in sourcing funds from ROSCAS. All that is required is for the MSME to join a ROSCAS and make the required contributions. This makes ROSCAS attractive to MSMEs as they do not have to meet the normally stringent requirements of formal sources or charged punitive interest rates by money lenders.
There are some shortcomings associated with ROSCAS that the SME should be aware of. They include:
- Loss of monies: The ROSCAS are informal groups and normally are not registered. There are cases where some members of a ROSCAS receive money and then fail to make further contributions to the ROSCAS. In such cases those members that had not received contributions from the ROSCAS end up losing their money.
- Small loan amounts: The funds that are advanced to ROSCAS members are limited to the contributions they collected in their meetings and ultimately only amount an individual member’s savings. This is because ROSCAS do not charge fees or high interest hence they do not have any other source of funds. In most cases these funds cannot meet the financing need of the entrepreneur.
Let us end here for today, next week we will discuss about formal sources of finance.
Prepared by Veneranda Sumila
Tanzania Private Sector Foundation (TPSF)