Expanding financing options for tech-based SMEs

July 10, 2024

Startups showcasing their business at the Digital Startup Marketplace in Addis Ababa, 2023

Small and medium-sized enterprises (SMEs) play a major role in emerging economies, contributing significantly to national GDP and job creation. SME development has therefore become a priority for many nations, including Ethiopia. Unfortunately, however, access to finance has become a significant hurdle for SMEs and start-ups, particularly for those in Ethiopia where the national financial sector’s mandate and ability to support and fund innovative projects and enterprises is severely limited.

The funding gap for SMEs in Ethiopia was estimated at $6.1 Billion in 2021. The root causes of this financing gap in Ethiopia are multifaceted, with high collateral requirements imposed by financial institutions and steep borrowing costs being among the primary challenges. These financial hurdles leave many innovative and promising small businesses struggling to secure the funds they need to sustain and grow their ventures.

The National Bank of Ethiopia's 2023 report on financial stability revealed that commercial banks held a total of Birr 1.9 trillion in loans and bonds as of June 2023. Surprisingly, 73% of these loans were concentrated among only 0.05% of borrowers, each of whom received loans exceeding 10 million Birr. As a result, a few large borrowers dominate the financial sector's lending, making it difficult for SMEs and startups to obtain loans from commercial banks.

On the other hand, Microfinance Institutions (MFIs), which are designed to meet the needs of small businesses, account for only 2% of total financial sector assets. By June 2023, MFIs had directed the majority of their loans to the trade sector. They are primarily focused on traditional sectors, leaving little room for SMEs in the emerging technology sector to access finance.
While lending to startups and SMES is limited, there are sector-specific preferences, nonetheless. Emerging industries, such as technology-based services and products, are more likely to be perceived as too risky. "We don't know much about tech business models, so it's difficult for us to assess their loan repayment capacity," explained a loan appraisal officer at a microfinance institution. The lack of experience in an emerging market limits tech startups' ability to obtain business loans.

To address these challenges, the UNDP Innovation for Development project established a $1 million USD Credit Risk Guarantee Fund (CRGF) at Ethiopia's Development Bank in 2023. The CRGF guarantees 50% of loans made to startups in the ICT sector by banks and MFIs. This guarantee significantly reduces the collateral requirements for these loans, while also providing financial institutions with familiarity and exposure to technology startups.

The CRGF aims to change financial institutions' perceptions of startups and SMEs, which are frequently viewed as high-risk and unsuitable for lending. The CRGF acts as a de-risking mechanism by providing a 50% guarantee that will be paid out in the event of default, encouraging financial institutions to lend to ICT startups and SMEs. This initiative not only shares the risk, but also assists financial institutions in meeting their SME lending quotas.

By providing technically qualified SMEs with this guarantee, the CRGF aims to demonstrate that these businesses are viable investments, thereby fostering a more supportive financial environment for tech startups in Ethiopia. This is a crucial step towards integrating SMEs and startups into the financial ecosystem, ultimately contributing to the broader economic development of the country.

Signing ceremony for the establishment of the CRGF attended by the UNDP RR, President of DBE, State Minister of MInT and MoLS at the

The CRGF has thus far provided guarantees to 11 loans to tech startup totaling to ETB 25.5 million. The loans were provided by 4 banks and 2 MFIs to 6 and 5 SMEs respectively. Two other SMEs are under process for their loans with a bank and an MFI.5 of the SMEs have started repaying the loan while the rest have still in the grace period to begin the payment.
Because this was the first time for UNDP and for the tech sector to take part in guarantee scheme, we designed a leaning exercise to identify what has worked well and what needs to be improved in our operational procedures. The learning session was conducted with key stakeholders including the Ministry of Innovation and Technology (MInT), the Development Bank of Ethiopia (DBE), financial institutions, and startups. to get an idea of their experience and what needs to improve. The goal of the session was to get insights from their experiences and identify areas that needed improvement. The following are the key findings of the review and our intervention strategies for resolving them:
Loan Capability: as much as financial institutions are doing appraisals for the businesses that they want to provide loans to; the business also needs to make sure that they are ready for loans and that the loan terms are agreeable to them. What we have seen in the first rounds is that this understanding is not universal among the startups and SMEs. For most of them. The CRGF process is their first time interacting with a formal financial institution and processing loans, so they are not aware of their responsibilities and requirements as part of the process. This has created delays in the loan appraisal process. Moving forward, we are putting in place an orientation session for startups and SMEs before they begin the loan process to help them understand what is required of them and what would be profitable for their businesses.
Islamic Lending: Islamic banking has been growing significantly over the past 10 year in Ethiopia with just commercial banks providing Islamic banking services and three full Islamic banks in operation. Requests for Islamic lending services have been seen during the CRGF. While banks do provide Islamic services to existing customers, MFI do not have that service capability. To accommodate this need, the project will explore adding the Islamic banks to the list of financial institutions that can access the Credit Risk Guarantee Fund.
Lending Restriction: In August 2023 he National Bank of Ethiopia introduced a credit cap at 14 % to fight against the inflation in the country. This means that commercial banks can increase their lending portfolio by 14% every year. This is one of the most common challenges that was raised among the financial institutions during our assessment as it limits their ability to support new customers. Given that the CRGF is focused on the SMEs, one of the suggested ways to mitigate these challenges is to create an exemption for loans provided to SMES to not be considered part of the cap. This will take negotiations with the relevant government stakeholder and UNDP will facilitate this discussion through the Ministry of Innovation and Technology.
In addition to the above-mentioned areas, the willingness and readiness of FIs to accommodate the lending operation for SMEs and Start-ups as they felt the process is cumbersome and has huge transactional cost is important. Financial institutions expressed significant concern about the time-consuming process and high transaction costs associated with lending to SMEs and startups. This concern underlines the vital need for streamlining processes and reducing transaction costs to make lending operations more efficient and appealing to financial institutions.

Moving Forward
The CRGF has started the second round of evaluating applications from ICT-based startups and SMEs. We are committed to continuously improving our operations and look forward to sharing our insights and best practices as we move forward. Our goal is to improve financial tools for SMEs and startups, giving them the resources, they need to thrive and contribute to Ethiopia's economic growth.

Stay tuned for more updates as we continue to innovate and support the entrepreneurial ecosystem in Ethiopia.

*** This blog is written by Wudasse Berhanu Berke, Program Analyst, UNDP