49252 MAY 2009 ABOUT THE AUTHOR Financial Innovation Drives Small Businesses PAOLO SPAGNOLETTO is an investment officer who IFC makes selective investments in small businesses that are in frontier has worked for several years with the Small Direct countries and have a strong developmental role. Since 2002, the Investment Unit of the Global Manufacturing and Services corporation has made 25 or so small direct investments (SDI), most of (GMS) Cluster in Washington, D.C. which turned out to be success stories. Over the years, SDI developed a specific methodology that works well with small companies. But the APPROVING MANAGER Richard Rutherford, chief most successful stories arise from innovative financial solutions investment officer, GMS, and head of the Small Direct tailored to help small businesses as they incubate and eventually Investment Unit of the GMS Cluster. graduate into fully bankable companies. IFC's Global Manufacturing and Services cooperative farm in a joint venture with Department(GMS)workseachyearonaverage farmers and donor funds. This could only have with at least two small companies that require happened with SECO's backing. On the one creative financing. This has resulted in far- hand, SECO funded PEP's advisory services to reaching developmental impact and replicable helpmanageSAS,notablywithlendingcriteria financial models that build IFC's competitive and loan portfolio management. On the other edge and goodwill in emerging markets. We hand, and more importantly, SECO provided discovered that innovation really is the key to the necessary capital to establish SAS, which making small businesses successful. GMS has neither IFC nor the farmers could do because an unbroken record when using financial IFC was restricted by its project exposure limits, innovation for small businesses. One good and the farmers had inadequate resources. example is the creation of a cooperative business, using innovative financing from both IFC was able to match SECO's $1.25 million IFC and donors, to help alleviate poverty contribution in two repeat investments with a among cotton farmers in Tajikistan. $500,000 loan in 2002 and $750,000 in 2004. Today, SAS has 1,035 farmers as shareholders, Lessons Learned all meeting constitutional criteria for incorporationsetbyIFC.WhileIFC'sinvestment 1) Partnerships help innovation. arm focused on setting up a financial structure that was viable, PEP laid the ground work with Tailored partnerships are key for financial the farmers, training them with best practices innovation with small businesses. In 2002, on cotton growing and corporate governance. with funding assistance from Switzerland's In 2008, IFC-PEP helped SAS establish a State Secretariat for Economic Affairs (SECO), microfinance subsidiary focusing on onlending IFC formed a partnership among SECO and to farmers in compliance with the National IFC's Private Enterprise Partnership (PEP), and Bank of Tajikistan's regulations for financial GMS's investment arm. Through this institutions. SAS, the parent company, remains partnership, GMS helped set up the first joint- in the business of marketing ginned cotton stock company in Tajikistan, SugdAgroinvest and procuring fertilizer and brings economies (SAS), wholly owned by Tajik farmers. SAS was of scale and wider distribution when done on established in the northern town of Khojand a wholesale basis. to provide financing and services directly to farmers, bypassing unnecessary middlemen Capitalize on donor-partner funds as part of and brokerage fees that kept farmers below innovative financing. IFC arranged for SECO the poverty line. to invest funds in SAS first with a capital reserve contribution in 2002 and then through In this case, the innovation is SAS itself, an IFC a share subscription to a capital increase in pilot project to set up the first private 2004. As an open joint stock company, SAS can IFC SMARTLESSONS -- MAY 2009 1 Its net profit margin ranges between 7 and 11 percent, and its return on equity is 5 percent, in linewithotherlendinginstitutions.SAScontinues to remain a viable model, charging farmers competitive market rates of 18 to 24 percent against IFC's fixed rate of 8 percent on average. SAS has no bad debts at present and does not have to increase its impairment reserves. The model is cautiously proving to be sustainable with monetary benefits to farmers. On the advisory side, IFC-PEP trained the farmers to act as shareholders that together share the profits and risks of their collectively owned company. This is not a popular concept for entrepreneurs who normally thrive on their individual success. The buy-in process takes time but has a lasting effect. Farmers can now pay IFC-PEP and investment teams in SAS cotton farms. themselves dividends, limit their indebtedness, and afford better fertilizers and equipment that yield higher productivity rates. This is the result increase its capital through an open subscription. However, of stronger cooperation among them under the guidance it cannot by law control the purchase or transfer of shares of PEP. and hence would be vulnerable to unfriendly takeovers--a high risk in a tightly controlled cotton regime. One option 3) It takes a village to innovate. would have been to change SAS into a limited