NextBillion - An Initiative of the William Davidson Institute at the University of Michigan

There’s an endless variety of small and medium-sized enterprises (SMEs) in the world, varying widely in size and capacity for growth, and facing a vast array of different challenges and opportunities. So it might seem impossible to categorize the problems and growth patterns these SMEs face in a systematic way that is useful to entrepreneurs and small business owners. However, these businesses often experience similar problems that arise at similar stages in their development. These points of similarity can be organized into a framework that increases our understanding of the nature, characteristics and problems of SMEs – from those with just one or two employees, to the fast-growing tech startups of today.

In the 1980s and 1990s, a widely accepted framework emerged, summarized in a Harvard Business Review piece from May 1983. The article confirmed that SMEs grow in five stages, and that every stage of business development has its own set of unique characteristics, including challenges and milestones. These growth stages included: 1) Existence, 2) Survival, 3) Success, 4) Take-off, and 5) Maturity. But though this framework has provided a valuable basis for understanding business growth, a recent project that I have been working on with the William Davidson Institute* and other partners has forced me to revisit the SME life cycle. Through it, I’ve learned that the startup revolution of the 21^st Century has expanded the number of SME growth stages. In my opinion, there are now seven stages, including a pre-stage, which are discussed below.

The Seven Stages of SME Growth

Stage 0 – Idea: People in this stage have an idea (maybe even a great idea), and want to start a business – but they haven’t committed to becoming entrepreneurs or small business owners. They are still researching their service or product and potential customers.

Stage 1 – Development: The development stage is all about market validation, ensuring that their product or service has an existing market, and actually solves the problem identified in the Idea stage. This is where proof of concept and prototyping come in to test the market.

Stage 2 – Launch: In this stage, entrepreneurs and SMEs have decided to start a business and are actively building their market and refining their product or service. They might not have many (or any) customers, but they’re no longer sitting on the fence about starting a business.

Stage 3 – Survival: Entrepreneurs and SMEs in this stage have a business plan and are growing their revenue streams with new clients and customers. They aren’t booked solid or running at full capacity yet, but there’s no longer a question that they have a viable business model.

Stage 4 – Growth or Success: This is the stage in which SMEs are working at full steam, but the demand for their goods and services outstrips their ability to meet it. Something has to give, but business owners often don’t want to let go of the business activities that have gotten them to this stage. At this point, they have to delegate responsibilities and begin to separate from the day-to-day management of the company.

Stage 5 – Expansion or Take-off: Entrepreneurs/SMEs have figured out what caused inefficiencies at Stage 4, have fixed it, and are now running effectively with rapid growth. They have the team, financing and support they need in order to focus on their core competencies – or if they don’t, they have a specific plan in place to secure those resources.

Stage 6 – Maturity and/or Scaling: SMEs that reach maturity often find that business levels off and may even slow down. For most businesses this is normal and to be expected. Other businesses will choose to expand further, after they have matured in one market. They will attempt to replicate their success, or scale their business into other markets, either domestically or internationally.

A Key Challenge for SMEs: Acquiring Financing That Corresponds to Growth Stages

Financing has always been, and still remains, one of the key challenges at every stage of development for entrepreneurs and SMEs. Determining financial needs, and matching financing options to the appropriate level of development or stage of growth is difficult for business owners – and that holds true regardless of region or sector.

I first experienced these challenges in the early 1990s, when I served as a U.S. Treasury advisor in Budapest, Hungary. Although my background was in corporate banking and sovereign lending, I was tasked with advising Hungary’s largest state-owned commercial bank, the Hungarian Credit Bank, on how to diversify its portfolio so that it could be privatized. One potential area of new business was SME lending. SMEs did not exist under communism, but since private sector development in the Central European countries was led by SMEs at that time, there was tremendous business potential for banks – at least in theory.