partnership, which restricts transfers of shares. However, to keep the Create the ideal mind-set for financial innovation. Bringing structure simple and facilitate PEP's management of the farmers together with a common goal of success is indeed a expansion, GMS recommended a capital increase in 2004 of process that takes time--in this case, three years of the existing SAS with SECO becoming a substantial, though preparatory work and another three to create the right temporary, shareholder. This would not totally prevent mind-set. Before SAS was established, IFC visited numerous unwanted parties from entering into SAS, but the likelihood times with the farmers, discussing the concept of a of an unfriendly takeover was greatly diminished. SECO cooperative business. IFC was in reality encouraging the had the ability to block decisions relating to amendments farmers to break ranks with the status quo and with the to the SAS charter, reorganization, or liquidation. SECO, tight farming regime, which in fact accounted for most of however, waived its right to dividend payments, allowing a the poverty in a predominantly agrarian country. IFC redistribution of dividend payouts among farmer inevitably encountered strong resistance from farmers who shareholders. were afraid to lose their only asset, which was their inherited land, as collateral to IFC's borrowing. There was Eventually, SECO will sell its shares to farmers who meet the also a lot of resistance from ginners, town mayors, and local eligibility criteria for qualifying as creditworthy borrowers banks which bartered discounted cotton prices in exchange of SAS. Depending on the timing, SECO's sale of shares to for loan refinancing that kept farmers in perpetual debt. new shareholders will be priced at either book or market value as advised by SAS' supervisory board and to the IFCcannotexpecttochangethecultureofanentireindustry, satisfaction of IFC. SECO will then reinvest the proceeds particularly one that is of such importance to a country. In from the secondary sale of shares into the capital reserves this case, IFC focused on first changing the mind-set of the on a grant basis. Thus, SAS operates independently with ultimate beneficiaries, the farmers. Second, IFC gave farmer shareholders in charge of the business while comfort to the converted farmers by providing them with a reporting to IFC and SECO through specific covenants. secure platform on which to conduct their business. SAS was, in fact, the insurance that farmers needed to break 2) Seek Innovation that lasts. away from middlemen and the cycle of debt. When IFC showed up in 2002 with a PEP advisory team and an Focus on the lasting effects of innovative financing for investment and legal team that literally covered all aspects small businesses. Although SAS itself is the innovation, IFC of their lifeline business, the farmers were greatly focused on creating a corporate culture and incentive encouraged and agreed to become shareholders of SAS. system that would keep farmers constantly engaged and They defied generations of a cultural mind-set and put interested in the long-term well-being of their company. everything they owned at risk. This was quite an Thanks to the commitment of the farmers, SAS averages accomplishment as farmers are generally not keen to revenues of approximately $200,000 each year on an modernize and innovate. Ginners started yielding higher outstanding loan portfolio of approximately $600,000. inputs on the farmers' cotton, and farmers used the extra Revenues comprise mostly interest income on loans to profits to start paying down debts. farmers and, to a lesser extent, commission income on procurement of fertilizers and marketing of ginned cotton. 2 IFC SMARTLESSONS -- MAY 2009 Measure financial innovation by the momentum it creates. SAS created a furor. Farmers were actually walking around town preaching to others about the benefits of becoming a shareholder of SAS. In addition to the 1,035 farmer shareholders that joined SAS, another 11,500 have indirectly benefited from SAS. These are largely family members of the shareholder farmers. On average, each shareholder farmer represents 10 other family members with about five to six of them having their own land and borrowing through the shareholder farmer. Many new farmers are expressing a desire to become full participants of SAS and not only be able to access the financing, input materials, and training it provides, but also actively participate as shareholders, along with corresponding rights and duties. Farmers signing up to become shareholders of SAS. IFC is measuring the financial performance of SAS, its productivity rates, and the breadth of that clears loans to farmers. The eligibility criteria for impact across the population of farmers in its region. The farmers borrowing from SAS was revamped and tightened traditional financial ratios of profit margins, debt-service by external consultants, and by 2007 SAS returned to coverage, and capitalization help track the performance of profitability. SAS. In this case, as part of the innovative aspect of this initiative, IFC set in place both real and financial-sector In addition, the right mind-set was created with all farmers ratios. The company is to maintain a