The problem, of course, was that new businesses are risky because they do not have a track record of success. Banks are conservative by nature, and typically only lend money to businesses with at least five years of financial statements. In Hungary, the situation was complicated by the fact that lending decisions at that time were dictated by the government via its Central Plan (implemented by the National Bank of Hungary), and were not made on a commercial basis. Lending practices – even to the large state-owned enterprises – needed to change dramatically.

When I started working with the Hungarian Credit Bank and its branches, I realized that neither the SMEs nor the bank understood the needs of these businesses. Therefore, they didn’t know how to structure loans to meet those needs. SMEs would often request a short-term loan (3-6 month tenor), even though they planned to build a manufacturing plant that would take 1-2 years to build. They would clearly be unable to repay the loan, because they were not yet generating revenue – but the bank issued them the loans anyway, to my frustration, due to the pressure to diversify. In Hungary, the attempt to diversify bank portfolios led to many poor lending decisions, as banks learned how to assess market-based risks. The ultimate privatization of the three main commercial banks, including the Hungarian Credit Bank in the mid-1990s, improved lending practices considerably, as the new foreign owners provided not only formal credit training to bankers, but also better management and oversight of lending decisions.

The recent project I worked on aims to help businesses and their funders avoid the problems faced in Hungary and other Central and Eastern European countries post-1989, in which business owners didn’t understand their own financing needs, and bankers didn’t have enough experience to advise them on the best structures and tenors of loans.

How to Match Funding to SMEs’ Changing Needs

Fortunately, there are multiple ways for SMEs to acquire funding that’s appropriate to their changing needs, as they progress through their growth stages. And one lesson I’ve learned in Eastern Europe is applicable across markets: As a rule, banks are never the appropriate place to start, even in more mature markets like the U.S. and Europe. In fact, it remains extremely difficult for SMEs to raise funds from any source – beyond the money provided by founders or their friends and family members – while they are developing their idea and/or testing the market. That’s why many engage in “bootstrapping,” or doing more with less, which encourages thriftiness and creativity among entrepreneurs who often find they can accomplish more with existing resources than they originally thought. This is a particularly common practice in Latin American and South Asia, where family resources are limited as well. Crowdfunding is another option for early-stage entrepreneurs and SMEs, provided that internet access is readily available. The practice took off more than a decade ago in the U.S. and Western Europe, and is now increasingly popular in Africa and Latin America, with Nigeria, Ghana, Argentina, Brazil, Chile and Mexico leading the way. However, significant obstacles to crowdfunding remain in developing countries – especially barriers (both legal and financial) to payment.

Opportunities for additional sources of finance improve once businesses are up and running. For instance, once a business has been launched – provided they have sold goods or services – they can engage in “factoring.” This is the process of selling invoices for sales that have been made but have not yet been paid for, in exchange for cash to purchase inputs needed to increase output. Factoring remains popular in emerging Europe, and has grown in popularity in Asia in recent years.

Businesses can also seek angel investment – particularly if they are in need of mentoring and industry expertise. To my surprise, I started to see angel investors providing much-needed early-stage capital to entrepreneurs in developing countries such as Ukraine, Egypt and Ghana in 2014-2015. However, in some developing countries, angel investors from outside of the country are not likely to invest, because of currency controls that limit their ability to repatriate their investments.

Leasing is another option in many emerging markets in the MENA region, West Africa and parts of Asia. SMEs are able to lease plant and equipment from another company in the area that might not be operating at full capacity, rather than buying their own production facilities outright, as a way to improve cash flow. And in later stages of development, after three to five years of successful operation, other, more traditional financing options become more accessible, including bank loans and venture capital.

I cannot stress enough how important it is for SMEs to understand what forms of finance are available at the various stages of growth. Regardless of their geography, one of the main reasons that SMEs fail is that the financing they seek is not appropriate for their level of development. Understanding where they are in terms of their growth – and given that stage of growth, what financing options are available and worth pursuing – is critical to the success of the business.

Barbara Peitsch is an international economic development consultant. 

* The William Davidson Institute is NextBillion’s parent organization.

Photo courtesy of Marco Verch via Flickr.