capital adequacy ratio and shareholders understanding that the sustainability of and an open-loan exposure ratio, in addition to debt-service SAS is for their ultimate benefit and eventually those of coverage and dividend-payout ratios just as banks do. To their children. They now appreciate that corporate date, SAS is maintaining a 13 percent capital adequacy ratio governance and transparency can lead to additional (minimum of 10 percent) and an open-loan exposure ratio funding and new investors. (past-due loans to equity) of just 1 percent (maximum of 25 percent) while the debt-service coverage remains close Stay focused on financial performance when innovation to1.0x. (versus a minimum of 1.3x). opens new doors. Recently, IFC received an e-mail with a summary proposal for SAS by one of its advisors. The advisor Capturing these results requires a truly innovative mind-set. proposed a two-step development approach as a way Having just one set of sector-based ratios is difficult enough forward for SAS. The e-mail recommended creating a new for just about any type of client. Imagine imposing two advisory program parallel to SAS as well as developing a different sector-type ratios on farmers who know very little new sister company to take over management of water about corporations to begin with. This is where the systems needed for crop irrigation and a campaign to help intervention of advisory services through a tailored increase SAS 10-fold over a four-year period. This would be partnership becomes critical, and corporate governance is a substantial diversion of effort. especially crucial as this is a new concept for the farmers to ingest. We begin by depicting the individual benefit to Instead, the SAS board and IFC decided to stay focused on farmers versus the collective benefit of SAS. making sure that farmers have good access to loans, that the loans can be repaid, and that farmers can bypass 4) Innovation can lead to divergent paths; but wherever unnecessary middlemen, including those that present it leads, you must measure it. themselves as potential investors in an expanded SAS. Changing the mind-set and culture of a key industry does IFC needs to regularly monitor monthly or quarterly not happen overnight. We are fortunate that it happened financial statements. In 2005, SAS incurred a loss by having over seven years (2002-2009) with Tajik cotton farmers and to write off bad loans that resulted from direct lending to just in one region of the country. SAS is an excellent example certain shareholders. What is more, the shareholders paid of a small innovative business that has weathered seven themselves a handsome dividend that came from cash years of challenges amid a difficult and complex economic reserves. This was quite embarrassing for IFC, which was backdrop. spearheading this pilot project and using donor funds from SECO. Fortunately, SAS did have audited reports, which 5) Innovation that works is replicable. highlighted the problem and prompted IFC to quickly intervene. Under the direction of PEP, SAS changed its Make financial innovation for small businesses replicable. board composition, brought an external party on board, The SAS story comes in handy as IFC promotes general and added an IFC staff member as an observer. In addition, innovation through small businesses. The SAS story is not no board member could be part of the lending committee over yet, and challenges still remain; but the impetus to IFC SMARTLESSONS -- MAY 2009 3 make it survive is stronger than ever from both sides: IFC and the farmers. IFC only has a return on investment in interest-income generated over IFC's small loan. But the developmental impact is tremendous if we consider the breakthrough IFC achieved in Tajikistan by empowering entrepreneurship at the Base of the Pyramid. Conclusion The story of innovation does not end there. IFC is using the SAS experience to promote innovation through small businesses in other contexts. In 2005, IFC set in place a three-year Recycling Linkages Program (RLP) in the Western Balkans to assist small recycling businesses. As it did with SAS, IFC maintains the retail approach through donor-funded advisory services for each small business, helping them endorse the right mind-set for long-termsustainability,corporategovernance, and transparency so that they can become fullybankableandattractivetootherinvestors. Using the SAS model, the wholesale RLP financing initiative will be tracked with specific measures that combine bank performance with the progression of recycling companies and energy and carbon emission savings over the years. DISCLAIMER IFC SmartLessons is an awards program to share lessons learned in development-oriented advisory services and investment operations. The findings, interpretations, and conclusions expressed in this paper are those of the author(s) and do not necessarily reflect the views of IFC or its partner organizations, the Executive Directors of The World Bank or the governments they represent. IFC does not assume any responsibility for the completeness or accuracy of the information contained in this document. Please see the terms and conditions at www.ifc.org/ smartlessons or contact the program at smartlessons@ifc.org. IFC SMARTLESSONS -- MAY 2009 4